-----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, ItX6gG6eG4lRolUUUdDooadM2XWnCmHUFOlesGruUKKN4x/4Bmp6y8fCD+bxNusR VR0OZuSCifuINZJ/vuZTVg== 0001116679-06-001877.txt : 20060808 0001116679-06-001877.hdr.sgml : 20060808 20060808160122 ACCESSION NUMBER: 0001116679-06-001877 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20060630 FILED AS OF DATE: 20060808 DATE AS OF CHANGE: 20060808 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CAPITAL TRUST INC CENTRAL INDEX KEY: 0001061630 STANDARD INDUSTRIAL CLASSIFICATION: REAL ESTATE INVESTMENT TRUSTS [6798] IRS NUMBER: 946181186 STATE OF INCORPORATION: MD FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-14788 FILM NUMBER: 061013034 BUSINESS ADDRESS: STREET 1: 410 PARK AVENUE STREET 2: 14TH FLOOR CITY: NEW YORK STATE: NY ZIP: 10022 BUSINESS PHONE: 2126550220 MAIL ADDRESS: STREET 1: PAUL, HASTINGS, JANOFSKY & WALKER LLP STREET 2: 75 E 55TH ST CITY: NEW YORK STATE: NY ZIP: 10022 10-Q 1 cap10q.txt JUNE 30, 2006 To be filed with the Securities and Exchange Commission on August 8, 2006 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 June 30, 2006 ------------- OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to _____________ Commission File Number 1-14788 Capital Trust, Inc. ------------------- (Exact name of registrant as specified in its charter) Maryland 94-6181186 -------- ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 410 Park Avenue, 14th Floor, New York, NY 10022 - ------------------------------------------ ----- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (212) 655-0220 -------------- 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 by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer |_| Accelerated filer |X| Non-accelerated filer |_| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X --- --- APPLICABLE ONLY TO CORPORATE ISSUERS: The number of outstanding shares of the registrant's class A common stock, par value $0.01 per share, as of August 8, 2006 was 15,339,191. CAPITAL TRUST, INC. INDEX
Part I. Financial Information Item 1: Financial Statements 1 Consolidated Balance Sheets - June 30, 2006 (unaudited) and December 31, 2005 (audited) 1 Consolidated Statements of Income - Three and Six Months Ended June 30, 2006 and 2005 (unaudited) 2 Consolidated Statements of Changes in Shareholders' Equity - Six Months Ended June 30, 2006 and 2005 (unaudited) 3 Consolidated Statements of Cash Flows - Six Months Ended June 30, 2006 and 2005 (unaudited) 4 Notes to Consolidated Financial Statements (unaudited) 5 Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations 23 Item 3: Quantitative and Qualitative Disclosures about Market Risk 29 Item 4: Controls and Procedures 30 Part II. Other Information Item 1: Legal Proceedings 31 Item 1A: Risk Factors 31 Item 2: Unregistered Sales of Equity Securities and Use of Proceeds 31 Item 3: Defaults Upon Senior Securities 31 Item 4: Submission of Matters to a Vote of Security Holders 31 Item 5: Other Information 31 Item 6: Exhibits 33 Signatures 34
Capital Trust, Inc. and Subsidiaries Consolidated Balance Sheets June 30, 2006 and December 31, 2005 (in thousands)
June 30, December 31, 2006 2005 -------------------- -------------------- (unaudited) (audited) Assets Cash and cash equivalents $ 10,233 $ 24,974 Restricted cash 3,344 1,264 Commercial mortgage-backed securities 835,021 487,970 Loans receivable 1,212,569 990,142 Total return swaps 4,138 4,000 Equity investment in CT Mezzanine Partners II LP ("Fund II"), CT MP II LLC ("Fund II GP") and CT Mezzanine Partners III, Inc. ("Fund III") (together "Funds") 9,810 14,301 Deposits and other receivables 49,917 5,679 Accrued interest receivable 11,899 9,437 Interest rate hedge assets 15,504 2,273 Deferred income taxes 4,671 3,979 Prepaid and other assets 17,820 13,511 -------------------- -------------------- Total assets $ 2,174,926 $ 1,557,530 ==================== ==================== Liabilities and Shareholders' Equity Liabilities: Accounts payable and accrued expenses $ 21,388 $ 24,957 Repurchase obligations 333,877 369,751 Collateralized debt obligations ("CDOs") 1,250,510 823,744 Junior subordinated debentures held by trust that issued trust preferred 51,550 -- securities Participations sold 155,950 -- Deferred origination fees and other revenue 2,332 228 -------------------- -------------------- Total liabilities 1,815,607 1,218,680 -------------------- -------------------- Commitments and contingencies Shareholders' equity: Class A common stock, $0.01 par value, 100,000 shares authorized, 14,904 and 14,870 shares issued and outstanding at June 30, 2006 and December 31, 2005, respectively ("class A common stock") 149 149 Restricted class A common stock, $0.01 par value 425 and 404 shares issued and outstanding at June 30, 2006 and December 31, 2005, respectively ("restricted class A common stock" and together with class A common stock, "common stock") 4 4 Additional paid-in capital 328,427 326,299 Accumulated other comprehensive gain 27,998 14,879 Retained earnings/(deficit) 2,741 (2,481) -------------------- -------------------- Total shareholders' equity 359,319 338,850 -------------------- -------------------- Total liabilities and shareholders' equity $ 2,174,926 $ 1,557,530 ==================== ====================
See accompanying notes to unaudited consolidated financial statements. -1- Capital Trust, Inc. and Subsidiaries Consolidated Statements of Income Three and Six Months Ended June 30, 2006 and 2005 (in thousands, except share and per share data) (unaudited)
Three Months Ended Six Months Ended June 30, June 30, -------------------------------------- -------------------------------------- 2006 2005 2006 2005 ----------------- ----------------- ----------------- ----------------- Income from loans and other investments: Interest and related income $ 46,219 $ 18,912 $ 77,851 $ 34,608 Less: Interest and related expenses 26,267 7,631 43,536 13,383 ----------------- ----------------- ----------------- ----------------- Income from loans and other investments, net 19,952 11,281 34,315 21,225 ----------------- ----------------- ----------------- ----------------- Other revenues: Management and advisory fees from Funds 711 2,723 1,447 10,627 Income/(loss) from equity investments in Funds 403 120 722 (1,302) Other interest income 120 212 351 237 ----------------- ----------------- ----------------- ----------------- Total other revenues 1,234 3,055 2,520 9,562 ----------------- ----------------- ----------------- ----------------- Other expenses: General and administrative 5,701 5,314 10,826 11,069 Depreciation and amortization 2,063 280 2,340 559 ----------------- ----------------- ----------------- ----------------- Total other expenses 7,764 5,594 13,166 11,628 ----------------- ----------------- ----------------- ----------------- Income before income taxes 13,422 8,742 23,669 19,159 (Benefit)/provision for income taxes (770) (106) (1,471) 1,161 ----------------- ----------------- ----------------- ----------------- Net income allocable to common stock $ 14,192 $ 8,848 $ 25,140 $ 17,998 ================= ================= ================= ================= Per share information: Net earnings per share of common stock: Basic $ 0.93 $ 0.59 $ 1.64 $ 1.19 ================= ================= ================= ================= Diluted $ 0.91 $ 0.58 $ 1.62 $ 1.17 ================= ================= ================= ================= Weighted average shares of common stock outstanding: Basic 15,329,727 15,117,066 15,323,041 15,102,492 ================= ================= ================= ================= Diluted 15,536,948 15,375,401 15,525,586 15,346,720 ================= ================= ================= ================= Dividends declared per share of common stock $ 0.70 $ 0.55 $ 1.30 $ 1.10 ================= ================= ================= =================
See accompanying notes to unaudited consolidated financial statements. -2- Capital Trust, Inc. and Subsidiaries Consolidated Statements of Changes in Shareholders' Equity For the Six Months Ended June 30, 2006 and 2005 (in thousands) (unaudited)
Restricted Accumulated Class A Class A Additional Other Retained Comprehensive Common Common Paid-In Comprehensive Earnings Income/(Loss) Stock Stock Capital Income/(Loss) (Deficit) Total -------------- ------------------------------------------------------------------------- Balance at January 1, 2005 $ 148 $ 3 $ 321,937 $ 3,815 $ (9,406) $ 316,497 Net income $ 17,998 -- -- -- -- 17,998 17,998 Unrealized loss on derivative financial instruments (2,575) -- -- -- (2,575) -- (2,575) Unrealized gain on available- for-sale securities 1,937 -- -- -- 1,937 -- 1,937 Sale of shares of class A common stock under stock option agreements -- -- -- 183 -- -- 183 Restricted class A common stock earned -- -- -- 1,285 -- -- 1,285 Restricted class A common stock forfeited upon resignation by holder -- -- -- (20) -- -- (20) Dividends declared on class A common stock -- -- -- -- -- (16,630) (16,630) -------------- ------------------------------------------------------------------------- Balance at June 30, 2005 $ 17,360 $ 148 $ 3 $ 323,385 $ 3,177 $ (8,038) $ 318,675 ============== ========================================================================= Balance at January 1, 2006 $ 149 $ 4 $ 326,299 $ 14,879 $ (2,481) $ 338,850 Net income $ 25,140 -- -- -- -- 25,140 25,140 Unrealized gain on derivative financial instruments 13,206 -- -- -- 13,206 -- 13,206 Unrealized loss on available for sale security (373) -- -- -- (373) (373) Amortization of unrealized gain on securities (814) -- -- -- (814) -- (814) Sale of shares of class A common stock under stock option agreements -- -- -- 219 -- -- 219 Deferred gain on settlement of swap, net of amortization -- -- -- -- 1,100 -- 1,100 Reimbursement of offering expenses -- -- -- 123 -- -- 123 Restricted class A common stock earned -- -- -- 1,831 -- -- 1,831 Restricted class A common stock forfeited upon resignation by holder -- -- -- (45) -- -- (45) Dividends declared on class A common stock -- -- -- -- -- (19,918) (19,918) -------------- ------------------------------------------------------------------------- Balance at June 30, 2006 $ 37,159 $ 149 $ 4 $ 328,427 $ 27,998 $ 2,741 $ 359,319 ============== =========================================================================
See accompanying notes to unaudited consolidated financial statements. -3- Capital Trust, Inc. and Subsidiaries Consolidated Statements of Cash Flows Six months ended June 30, 2006 and 2005 (in thousands) (unaudited)
2006 2005 ---------------- ----------------- Cash flows from operating activities: Net income $ 25,140 $ 17,998 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,340 559 (Income)/loss from equity investments in Funds (722) 1,302 Distributions from equity investments in Funds 633 -- Restricted class A common stock earned 1,831 1,285 Amortization of premiums and accretion of discounts on loans and investments, net (635) (1,192) Amortization of deferred gains on interest rate hedges (86) -- Stock based compensation (45) (20) Changes in assets and liabilities, net: Deposits and other receivables 5,236 229 Accrued interest receivable (2,462) (1,391) Deferred income taxes (692) 1,996 Prepaid and other assets 960 1,889 Accounts payable and accrued expenses (2,073) (2,940) Deferred origination fees and other revenue 2,104 302 ---------------- ----------------- Net cash provided by operating activities 31,529 20,017 ---------------- ----------------- Cash flows from investing activities: Purchases of commercial mortgage-backed securities (359,280) (15,156) Principal collections on and proceeds from sale of commercial mortgage-backed securities 11,344 8,008 Origination and purchase of loans receivable (453,559) (357,644) Principal collections on loans receivable 181,992 210,608 Equity investments in Funds -- (4,660) Return of capital from Funds 2,295 3,504 Purchase of total return swaps (4,138) (4,000) Proceeds from total return swaps 4,000 -- Increase in restricted cash (2,080) (2,216) ---------------- ----------------- Net cash used in investing activities (619,426) (161,556) ---------------- ----------------- Cash flows from financing activities: Proceeds from repurchase obligations 534,529 256,491 Repayment of repurchase obligations (570,403) (354,558) Proceeds from credit facilities -- 88,891 Repayment of credit facilities -- (137,076) Issuance of junior subordinated debentures 51,550 -- Purchase of common equity in CT Preferred Trust I (1,550) -- Proceeds from CDOs 429,398 298,913 Repayments of CDOs (2,632) -- Proceeds from participations sold 155,950 -- Settlement of interest rate hedge 1,186 -- Payment of deferred financing costs (3,799) (5,560) Reimbursement of offering expenses 123 -- Dividends paid on class A common stock (21,415) (15,841) Sale of shares of class A common stock under stock option agreements 219 183 ---------------- ----------------- Net cash provided by financing activities 573,156 131,443 ---------------- ----------------- Net decrease in cash and cash equivalents (14,741) (10,096) Cash and cash equivalents at beginning of year 24,974 24,583 ---------------- ----------------- Cash and cash equivalents at end of period $ 10,233 $ 14,487 ================ =================
See accompanying notes to unaudited consolidated financial statements -4- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 1. Organization References herein to "we," "us" or "our" refer to Capital Trust, Inc. and its subsidiaries unless the context specifically requires otherwise. We are a fully integrated, self-managed finance and investment management company that specializes in credit-sensitive structured financial products. To date, our investment programs have focused on loans and securities backed by income-producing commercial real estate assets. We invest for our own account and for private equity funds that we manage on behalf of third parties. From the commencement of our finance business in 1997 through June 30, 2006, we have completed $6.7 billion of investments both directly and on behalf of our managed funds. We conduct our operations as a real estate investment trust, or REIT, for federal income tax purposes and we have tailored our balance sheet investment program to originate and acquire investments to produce a portfolio that meets the asset and income tests necessary to maintain qualification as a REIT. We are headquartered in New York City. 2. Summary of Significant Accounting Policies The accompanying unaudited consolidated interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The accompanying unaudited consolidated interim financial statements should be read in conjunction with the financial statements and the related management discussion and analysis of financial condition and results of operations filed with our Annual Report on Form 10-K for the fiscal year ended December 31, 2005. In our opinion, all adjustments (consisting only of normal, recurring accruals) considered necessary for a fair presentation have been included. The results of operations for the three and six months ended June 30, 2006 are not necessarily indicative of results that may be expected for the entire year ending December 31, 2006. Principles of Consolidation The accompanying unaudited consolidated interim financial statements include, on a consolidated basis, our accounts, the accounts of our wholly-owned subsidiaries and our interests in variable interest entities in which we are the primary beneficiary. All significant intercompany balances and transactions have been eliminated in consolidation. Our interest in CT Preferred Trust I (see Note 7) is accounted for using the equity method and the assets and liabilities are not consolidated into our financial statements due to our determination that CT Preferred Trust I is a variable interest entity in which we are not the primary beneficiary under Financial Accounting Standards Board, or FASB, Interpretation No. 46, or FIN 46. We account for our co-investment interests in two of the private equity funds we co-sponsor and manage, CT Mezzanine Partners II LP and CT Mezzanine Partners III, Inc., or the Funds, under the equity method of accounting. As such, we report a percentage of the earnings of the Funds equal to our ownership percentage on a single line item in the consolidated statement of operations as income from equity investments in the Funds. Our accounting and reporting policies conform in all material respects to accounting principles generally accepted in the United States. Certain prior period amounts have been reclassified to conform to current period classifications. Revenue Recognition Interest income from our loans receivable is recognized over the life of the investment using the effective interest method and recorded on the accrual basis. Fees, premiums, discounts and direct costs in connection with these investments are deferred until the loan is advanced and are then recognized over the term of the loan as an adjustment to yield. Fees on commitments that expire unused are recognized at expiration. For loans where we have unfunded commitments, we amortize the appropriate items on a straight line basis. Income recognition is generally suspended for loans at the earlier of the date at which payments become 90 days past due or when, in the opinion of management, a full recovery of income and principal becomes doubtful. Income recognition is resumed when the loan becomes contractually current and performance is demonstrated to be resumed. Fees from special servicing and asset management services are recognized as services are rendered. We account for incentive fees we can potentially earn from the Funds in accordance with Method 1 of Emerging Issues Task Force Topic D-96. Under Method 1, no incentive income is recorded until all contingencies have been eliminated. Incentive income received prior to that date is recorded as unearned income (a liability). -5- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) Restricted Cash Restricted cash of $3.3 million at June 30, 2006 is on deposit with the trustee for our CDOs and is expected to be used to pay contractual interest and principal and to purchase replacement collateral for our reinvesting CDOs during their respective reinvestment periods. Commercial Mortgage Backed Securities From time to time we purchase commercial mortgage-backed securities, or CMBS, and other investments in which we have a level of control over the issuing entity; we refer to these investments as controlling class investments, or Controlling Class Investments. The presentation of Controlling Class Investments in our financial statements is governed in part by FIN 46. FIN 46 could require that certain Controlling Class Investments be presented on a consolidated basis. Based upon the specific circumstances of certain of our CMBS investments that are Controlling Class Investments and our interpretation of FIN 46, specifically the exemption for qualifying special purpose entities as defined under FASB Statements of Financial Accounting Standard No. 140, or FAS 140, we have concluded that the entities that have issued the Controlling Class Investments should not be presented on a consolidated basis. We are aware that FAS 140 is currently under review by standard setters and that, as a result of this review, our current interpretation of FIN 46 and FAS 140 may change. We classify our investments pursuant to FAS No. 115 on the date of acquisition of the investment. On August 4, 2005, we made a decision to change the accounting classification of our CMBS investments from available-for-sale to held-to-maturity. Held-to-maturity investments are stated at cost plus the amortization of any premiums or discounts and any premiums or discounts will be amortized through the income statement using the level yield method. Other than in the instance of impairment, these held-to-maturity investments will be shown in our financial statements at their adjusted values pursuant to the methodology described above. We may from time to time invest in CMBS and certain other securities which may be classified as available-for-sale. Available-for-sale securities are carried at estimated fair value with the net unrealized gains or losses reported as a component of accumulated other comprehensive income/(loss) in shareholders' equity. Many of these investments are relatively illiquid and management must estimate their values. In making these estimates, management utilizes market prices provided by dealers who make markets in these securities, but may, under certain circumstances, adjust these valuations based on management's judgment. Changes in the valuations do not affect our reported income or cash flows, but impact shareholders' equity and, accordingly, book value per share. Income on these securities is recognized based upon a number of assumptions that are subject to uncertainties and contingencies. Examples include, among other things, the rate and timing of principal payments, including prepayments, repurchases, defaults and liquidations, the pass-through or coupon rate and interest rates. Additional factors that may affect our reported interest income on our mortgage-backed securities include interest payment shortfalls due to delinquencies on the underlying mortgage loans and the timing and magnitude of credit losses on the mortgage loans underlying the securities that are impacted by, among other things, the general condition of the real estate market, including competition for tenants and their related credit quality, and changes in market rental rates. These uncertainties and contingencies are difficult to predict and are subject to future events that may alter the assumptions. We account for CMBS under Emerging Issues Task Force 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets", or EITF 99-20. Under EITF 99-20, when significant changes in estimated cash flows from the cash flows previously estimated occur due to actual prepayment and credit loss experience and the present value of the revised cash flows using the current expected yield is less than the present value of the previously estimated remaining cash flows, adjusted for cash receipts during the intervening period, an other-than-temporary impairment is deemed to have occurred. Accordingly, the security is written down to fair value with the resulting change being included in income and a new cost basis established with the original discount or premium written off when the new cost basis is established. In accordance with this guidance, on a quarterly basis, when significant changes in estimated cash flows from the cash flows previously estimated occur due to actual prepayment and credit loss experience, we calculate a revised yield based upon the current amortized cost of the investment, including any other-than-temporary impairments recognized to date, and the revised cash flows. The revised yield is then applied prospectively to recognize interest income. Management must also assess whether unrealized losses on securities reflect a decline in value that is other-than-temporary, and, accordingly, write down the impaired security to its fair value, through a charge to earnings. -6- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) Significant judgment of management is required in this analysis that includes, but is not limited to, making assumptions regarding the collectibility of the principal and interest, net of related expenses, on the underlying loans. Loans Receivable and Reserve for Possible Credit Losses We purchase and originate commercial real estate debt and related instruments, or Loans, to be held as long term investments at amortized cost. Management must periodically evaluate each of these loans for possible impairment. Impairment is indicated when it is deemed probable that we will not be able to collect all amounts due according to the contractual terms of the loan. If a loan were determined to be permanently impaired, we would write down the loan through a charge to the reserve for possible credit losses. Given the nature of our loan portfolio and the underlying commercial real estate collateral, significant judgment of management is required in determining permanent impairment and the resulting charge to the reserve, which includes but is not limited to making assumptions regarding the value of the real estate that secures the mortgage loan. Our accounting policies require that an allowance for estimated credit losses be reflected in our financial statements based upon an evaluation of known and inherent risks in our Loans. Quarterly, management reevaluates our current portfolio to determine the reserve for possible credit losses. Each loan in our portfolio is evaluated using our loan risk rating system which considers loan-to-value, debt yield, cash flow stability, exit plan, loan sponsorship, loan structure and other factors deemed necessary by management to assess the likelihood of delinquency or default. If we believe that there is a potential for delinquency or default, a downside analysis is prepared to estimate the value of the collateral underlying our loan, and this potential loss is multiplied by the default likelihood to determine the size of the reserve. Actual losses, if any, could ultimately differ from these estimates. Repurchase Obligations In certain circumstances, we have financed the purchase of investments from a counterparty through a repurchase agreement with that same counterparty. We currently record these investments in the same manner as other investments financed with repurchase agreements, with the investment recorded as an asset and the related borrowing under any repurchase agreement as a liability on our consolidated balance sheet. Interest income earned on the investments and interest expense incurred on the repurchase obligations are reported separately on the consolidated income statement. There is a view under consideration by industry participants, based upon a technical interpretation of FAS 140, that these transactions will not qualify as a purchase by us. We believe, consistent with industry practice, that we are accounting for these transactions in an appropriate manner; however, if these investments do not qualify as a purchase under FAS 140, we would be required to present the net investment (asset balance less the repurchase obligation balance) on our balance sheet together with an embedded derivative with the corresponding change in fair value of the derivative being recorded in the income statement. The value of the derivative would reflect not only changes in the value of the underlying investment, but also changes in the value of the underlying credit provided by the counterparty. Income from these arrangements would be presented on a net basis. Furthermore, hedge instruments related to these assets and liabilities, currently deemed effective, may no longer be effective and may have to be accounted for as non-hedge derivatives. As of June 30, 2006 we had entered into eleven such transactions, with a book value of the associated assets of $235.5 million financed with repurchase obligations of $136.5 million. Adoption of the aforementioned treatment would result in a reduction in total assets and liabilities on our consolidated balance sheet of $136.5 million and $118.2 million at June 30, 2006 and December 31, 2005, respectively. Interest Rate Derivative Financial Instruments In the normal course of business, we use interest rate derivative financial instruments to manage, or hedge, cash flow variability caused by interest rate fluctuations. Specifically, we currently use interest rate swaps to effectively convert variable rate liabilities, that are financing fixed rate assets, to fixed rate liabilities. The differential to be paid or received on these agreements is recognized on the accrual basis as an adjustment to the interest expense related to the attendant liability. The swap agreements are generally accounted for on a held-to-maturity basis, and, in cases where they are terminated early, any gain or loss is generally amortized over the remaining life of the hedged item. These swap agreements must be effective in reducing the variability of cash flows of the hedged items in order to qualify for the aforementioned hedge accounting treatment. Changes in value of effective cash flow hedges are reflected in our financial statements through other comprehensive income and do not affect our net income. To the extent a derivative does not qualify for hedge accounting, and is deemed a non-hedge derivative, the changes in its value are included in net income. -7- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) To determine the fair value of derivative instruments, we use third parties to periodically value our interests. Income Taxes Our financial results generally do not reflect provisions for current or deferred income taxes on our REIT taxable income. Management believes that we have and intend to continue to operate in a manner that will continue to allow us to be taxed as a REIT and, as a result, do not expect to pay substantial corporate-level taxes (other than taxes payable by our taxable REIT subsidiaries which are accounted for in accordance with Statement of Financial Accounting Standards No. 109). Many of these requirements, however, are highly technical and complex. If we were to fail to meet these requirements, we may be subject to Federal income tax. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may ultimately differ from those estimates. Reclassifications Certain reclassifications have been made in the presentation of the prior periods consolidated financial statements to conform to the June 30, 2006 presentation. -8- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 3. Commercial Mortgage-Backed Securities Activity relating to our commercial mortgage-backed securities, or CMBS, for the six months ending June 30, 2006 was as follows ($ values in thousands):
Weighted Average ----------------------------------------- Number Number Face Book of of Maturity Asset Type Value Value Securities Issues Rating(1) Coupon(2) Yield(2) (Years)(3) - ------------------------------------------------------------------------------------------------------------------------ December 31, 2005 Floating Rate $ 106,666 $ 105,032 11 9 BBB- 6.89% 6.99% 2.3 Fixed Rate 419,885 382,938 34 22 B+ 6.97% 7.72% 10.1 ----------- ----------- ------- -------- -------- --------- --------- --------- Total/Average 526,551 487,970 45 31 BB- 6.95% 7.57% 8.4 Originations- Six Months Floating Rate $ -- $ -- -- -- -- -- -- -- Fixed Rate 361,255 359,280 34 29 BBB- 6.35% 6.29% 8.1 ----------- ----------- ------- -------- -------- --------- --------- --------- Total/Average 361,255 359,280 34 29 BBB- 6.35% 6.29% 8.1 Repayments & Other(4)-Six Months Floating Rate $ 10,452 $ 10,451 2 1 N/A N/A N/A N/A Fixed Rate 2,152 1,778 0 0 N/A N/A N/A N/A ----------- ----------- ------- -------- -------- --------- --------- --------- Total/Average 12,604 12,229 2 1 N/A N/A N/A N/A June 30, 2006 Floating Rate $ 96,214 $ 94,581 9 8 BBB- 7.81% 7.99% 1.9 Fixed Rate 778,988 740,440 68 51 BB 6.68% 7.35% 8.9 ----------- ----------- ------- -------- -------- --------- --------- --------- Total/Average $ 875,202 $ 835,021 77 59 BB 6.81% 7.42% 8.1 -=========== =========== ======= ======== ======== ========= ========= =========
(1) Rating is the lowest rating from Fitch Ratings, Standard & Poor's and/or Moody's Investors Service and the weighted average is calculated using the Fitch Ratings methodology. (2) Calculations based on LIBOR of 5.33% as of June 30, 2006 and LIBOR of 4.39% as of December 31, 2005. (3) Represents the maturity of the investment assuming all extension options are executed. (4) Includes full repayments, sale, partial repayments, mark-to-market adjustments, and the impact of premium and discount amortization and losses, if any. The figures shown in "Number of Securities" and "Number of Issues" represent the full repayments/sales, if any. At June 30, 2006, we had one CMBS investment that we designated and account for on an available-for-sale basis with a face value of $10.0 million. The security earns interest at a rate of 8.00%. As of June 30, 2006, the security was carried at its fair market value of $10.2 million. The investment matures in February 2010. Quarterly, we reevaluate our CMBS portfolio to determine if there has been an other-than-temporary impairment based upon our assessment of future cash flow receipts. For the six months ended June 30, 2006, we believe that there has not been any adverse change in cash flows for our CMBS portfolio and, therefore, did not recognize any other-than-temporary impairments. During the fourth quarter of 2004, we concluded that two of our CMBS investments had incurred other-than-temporary impairment and we incurred a charge of $5.9 million through the income statement. Significant judgment of management is required in this analysis that includes, but is not limited to, making assumptions regarding the collectibility of the principal and interest, net of related expenses, on the underlying loans. -9- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 4. Loans Receivable Activity relating to our loans receivable for the six months ending June 30, 2006 was as follows ($ values in thousands):
Weighted Average -------------------------------------------- Number of Maturity Asset Type Face Value(1) Book Value(1) Investments LTV(2) Coupon(3) Yield(3) (Years)(4) - ------------------------------------- --------------- --------------- ------------- ---------- ----------- ---------- ---------- December 31, 2005 Floating rate Mortgage loans $ 66,471 $ 66,471 3 71.8% 6.90% 6.85% 2.8 Subordinate mortgage interests 527,497 526,435 51 64.3% 7.75% 7.82% 3.7 Mezzanine loans 230,174 229,998 14 70.4% 8.56% 8.59% 3.5 --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average 824,142 822,904 68 66.6% 7.91% 7.96% 3.6 Fixed rate Mortgage loans -- -- -- -- -- -- -- Subordinate mortgage interests 49,390 48,435 4 71.6% 7.78% 8.15% 16.9 Mezzanine loans 119,543 115,764 4 70.5% 9.00% 9.54% 5.9 --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average 168,933 164,199 8 70.8% 8.65% 9.13% 9.2 --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average - December 31, 2005 993,075 987,103 76 67.1% 8.01% 8.13% 4.5 =============== =============== ============= ========== =========== ========== ========== Originations - Six Months Floating rate Mortgage loans 29,720 29,720 3 72.0% 9.80% 9.79% 4.5 Subordinate mortgage interests 180,630 180,630 3 78.5% 9.36% 9.73% 4.5 Mezzanine loans 224,296 224,296 6 73.3% 10.49% 10.71% 4.7 --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average 434,646 434,646 12 75.5% 9.98% 10.24% 4.6 Fixed rate Mortgage loans -- -- -- -- -- -- -- Subordinate mortgage interests -- -- -- -- -- -- -- Mezzanine loans 18,200 18,913 3 75.7% 9.76% 8.78% 6.5 --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average 18,200 18,913 3 75.7% 9.76% 8.78% 6.5 --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average 452,846 453,559 15 75.5% 9.97% 10.18% 4.7 =============== =============== ============= ========== =========== ========== ========== Repayments & Other(5) - Six Months Floating rate Mortgage loans 25,615 25,615 2 N/A N/A N/A N/A Subordinate mortgage interests 147,077 146,967 18 N/A N/A N/A N/A Mezzanine loans 58,025 58,003 3 N/A N/A N/A N/A --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average 230,717 230,585 23 N/A N/A N/A N/A Fixed rate Mortgage loans -- -- -- N/A N/A N/A N/A Subordinate mortgage interests 104 39 -- N/A N/A N/A N/A Mezzanine loans 355 218 -- N/A N/A N/A N/A --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average 459 257 -- N/A N/A N/A N/A --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average 231,176 230,842 23 N/A N/A N/A N/A =============== =============== ============= ========== =========== ========== ========== June 30, 2006 Floating rate Mortgage loans 70,576 70,576 4 68.0% 8.51% 8.50% 3.6 Subordinate mortgage interests 561,050 560,098 36 66.3% 8.82% 9.02% 3.7 Mezzanine loans 396,445 396,291 17 70.6% 10.09% 10.23% 4.2 --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average 1,028,071 1,026,965 57 66.9% 9.29% 9.45% 3.9 Fixed rate Mortgage loans -- -- -- -- -- -- -- Subordinate mortgage interests 49,286 48,396 4 71.2% 7.78% 8.23% 16.5 Mezzanine loans 137,388 134,459 7 67.9% 9.10% 9.51% 5.6 --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average 186,674 182,855 11 68.8% 8.75% 9.17% 8.5 --------------- --------------- ------------- ---------- ----------- ---------- ---------- Total/Average - June 30, 2006 $ 1,214,745 $ 1,209,820 68 68.2% 9.21% 9.41% 4.6 =============== =============== ============= ========== =========== ========== ==========
(1) Does not include one non-performing loan with a face and book value of $8,000 and $2,749, respectively. (2) Loan to value is based upon appraised values determined by third parties. (3) Calculations based on LIBOR of 5.33% as of June 30, 2006 and LIBOR of 4.39% as of December 31, 2005. (4) Represents the maturity of the investment assuming all extension options are executed. (5) Includes full repayments, sale, partial repayments and the impact of premium and discount amortization and losses, if any. The figures shown in "Number of Investments" represents the full repayments/sales, if any. -10- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) We continue to have one defaulted loan, an $8.0 million first mortgage at June 30, 2006. We received $288,000 in cash on the loan during the six months ended June 30, 2006. The cash collections reduced the carrying value to $2.7 million at June 30, 2006. In some instances, we have a further obligation to fund additional amounts under our Loan arrangements, or Unfunded Commitments. At June 30, 2006, we had one such Unfunded Commitment for a total future funding obligation of $5.1 million. At June 30, 2006 we had $49.5 million included in deposits and other receivables which represented loans that were satisfied and repaid prior to June 30, the proceeds of which had not been remitted to us by our servicers. Quarterly, we reevaluate the reserve for possible credit losses based upon our current portfolio of loans. At June 30, 2006, a detailed review of the entire portfolio was completed, and we concluded that a reserve for possible credit losses was not warranted. 5. Total Return Swaps Total return swaps are derivative contracts in which one party agrees to make payments that replicate the total return of a defined underlying asset, typically in return for another party agreeing to bear the risk of performance of the defined underlying asset. Under our current total return swaps, we bear the risk of performance of the underlying asset and receive payments from our counterparty as compensation. In effect, these total return swaps allow us to receive the leveraged economic benefits of asset ownership without our acquiring, or our counterparty selling, the actual underlying asset. Our total return swaps reference commercial real estate loans and contain a put provision whereby our counterparty has the right to require us to buy the reference loan at its par value under certain reference loan performance scenarios. The put obligation imbedded in these arrangements constitutes a recourse obligation for us to perform under the terms of the contract. Activity relating to our total return swaps for the six months ending June 30, 2006 was as follows ($ values in thousands):
Weighted Average ------------------------ Fair Market Reference Number Value Cash Loan/ of Maturity Asset Type (Book Value) Collateral Participation Investments Yield(1) (Years) - ---------------------------- --------------- ------------ -------------- ----------- ---------- ------------ December 31, 2005 $ 4,000 $ 4,000 $ 20,000 1 18.14% 0.6 Originations- Six Months(2) 4,138 4,138 40,000 2 19.55% 1.9 Repayments- Six Months 4,000 4,000 20,000 1 N/A N/A - ---------------------------- --------------- ------------ -------------- ----------- ---------- ------------ June 30, 2006(2) $ 4,138 $ 4,138 $ 40,000 2 19.55% 1.9 =============== ============ ============== =========== ========== ============
(1) Calculations based on LIBOR of 5.33% as of June 30, 2006 and LIBOR of 4.39% as of December 31, 2005. (2) One total return swap is only partially funded and a $1.9 million Unfunded Commitment exists. The total return swaps are treated as non-hedge derivatives for accounting purposes and, as such, changes in their market value are recorded through the income statement. At June 30, 2006, our total return swaps were valued at par and no such income statement impact was recorded. -11- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 6. Equity Investment in Funds Pursuant to a venture agreement with Citigroup Alternative Investments, LLC, or the Venture Agreement, entered into in 2000 and subsequently amended in 2003, we co-sponsor two funds: CT Mezzanine Partners II LP and CT Mezzanine Partners III, Inc., or the Funds. We are an investor in the Funds and our wholly-owned subsidiary, CT Investment Management Co., LLC, serves as the investment manager to the Funds. The Funds have concluded their respective investment periods and are liquidating in the ordinary course. In connection with entering into the Venture Agreement and the formation of the Funds, we capitalized certain costs. These costs are being amortized over the expected life of each fund with respect to the Funds. During the quarter, management concluded that it no longer intends to co-sponsor investment management vehicles pursuant to the Venture Agreement. Accordingly, the costs related to the Venture Agreement were accelerated and fully amortized during the quarter ended June 30, 2006. Included in depreciation and amortization is $1.8 million of the accelerated amortization of these costs for the quarter. Activity relating to our equity investment in funds for the six months ending June 30, 2006 was as follows ($ values in thousands):
Fund II Venture Fund II GP(1) Fund III Agreement Total ---------- ----------- ---------- ------------ ----------- Equity Investment Beginning Balance $1,278 $692 $7,754 -- $9,724 Company portion of fund income 244 (50) 591 -- 785 Amortization of capitalized costs (63) -- -- -- (63) Investment/(Distributions) from funds (106) -- (2,821) -- (2,927) ---------- ----------- ---------- ------------ ----------- Ending Balance $1,353 $642 $5,524 -- $7,519 ========== =========== ========== ============ =========== Capitalized Costs Beginning Balance $2,036 -- $521 $2,020 $4,577 Amortization of capitalized costs (189) -- (77) (2,020) (2,286) ---------- ----------- ---------- ------------ ----------- Ending Balance $1,847 -- $444 -- $2,291 ========== =========== ========== ============ =========== Total Beginning Balance $3,314 $692 $8,275 $2,020 $14,301 Company portion of fund income 244 (50) 591 -- 785 Amortization of capitalized costs (252) -- (77) (2,020) (2,349) Distributions from funds (106) -- (2,821) -- (2,927) ---------- ----------- ---------- ------------ ----------- Ending Balance $3,200 $642 $5,968 -- $9,810 ========== =========== ========== ============ ===========
(1) $456,000 of the equity investment consists of capitalized costs at Fund II GP which are being amortized over the expected life of the Fund. -12- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 7. Debt At June 30, 2006 and December 31, 2005 we had approximately $1.6 billion and $1.2 billion, respectively, of total debt outstanding. The balances of each category of debt and their respective all-in effective cost, including the amortization of fee and expenses, as of June 30, 2006 and December 31, 2005 were as follows ($ values in thousands):
June 30, 2006 December 31, 2005 ------------------------------------------------ ---------------------------------------------- All-In All-In Face Value Book Value Coupon(1) Cost Face Value Book Value Coupon(1) Cost ---------- ---------- --------- ---- ---------- ---------- --------- ---- Repurchase Obligations $333,877 $333,877 6.48% 6.77% $369,751 $369,751 5.33% 5.57% Collateralized Debt Obligations CDO I (Floating) 252,778 252,778 5.95% 6.37% 252,778 252,778 5.01% 5.43% CDO II (Floating) 298,913 298,913 5.82% 6.04% 298,913 298,913 4.88% 5.10% CDO III (Fixed) 269,594 271,905 5.22% 5.25% 269,594 272,053 5.22% 5.25% CDO IV (Fixed) 426,914 426,914 5.52% 5.62% N/A N/A N/A N/A ------- ------- ----- ----- --- --- --- --- Total CDOs 1,248,199 1,250,510 5.61% 5.79% 821,285 823,744 5.03% 5.25% Junior subordinated debentures 51,550 51,550 7.45% 7.53% N/A N/A N/A N/A ------ ------ ----- ----- --- --- --- --- Total $1,633,626 $1,635,937 5.85% 6.05% $1,191,036 $1,193,495 5.12% 5.35% ========== ========== ===== ===== ========== ========== ===== =====
(1) Calculations based on LIBOR of 5.33% as of June 30, 2006 and LIBOR of 4.39% as of December 31, 2005. Repurchase Obligations At June 30, 2006, we were a party to eight repurchase agreements with six counterparties that provide total commitments of $900.0 million. At quarter end, we borrowed $333.9 million under these agreements and had the ability to borrow $87.8 million without pledging additional collateral. In February 2006, we amended and restated our repurchase agreements with Bear Stearns increasing the combined commitment by $75 million to $200 million. The agreements expire in August 2008 and are designed to finance, on a recourse basis, our general investment activity as well as assets designated for one or more of our CDOs. Under the agreements, advance rates are up to 85.0% and cash costs of funds range from LIBOR plus 0.55% to LIBOR plus 2.00%. At June 30, 2006, we had incurred borrowings under the agreements of $130.1 million and had the ability to borrow an additional $20.4 million against the assets collateralizing the borrowings under the agreement. In March 2006, we extended our $200 million repurchase agreement with Liquid Funding, LTD., an affiliate of Bear Stearns. The agreement, which we originally entered into in February 2002, is designed to provide us with non-recourse financing for our general securities investment activity. Under the agreement, advance rates are up to 85.0% and cash costs of funds range from LIBOR plus 0.40% to LIBOR plus 1.70%. At June 30, 2006, we had no borrowings under the agreement. In March 2006, we entered into a loan-specific repurchase obligation representing borrowings of $6.0 million with Lehman Brothers. The obligation is non-recourse, has a term of one year and the advance rate is 60.0% with a cash cost of LIBOR plus 2.50%. -13- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) In June 2006, we extended our $100 million repurchase agreement with Goldman Sachs Mortgage Company to June 2009. The agreement, which we originally entered into in May 2003, is designed to finance, on a recourse basis, our general investment activity. Under the agreement, advance rates are up to 88.0% and cash costs of funds range from LIBOR plus 0.60% to LIBOR plus 1.95%. At June 30, 2006, we had incurred borrowings under the agreement of $71.7 million and had the ability to borrow an additional $11.1 million against the assets collateralizing the borrowings under the agreement. Collateralized Debt Obligations At June 30, 2006, we had collateralized debt obligations, or CDOs, outstanding from four separate issuances with a total face value of $1.2 billion. Our CDOs are financing vehicles for our assets and, as such, are consolidated on our balance sheet at $1.3 billion, representing the amortized sales price of the securities sold to third parties. In total, our two floating rate reinvesting CDOs provide us with $551.7 million of debt financing at a cash cost of LIBOR plus 0.55% (5.88% at June 30, 2006) and an all-in effective interest rate (including the amortization of issuance costs) of LIBOR plus 0.87% (6.20% at June 30, 2006). Our two fixed rate static CDOs provide us with $698.8 million of financing with a cash cost of 5.35% and an all-in effective interest rate of 5.49%. On a combined basis, our CDOs provide us with $1.3 billion of non-recourse, non-mark-to-market, index matched financing at a weighted average cash cost of 0.49% over the applicable index (5.61% at June 30, 2006) and a weighted average all-in cost of 0.69% over the applicable index (5.79% at June 30, 2006). Junior Subordinated Debentures In February 2006, we sold $50 million of trust preferred securities through a subsidiary, CT Preferred Trust I. The trust preferred securities have a 30-year term ending April 2036, are redeemable at par on or after April 30, 2011 and pay distributions at a fixed rate of 7.45% for the first ten years ending April 2016, and thereafter, at a floating rate of three month LIBOR plus 2.65%. The all-in cost of the junior subordinated debentures is 7.53%. Our interest in CT Preferred Trust I is accounted for using the equity method and the assets and liabilities are not consolidated into our financial statements due to our determination that CT Preferred Trust I is a variable interest entity under FIN 46 and that we are not the primary beneficiary of the entity. Interest on the junior subordinated debentures is included in interest expense on our consolidated income statements while the junior subordinated notes are presented as a separate item in our consolidated balance sheet. Participations Sold Participations sold represent interests in loans that we originated and subsequently sold to third parties. We present these sold interests as secured borrowings in conformity with GAAP on the basis that these arrangements do not qualify as sales under FAS 140. At June 30, 2006, we had two such participations sold, a $56.7 million senior participation that bears interest at a rate of LIBOR plus 2.25% in a $86.7 million mezzanine loan that earns interest at a rate of LIBOR plus 5.85%, and a $100 million pari passu interest in a $150 million subordinate mortgage interest that was sold to CT Large Loan 2006, Inc., an entity managed by us. -14- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 8. Derivative Financial Instruments To manage interest rate risk, we typically employ interest rate swaps or other arrangements, to convert a portion of our floating rate debt to fixed rate debt in order to index match our assets and liabilities. The net payments due under these swap contracts are recognized as interest expense over the life of the contracts. During the six month period ended June 30, 2006, we entered into eight new cash flow hedge agreements with a total notional balance of $388.8 million. Additionally, during the six months ended June 30, 2006, we received $1.2 million from counterparties in settlement of seven interest rate swaps. Recognition of these settlements has been deferred and is being amortized over the remaining life of the previously hedged item using an approximation of the level yield basis. The following table summarizes the notional and fair values of our derivative financial instruments as of June 30, 2006. The notional value provides an indication of the extent of our involvement in the instruments at that time, but does not represent exposure to credit or interest rate risk ($ values in thousands):
Hedge Type Notional Value Interest Rate Maturity Fair Value ---------- --------------------- -------------------- ------------------ ------------- ------------- Swap Cash Flow Hedge $342,481 5.10% 2015 $8,987 Swap Cash Flow Hedge 74,094 4.58% 2014 3,416 Swap Cash Flow Hedge 19,094 3.95% 2011 1,281 Swap Cash Flow Hedge 16,894 4.83% 2014 801 Swap Cash Flow Hedge 16,377 5.52% 2018 77 Swap Cash Flow Hedge 8,007 4.77% 2011 182 Swap Cash Flow Hedge 7,410 5.31% 2011 61 Swap Cash Flow Hedge 7,062 5.10% 2016 244 Swap Cash Flow Hedge 6,328 4.78% 2007 65 Swap Cash Flow Hedge 5,411 3.12% 2007 122 Swap Cash Flow Hedge 5,104 5.18% 2016 150 Swap Cash Flow Hedge 4,134 4.76% 2007 43 Swap Cash Flow Hedge 3,325 5.45% 2015 26 Swap Cash Flow Hedge 2,870 5.08% 2011 49 -------------------- ------------------ ------------- ------------- Total/Weighted Average $518,591 4.96% 2015 $15,504 ==================== ================== ============= =============
As of June 30, 2006, the derivative financial instruments were reported at their fair value of $15.5 million as interest rate hedge assets. Income and expense associated with these instruments is recorded as interest expense on the company's income statement. -15- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 9. Earnings Per Share The following table sets forth the calculation of Basic and Diluted EPS for the six months ended June 30, 2006 and 2005 (in thousands, except share and per share amounts):
Six months Ended June 30, 2006 Six months Ended June 30, 2005 ----------------------------------------------------------------------------------------- Per Share Per Share Net Income Shares Amount Net Income Shares Amount ----------------------------------------------------------- ----------------- ----------- Basic EPS: Net earnings per share of common stock $ 25,140 15,323,041 $ 1.64 $ 17,998 15,102,492 $ 1.19 ============== =========== Effect of Dilutive Securities: Options outstanding for the purchase of common stock -- 137,260 -- 189,210 Stock units outstanding convertible to shares of common stock -- 65,285 -- 55,018 ------------------------------- -------------- ----------------- Diluted EPS: Net earnings per share of common stock and assumed conversions $ 25,140 15,525,586 $ 1.62 $ 17,998 15,346,720 $ 1.17 =============== ============= ========== =============== ================= ===========
The following table sets forth the calculation of Basic and Diluted EPS for the three months ended June 30, 2006 and 2005 (in thousands, except share and per share amounts):
Three months Ended June 30, 2006 Three months Ended June 30, 2005 ----------------------------------------------------------------------------------------- Per Share Per Share Net Income Shares Amount Net Income Shares Amount ----------------------------------------------------------- ----------------- ----------- Basic EPS: Net earnings per share of common stock $ 14,192 15,329,727 $ 0.93 $ 8,848 15,117,066 $ 0.59 ============== =========== Effect of Dilutive Securities: Options outstanding for the purchase of common stock -- 140,452 -- 202,278 Stock units outstanding convertible to shares of common stock -- 66,769 -- 56,057 ------------------------------- -------------- ----------------- Diluted EPS: Net earnings per share of common stock and assumed conversions $ 14,192 15,536,948 $ 0.91 $ 8,848 15,375,401 $ 0.58 =============== ============= ========== =============== ================= ===========
-16- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 10. Income Taxes We made an election to be taxed as a REIT under Section 856(c) of the Internal Revenue Code of 1986, as amended, commencing with the tax year ended December 31, 2003. As a REIT, we are generally not subject to federal income tax. To maintain qualification as a REIT, we must distribute at least 90% of our REIT taxable income to our shareholders and meet certain other requirements. If we fail to qualify as a REIT in any taxable year, we will be subject to federal income tax on taxable income at regular corporate rates. Under certain circumstances, federal income and excise taxes may be due on our undistributed taxable income. At June 30, 2006, we were in compliance with all REIT requirements. During the three and six months ended June 30, 2006, we recorded $770,000 and $1.5 million of income tax benefit for losses of $1.7 million and $3.1 million, respectively, attributable to our taxable REIT subsidiary. Our effective tax rate for the three and six months ended June 30, 2006 attributable to the taxable REIT subsidiary was 46.5% and 47.5%, respectively. 11. Shareholders' Equity On June 14, 2006, we declared a dividend of approximately $10.7 million, or $0.70 per share of common stock applicable to the three-month period ended June 30, 2006, which was paid on July 14, 2006 to shareholders of record on June 30, 2006. All dividends paid during the period presented were ordinary income. 12. Employee Benefit Plans We have three benefit plans in effect at June 30, 2006: (1) the Second Amended and Restated 1997 Long-Term Incentive Stock Plan, or 1997 Employee Plan, (2) the Amended and Restated 1997 Non-Employee Director Stock Plan, or 1997 Director Plan, and (3) the Amended and Restated 2004 Long-Term Incentive Plan, or 2004 Employee Plan. Activity under these three plans for the six month period ended June 30, 2006 is summarized in the chart below in share and share equivalents:
1997 Employee 1997 Director Plan Plan 2004 Employee Plan Total ------------------ -------------------- ------------------- -------------------- Options(1) Beginning Balance 352,960 85,002 -- 437,962 Granted 2006 -- -- -- -- Exercised 2006 (13,169) -- -- (13,169) Canceled 2006 -- -- -- -- ------------------ -------------------- ------------------- -------------------- Ending Balance 339,791 85,002 -- 424,793 Restricted Stock(2) Beginning Balance -- -- 405,790 405,790 Granted 2006 -- -- 49,994 49,994 Vested 2006 -- -- (23,366) (23,366) Forfeited 2006 -- -- (7,414) (7,414) ------------------ -------------------- ------------------- -------------------- Ending Balance -- -- 425,004 425,004 Stock Units(3) Beginning Balance -- 62,384 -- 62,384 Granted 2006 -- 6,226 -- 6,226 Converted 2006 -- -- -- -- ------------------ -------------------- ------------------- -------------------- Ending Balance -- 68,610 -- 68,610 ------------------ -------------------- ------------------- -------------------- Total Outstanding Shares 339,791 153,612 425,004 918,407 ================== ==================== =================== ====================
(1) All options are fully vested as of June 30, 2006. (2) Comprised of both performance based awards that vest upon the attainment of certain common equity return thresholds and time based awards that vest based upon an employee's continued employment on vesting dates. (3) Stock units are given to certain members of our board of directors in lieu of cash compensation for services and in lieu of dividends earned on previously granted stock units. -17- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) Compensation expense for stock awards is recognized on the accelerated attribution method under FASB Interpretation No. 28. The following table summarizes the outstanding options as of June 30, 2006:
Exercise Price Options Weighted Average Weighted per Share Outstanding Exercise Price per Share Average Remaining Life --------------------- ----------------------------- ----------------------------- ------------------------------- 1997 1997 1997 1997 Employee Director 1997 Employee Director 1997 Employee Director Plan Plan Plan Plan Plan Plan --------------- ------------- -------------- -------------- --------------- ---------------- $10.00 - $15.00 55,939 -- 13.34 -- 4.42 -- $15.00 - $20.00 197,184 16,668 16.85 18.00 3.97 1.04 $20.00 - $25.00 -- -- -- -- -- -- $25.00 - $30.00 86,668 68,334 28.85 30.00 1.80 1.59 --------------- ------------- -------------- -------------- --------------- ---------------- Total/W. Average 339,791 85,002 19.33 27.65 3.50 1.48 =============== ============= ============== ============== =============== ================
In addition to the equity interests detailed above, we have granted percentage interests in the incentive compensation received by us from the Funds. During the six months ended June 30, 2006, we granted, net of forfeitures, interests totaling 13.9% of the incentive compensation received by us from Fund III. 13. Supplemental Disclosures for Consolidated Statements of Cash Flows Interest paid on our outstanding debt during the six months ended June 30, 2006 and 2005 was $41.6 million and $13.2 million, respectively. We paid income taxes during the six months ended June 30, 2006 and 2005 of $197,000 and $5,000, respectively. The $49.5 million of loan proceeds classified as deposits and other receivables, as described in Note 4, resulted in a non-cash investing activity. -18- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) 14. Segment Reporting We operate two reportable segments. We have an internal information system that produces performance and asset data for the two segments along business lines. The Balance Sheet Investment segment includes all activities related to direct investment activities (including direct investments in Funds) and the financing thereof. The Investment Management segment includes all activities related to investment management services provided to us and third-party funds under management and includes our taxable REIT subsidiary, CT Investment Management Co., LLC and its subsidiaries. The following table details each segment's contribution to our overall profitability and the identified assets attributable to each such segment for the six months ended, and as of, June 30, 2006, respectively (in thousands):
Balance Sheet Investment Inter-Segment Investment Management Activities Total ------------------ ------------------ ----------------- ----------------- Income from loans and other investments: Interest and related income $ 77,851 $ -- $ -- $ 77,851 Less: Interest and related expenses 43,536 -- -- 43,536 ------------------ ------------------ ----------------- ----------------- Income from loans and other investments, net 34,315 -- -- 34,315 ------------------ ------------------ ----------------- ----------------- Other revenues: Management and advisory fees -- 5,454 (4,007) 1,447 Income/(loss) from equity investments in Funds 772 (50) -- 722 Other interest income 331 20 -- 351 ------------------ ------------------ ----------------- ----------------- Total other revenues 1,103 5,424 (4,007) 2,520 ------------------ ------------------ ----------------- ----------------- Other expenses: General and administrative 6,440 8,393 (4,007) 10,826 Depreciation and amortization 2,210 130 -- 2,340 ------------------ ------------------ ----------------- ----------------- Total other expenses 8,650 8,523 (4,007) 13,166 ------------------ ------------------ ----------------- ----------------- Income before income taxes 26,768 (3,099) -- 23,669 Benefit for income taxes -- (1,471) -- (1,471) ------------------ ------------------ ----------------- ----------------- Net income allocable to class A common stock $ 26,768 $ (1,628) $ -- $ 25,140 ================== ================== ================= ================= Total Assets $ 2,168,885 $ 7,859 $ (1,818) $ 2,174,926 ================== ================== ================= =================
All revenues were generated from external sources within the United States. The Balance Sheet Investment segment paid the Investment Management segment fees of $4.0 million for management of the segment for the six months ended June 30, 2006, which is reflected as offsetting adjustments to other revenues and other expenses in the Inter-Segment Activities column in the tables above. -19- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) The following table details each segment's contribution to our overall profitability and the identified assets attributable to each such segment for the six months ended, and as of, June 30, 2005, respectively (in thousands):
Balance Sheet Investment Inter-Segment Investment Management Activities Total ------------------- ----------------- -------------------- ------------------- Income from loans and other investments: Interest and related income $ 34,608 $ -- $ -- $ 34,608 Less: Interest and related expenses 13,383 -- -- 13,383 ------------------- ----------------- -------------------- ------------------- Income from loans and other investments, net 21,225 -- -- 21,225 ------------------- ----------------- -------------------- ------------------- Other revenues: Management and advisory fees -- 13,007 (2,380) 10,627 Income/(loss) from equity investments in Funds 100 (1,402) -- (1,302) Other interest income 207 38 (8) 237 ------------------- ----------------- -------------------- ------------------- Total other revenues 307 11,643 (2,388) 9,562 ------------------- ----------------- -------------------- ------------------- Other expenses: General and administrative 4,685 8,764 (2,380) 11,069 Other interest expense 8 -- (8) -- Depreciation and amortization 422 137 -- 559 ------------------- ----------------- -------------------- ------------------- Total other expenses 5,115 8,901 (2,388) 11,628 ------------------- ----------------- -------------------- ------------------- Income before income taxes 16,417 2,742 -- 19,159 Provision for income taxes -- 1,161 -- 1,161 ------------------- ----------------- -------------------- ------------------- Net income allocable to class A common stock $ 16,417 $ 1,581 $ -- $ 17,998 =================== ================= ==================== =================== Total Assets $ 1,033,005 $ 11,353 $ (11,221) $ 1,033,137 =================== ================= ==================== ===================
All revenues were generated from external sources within the United States. The Balance Sheet Investment segment paid the Investment Management segment fees of $2.4 million for management of the segment for the six months ended June 30, 2005, which is reflected as offsetting adjustments to other revenues and other expenses in the Inter-Segment Activities column in the tables above. -20- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) The following table details each segment's contribution to our overall profitability and the identified assets attributable to each such segment for the three months ended, and as of, June 30, 2006, respectively (in thousands):
Balance Sheet Investment Inter-Segment Investment Management Activities Total ------------------- ----------------- -------------------- ------------------- Income from loans and other investments: Interest and related income $ 46,219 $ -- $ -- $ 46,219 Less: Interest and related expenses 26,267 -- -- 26,267 ------------------- ----------------- -------------------- ------------------- Income from loans and other investments, net 19,952 -- -- 19,952 ------------------- ----------------- -------------------- ------------------- Other revenues: Management and advisory fees -- 2,850 (2,139) 711 Income/(loss) from equity investments in Funds 412 (9) -- 403 Other interest income 113 7 -- 120 ------------------- ----------------- -------------------- ------------------- Total other revenues 525 2,848 (2,139) 1,234 ------------------- ----------------- -------------------- ------------------- Other expenses: General and administrative 3,400 4,440 (2,139) 5,701 Depreciation and amortization 1,998 65 -- 2,063 ------------------- ----------------- -------------------- ------------------- Total other expenses 5,398 4,505 (2,139) 7,764 ------------------- ----------------- -------------------- ------------------- Income before income taxes 15,079 (1,657) -- 13,422 Benefit for income taxes -- (770) -- (770) ------------------- ----------------- -------------------- ------------------- Net income allocable to class A common stock $ 15,079 $ (887) $ -- $ 14,192 =================== ================= ==================== =================== Total Assets $ 2,168,885 $ 7,859 $ (1,818) $ 2,174,926 =================== ================= ==================== ===================
All revenues were generated from external sources within the United States. The Balance Sheet Investment segment paid the Investment Management segment fees of $2.1 million for management of the segment for the three months ended June 30, 2006, which is reflected as offsetting adjustments to other revenues and other expenses in the Inter-Segment Activities column in the tables above. -21- Capital Trust, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) (unaudited) The following table details each segment's contribution to our overall profitability and the identified assets attributable to each such segment for the three months ended, and as of, June 30, 2005, respectively (in thousands):
Balance Sheet Investment Inter-Segment Investment Management Activities Total ------------------- ----------------- -------------------- ------------------- Income from loans and other investments: Interest and related income $ 18,912 $ -- $ -- $ 18,912 Less: Interest and related expenses 7,631 -- -- 7,631 ------------------- ----------------- -------------------- ------------------- Income from loans and other investments, net 11,281 -- -- 11,281 ------------------- ----------------- -------------------- ------------------- Other revenues: Management and advisory fees -- 3,916 (1,193) 2,723 Income/(loss) from equity investments in Funds 352 (232) -- 120 Other interest income 184 28 -- 212 ------------------- ----------------- -------------------- ------------------- Total other revenues 536 3,712 (1,193) 3,055 ------------------- ----------------- -------------------- ------------------- Other expenses: General and administrative 2,620 3,887 (1,193) 5,314 Other interest expense -- -- -- -- Depreciation and amortization 211 69 -- 280 ------------------- ----------------- -------------------- ------------------- Total other expenses 2,831 3,956 (1,193) 5,594 ------------------- ----------------- -------------------- ------------------- Income before income taxes 8,986 (244) -- 8,742 Benefit for income taxes -- (106) -- (106) ------------------- ----------------- -------------------- ------------------- Net income allocable to class A common stock $ 8,986 $ (138) $ -- $ 8,848 =================== ================= ==================== =================== Total Assets $ 1,033,005 $ 11,353 $ (11,221) $ 1,033,137 =================== ================= ==================== ===================
All revenues were generated from external sources within the United States. The Balance Sheet Investment segment paid the Investment Management segment fees of $1.2 million for management of the segment for the three months ended June 30, 2005, which is reflected as offsetting adjustments to other revenues and other expenses in the Inter-Segment Activities column in the tables above. -22- ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q. Historical results set forth are not necessarily indicative of our future financial position and results of operations. Introduction We are a fully integrated, self-managed finance and investment management company that specializes in credit-sensitive structured financial products. To date, our investment programs have focused on loans and securities backed by income-producing commercial real estate assets. We invest for our own account and for private equity funds that we manage on behalf of third parties. From the commencement of our finance business in 1997 through June 30, 2006 we have completed $6.7 billion of investments both directly and on behalf of our managed funds. We conduct our operations as a real estate investment trust, or REIT, for federal income tax purposes and we are headquartered in New York City. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements. Actual results could differ from these estimates. There have been no material changes to our Critical Accounting Policies described in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 10, 2006. Balance Sheet Overview At June 30, 2006, total assets were $2.2 billion, an increase of $617.4 million or 40% from year end 2005. Asset growth was driven predominantly by growth in CMBS, Loans and total return swaps, or, collectively, Interest Earning Assets. Interest Earning Assets grew by $569.6 million or 38% from $1.5 billion at year end 2005 to $2.1 billion at June 30, 2006. At June 30, 2006, Interest Earning Assets had a weighted average yield of 8.62% (based upon LIBOR of 5.33% as of June 30, 2006). During the six months ended June 30, 2006, we made 34 investments in CMBS, with a total purchase price of $359.3 million ($361.3 million face value). All 34 investments earn interest at fixed rates with a weighted average yield of 6.29%. At June 30, 2006, we held 77 investments in 59 separate issues of CMBS with an aggregate book value of $835.0 million that yield 7.42%. Floating rate CMBS with a book value of $94.6 million yields LIBOR plus 2.66% (7.99% at June 30, 2006). The remaining CMBS, $740.4 million book value, earns interest at fixed rates and yields 7.35%. At June 30, 2006, the expected average life for the CMBS portfolio was 97 months. During the six months ended June 30, 2006, we originated $453.6 million of Loans comprised of three mortgage loans for $29.7 million, three subordinate mortgage interests for $180.6 million and nine mezzanine loans for $243.2 million. Twelve of the loans we originated with a balance of $434.6 million bear interest at floating rates with a yield of LIBOR plus 4.91% (10.24% at June 30, 2006). Three loans with a balance of $18.9 million bear interest at fixed rates with a yield of 8.78%. At June 30, 2006, we had one outstanding unfunded loan commitment for $5.1 million. At June 30, 2006, we had 68 performing loans with a current book value of $1.2 billion and a yield of 9.41%. Eleven of the loans totaling $182.9 million bear interest at fixed rates with a yield of 9.17%. The 57 remaining loans, totaling $1.0 billion, bear interest at variable rates with a yield of LIBOR plus 4.12% (9.45% at June 30, 2006). One mortgage loan with an original principal balance of $8.0 million matured on July 15, 2000 but has not been repaid with respect to principal and interest, all other loans were performing in accordance with their terms. At June 30, 2006, we had two total return swaps with total market value of $4.1 million that earned interest at floating rates with a yield of LIBOR plus 14.22% (19.55% at June 30, 2006). The total return swaps are treated as non-hedge derivatives for accounting purposes and, as such, changes in their market value are recorded through the income statement. -23- At June 30, 2006, we had investments in Funds of $9.8 million, including $2.3 million of unamortized costs capitalized in connection with raising the Funds. These costs are being amortized over the expected lives of the Funds. We were party to 14 cash flow interest rate swaps with a total notional value of $518.6 million as of June 30, 2006. These cash flow interest rate swaps effectively convert floating rate debt to fixed rate debt, which is utilized to finance assets that earn interest at fixed rates. Under these swaps, we receive a rate equal to LIBOR (5.33% at June 30, 2006) and pay a weighted average rate of 4.96%. The market value of the swaps at June 30, 2006 was $15.5 million, which is recorded as an interest rate hedge asset and as a component of accumulated other comprehensive gain/(loss) on our balance sheet. At June 30, 2006, total liabilities were $1.8 billion, an increase of $597.0 million or 49% from year end 2005. Liability growth, the vast majority of which was in the form of repurchase obligations, CDOs and junior subordinated debentures, or, collectively, Interest Bearing Liabilities, was the primary source of funds to finance new originations. At June 30, 2006, Interest Bearing Liabilities had a weighted average cost of 6.05% (based upon LIBOR of 5.33% as of June 30, 2006). At June 30, 2006 we were a party to eight repurchase agreements with six counterparties that provide for total commitments of $900.0 million. At quarter end we borrowed $333.9 million under these agreements and had the ability to borrow an additional $87.8 million without pledging additional collateral. The weighted average cash borrowing cost for all the repurchase agreements outstanding at June 30, 2006 was LIBOR plus 1.15% (6.48% at June 30, 2006). Assuming no additional utilization under the repurchase agreements and including the amortization of all fees paid and capitalized over the remaining term of the repurchase agreements, the all-in effective borrowing cost was LIBOR plus 1.44% (6.77% at June 30, 2006). At June 30, 2006, we had CDOs outstanding from four separate issuances with a total face value of $1.2 billion. Our CDOs are financing vehicles for our assets and, as such, are consolidated on our balance sheet at $1.3 billion, representing the amortized sales price of the securities sold to third parties. In total, our two floating rate reinvesting CDOs provide us with $551.7 million of debt financing at a cash cost of LIBOR plus 0.55% (5.88% at June 30, 2006) and an all-in effective interest rate (including the amortization of issuance costs) of LIBOR plus 0.87% (6.20% at June 30, 2006). Our two fixed rate static CDOs provide us with $698.8 million of financing with a cash cost of 5.35% and an all-in effective interest rate of 5.49%. On a combined basis, our CDOs provide us with $1.3 billion of non-recourse, non-mark-to-market, index matched financing at a weighted average cash cost of 0.49% over the applicable index (5.61% at June 30, 2006) and a weighted average all-in cost of 0.69% over the applicable index (5.79% at June 30, 2006). In February 2006, we sold $50 million of trust preferred securities through a subsidiary, CT Preferred Trust I. The trust preferred securities have a 30-year term ending April 2036, are redeemable at par on or after April 30, 2011 and pay distributions at a fixed rate of 7.45% for the first ten years ending April 2016, and thereafter, at a floating rate of three month LIBOR plus 2.65%. The all-in cost of the junior subordinated debentures is 7.53%. At June 30, 2006, total shareholders' equity was $359.3 million, an increase of $20.5 million or 6% from year end 2005. Growth in shareholders' equity was primarily due to an increase in other comprehensive income as the value of our interest rate swaps increased by $13.2 million and our retained earnings increased by $5.2 million as our net income exceeded our dividends declared by that same amount. At June 30, 2006, we had 15,329,196 shares of our class A common stock outstanding including unearned restricted stock. -24- Investment Management Overview In addition to our balance sheet investment activities, we act as an investment advisor to three private equity funds through our wholly-owned, taxable, investment management subsidiary, CT Investment Management Co., LLC, or CTIMCO. Two of these funds, CT Mezzanine Partners II LP, or Fund II, and CT Mezzanine Partners III, Inc., or Fund III, are co-sponsored vehicles under a joint venture with Citigroup Alternative Investments, or CAI. During the three months ended June 30, 2006, we concluded that we no longer intend to co-sponsor investment management vehicles with CAI. Accordingly, during the three months ended June 30, 2006, we expensed an additional $1.8 million of capitalized costs relating to the Venture Agreement. The third fund, CT Large Loan 2006, Inc., or Large Loan Fund, held its initial and final closing during the quarter ended June 30, 2006, is exclusively sponsored by us and is not governed by the Venture Agreement. At June 30, 2006, Fund II had five investments, total assets of $52.4 million and invested equity of $24.6 million. Our equity co-investment at quarter end totaled $1.4 million (5.88%). CTIMCO earns base management fees of 1.29% per annum on invested capital and is entitled to incentive compensation payments on a 50/50 basis with our co-sponsor. We have agreed to pay up to 25% of the incentive compensation we receive to employees. If Fund II's assets were sold and liabilities were settled on July 1, 2006 at the recorded book value, and the fund's equity and income were distributed, we would record approximately $2.5 million of additional gross incentive fees. At June 30, 2006, Fund III had 10 investments, total assets of $375.2 million and invested equity of $106.7 million. Our equity co-investment at quarter end totaled $5.5 million (4.71%). CTIMCO earns base management fees of 1.42% per annum on invested capital and is entitled to incentive compensation payments on a 62.5/37.5 basis with our co-sponsor. We have agreed to pay up to 40% of the incentive compensation we receive to employees. If Fund III's assets were sold and liabilities were settled on July 1, 2006 at the recorded book value, and the fund's equity and income were distributed, we would record approximately $6.7 million of additional gross incentive fees. On May 9, 2006 and June 26, 2006, we held the initial and final closings, respectively, of Large Loan Fund obtaining total equity commitments of $325 million, all from third parties. This fund will co-invest with us in real estate mezzanine investments in excess of $50 million. Large Loan Fund made its initial investment in May of 2006, purchasing $100 million of a $150 million subordinate mortgage interest that we originated, with the $50 million balance held by us. Large Loan Fund will employ leverage capped at 1:1. At June 30, 2006, Large Loan Fund had one investment with a total book value of $100 million. CTIMCO earns management fees of 0.75% per annum of invested assets. Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005 We reported net income of $14.2 million for the three months ended June 30, 2006, an increase of $5.3 million (60%) from net income of $8.8 million for the three months ended June 30, 2005. The increase was primarily the result of an increase in net interest income from Interest Earning Assets (due to both higher levels of aggregate investments and increases in average LIBOR), partially offset by decreases in fund base management and incentive management fees. Interest and related income from Interest Earning Assets amounted to $46.2 million for the three months ended June 30, 2006, an increase of $27.3 million or 144.4% from the $18.9 million for the three months ended June 30, 2005. The increase in interest income was due to the growth in Interest Earning Assets and a higher average LIBOR rate, which increased by 2.05% from 3.11% for the three months ended June 30, 2005 to 5.16% for the three months ended June 30, 2006. Interest and related expenses on Interest Bearing Liabilities amounted to $26.3 million for the three months ended June 30, 2006, an increase of $18.7 million from the $7.6 million for the three months ended June 30, 2005. The increase in expense was due to an increase in the amount of Interest Bearing Liabilities outstanding in connection with our asset growth as well as an increase in LIBOR. The increase in interest expense was partially offset by the increased use of lower cost collateralized debt obligations and more favorable terms under our repurchase agreements. Other revenues decreased $1.9 million from $3.1 million for the three months ended June 30, 2005 to $1.2 million for the three months ended June 30, 2006. The decrease was primarily due to the lower level of fund management fees received during the three months ended June 30, 2006. -25- General and administrative expenses increased $387,000 to $5.7 million for the three months ended June 30, 2006 from approximately $5.3 million for the three months ended June 30, 2005. The increase in general and administrative expenses was primarily due to increased employee compensation expense. Depreciation and amortization increased by $1.8 million from $280,000 to $2.1 million for the three months ended June 30, 2006 as a result of our expensing all of the capitalized costs relating to the Venture Agreement. We have made an election to be taxed as a REIT under Section 856(c) of the Internal Revenue Code of 1986, as amended, commencing with the tax year ended December 31, 2003. As a REIT, we generally are not subject to federal income tax. To maintain qualification as a REIT, we must distribute at least 90% of our REIT taxable income to our shareholders and meet certain other requirements. If we fail to qualify as a REIT in any taxable three months, we will be subject to federal income tax on our taxable income at regular corporate rates. We may also be subject to certain state and local taxes on our income and property. Under certain circumstances, federal income and excise taxes may be due on our undistributed taxable income. At June 30, 2006 and 2005, we were in compliance with all REIT requirements and, therefore, have not provided for income tax expense on our REIT taxable income for the three months ended June 30, 2006 and 2005. We also have taxable REIT subsidiaries which are subject to tax at regular corporate rates. During the three months ended June 30, 2006 and 2005, we recorded a $770,000 and $106,000 income tax benefit, respectively. The income tax benefits resulted from a net operating loss for the period in our taxable REIT subsidiaries. Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005 We reported net income of $25.1 million for the six months ended June 30, 2006, an increase of $7.1 million (40%) from net income of $18.0 million for the six months ended June 30, 2005. The increase was primarily the result of an increase in net interest income from Interest Earning Assets (due to both higher levels of aggregate investments and increases in average LIBOR), partially offset by decreases in fund base management and incentive management fees. Interest and related income from Interest Earning Assets amounted to $77.9 million for the six months ended June 30, 2006, an increase of $43.2 million or 125.0% from the $34.6 million for the six months ended June 30, 2005. The increase in interest income was due to the growth in Interest Earning Assets and a higher average LIBOR rate, which increased by 1.97% from 2.88% for the six months ended June 30, 2005 to 4.85% for the six months ended June 30, 2006. Interest and related expenses on Interest Bearing Liabilities amounted to $43.5 million for the six months ended June 30, 2006, an increase of $30.1 million from the $13.4 million for the six months ended June 30, 2005. The increase in expense was due to an increase in the amount of Interest Bearing Liabilities outstanding in connection with our asset growth as well as an increase in LIBOR. The increase in interest expense was partially offset by the increased use of lower cost collateralized debt obligations and more favorable terms under our repurchase agreements. Other revenues decreased $7.1 million from $9.6 million for the six months ended June 30, 2005 to $2.5 million for the six months ended June 30, 2006. The decrease was primarily due to the receipt of $6.2 million of incentive management fees from Fund II during the six months ended June 30, 2005 offset by the acceleration of $1.0 million of previously capitalized fund related expenses in that same period as well as the lower level of fund management fees received during the six months ended June 30, 2006. General and administrative expenses decreased $242,000 to $10.8 million for the six months ended June 30, 2006 from approximately $11.1 million for the six months ended June 30, 2005. The decrease in general and administrative expenses was primarily due to the allocation in March 2005 of Fund II incentive management fees for payment to employees (representing 25% of the total received by us, or $2.0 million) offset by generally higher employee compensation expense. Depreciation and amortization increased by $1.8 million from $559,000 to $2.3 million for the six months ended June 30, 2006 as a result of our expensing all of the capitalized costs relating to the Venture Agreement. At June 30, 2006 and 2005, we were in compliance with all REIT requirements and, therefore, have not provided for income tax expense on our REIT taxable income for the six months ended June 30, 2006 and 2005. We also have taxable REIT subsidiaries which are subject to tax at regular corporate rates. During the six months ended June 30, -26- 2006 and 2005, we recorded a $1.5 million income tax benefit and a $1.2 million income tax expense, respectively. The income tax benefit resulted from a net operating loss for the period in our taxable REIT subsidiaries. Liquidity and Capital Resources We expect that during the balance of 2006, we will use a significant amount of our available capital resources to originate or purchase new loans and investments for our balance sheet. We intend to continue to employ leverage on our balance sheet assets to enhance our return on equity. At June 30, 2006, we had $10.2 million in cash, $3.3 million in restricted cash and $87.8 million of immediately available liquidity from our repurchase agreements. Our primary sources of liquidity for the remainder of 2006 are expected to be cash on hand, cash generated from operations, principal and interest payments received on loans and investments, additional borrowings under our repurchase agreements, and capital raised through CDO issuances, stock offerings, junior subordinated debenture issuances and other capital activities. We believe these sources of capital will be adequate to meet future cash requirements. We experienced a net decrease in cash of $14.7 million for the six months ended June 30, 2006, compared to a net decrease of $10.1 million for the six months ended June 30, 2005. Cash provided by operating activities during the six months ended June 30, 2006 was $31.5 million, compared to cash provided by operating activities of $20.0 million during the same period of 2005. The change was primarily due to increased net interest income due to our increased investment originations. For the six months ended June 30, 2006, cash used in investing activities was $619.4 million, compared to $161.6 million during the same period in 2005. The change was primarily due to our increased investment originations. For the six months ended June 30, 2006, cash provided by financing activities was $573.2 million, compared to $131.4 million during the same period in 2005. The change was primarily due to our increased investment originations. At June 30, 2006, we had outstanding repurchase obligations totaling $333.9 million. At June 30, 2006, we had pledged assets that enable us to obtain an additional $87.8 million of financing under our repurchase agreements. At June 30, 2006, we had $596.5 million of credit available for the financing of new and existing unpledged assets pursuant to our repurchase agreements. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements. Impact of Inflation Our operating results depend in part on the difference between the interest income earned on our interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities. Changes in the general level of interest rates prevailing in the economy in response to changes in the rate of inflation or otherwise can affect our income by affecting the spread between our interest-earning assets and interest-bearing liabilities, as well as, among other things, the value of our interest-earning assets and our ability to realize gains from the sale of assets and the average life of our interest-earning assets. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations, and other factors beyond our control. We employ the use of correlated hedging strategies to limit the effects of changes in interest rates on our operations, including engaging in interest rate swaps and interest rate caps to minimize our exposure to changes in interest rates. There can be no assurance that we will be able to adequately protect against the foregoing risks or that we will ultimately realize an economic benefit from any hedging contract into which we enter. -27- Note on Forward-Looking Statements Except for historical information contained herein, this quarterly report on Form 10-Q contains forward-looking statements within the meaning of the Section 21E of the Securities and Exchange Act of 1934, as amended, which involve certain risks and uncertainties. Forward-looking statements are included with respect to, among other things, the our current business plan, business and investment strategy and portfolio management. These forward-looking statements are identified by their use of such terms and phrases as "intends," "intend," "intended," "goal," "estimate," "estimates," "expects," "expect," "expected," "project," "projected," "projections," "plans," "anticipates," "anticipated," "should," "designed to," "foreseeable future," "believe," "believes" and "scheduled" and similar expressions. Our actual results or outcomes may differ materially from those anticipated. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date the statement was made. We assume no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Important factors that we believe might cause actual results to differ from any results expressed or implied by these forward-looking statements are discussed in the cautionary statements contained in Exhibit 99.1 to this Form 10-Q, which are incorporated herein by reference. In assessing forward-looking statements contained herein, readers are urged to read carefully all cautionary statements contained in this Form 10-Q. -28- ITEM 3. Quantitative and Qualitative Disclosures about Market Risk The principal objective of our asset/liability management activities is to maximize net interest income, while managing levels of interest rate risk. Net interest income and interest expense are subject to the risk of interest rate fluctuations. In certain instances, to mitigate the impact of fluctuations in interest rates, we use interest rate swaps to effectively convert variable rate liabilities to fixed rate liabilities for proper matching with fixed rate assets. The swap agreements are generally held-to-maturity and we do not use interest rate derivative financial instruments for trading purposes. The differential to be paid or received on these agreements is recognized as an adjustment to the interest expense related to debt and is recognized on the accrual basis. Our loans and investments, including our fund investments, are also subject to credit risk. The ultimate performance and value of our loans and investments depends upon the owner's ability to operate the properties that serve as our collateral so that they produce cash flows adequate to pay interest and principal due us. To monitor this risk, our asset management team continuously reviews the investment portfolio and in certain instances is in constant contact with our borrowers, monitoring performance of the collateral and enforcing our rights as necessary. The following table provides information about our financial instruments that are sensitive to changes in interest rates at June 30, 2006. For financial assets and debt obligations, the table presents cash flows (in certain cases, face adjusted for expected losses) to the expected maturity and weighted average interest rates based upon the current carrying values of the remaining assets and liabilities. For interest rate swaps, the table presents notional amounts and weighted average fixed pay and variable receive interest rates by contractual maturity dates. Notional amounts are used to calculate the contractual cash flows to be exchanged under the contract. Weighted average variable rates are based on rates in effect as of the reporting date.
Expected Maturity Dates ------------------------------------------------------------------------------------------------- 2006 2007 2008 2009 2010 Thereafter Total Fair Value ---- ---- ---- ---- ---- ---------- ----- ---------- Assets: (dollars in thousands) Commercial Mortgage- backed Securities Fixed Rate $ 8,690 $ 21,745 $ 48,529 $ 7,784 $ 17,639 $ 644,661 $ 749,048 $ 713,229 Average interest rate 6.66% 6.66% 6.67% 6.71% 6.70% 6.49% 6.52% Variable Rate $ 2,141 $ 18,603 $ 58,929 $ 7,571 -- $ 1,584 $ 88,828 $ 95,195 Average interest rate 7.77% 7.68% 7.78% 8.02% -- 8.48% 7.79% Loans receivable Fixed Rate $ 740 $ 8,390 $ 61,147 $ 1,538 $ 1,671 $ 113,188 $ 186,674 $ 183,029 Average interest rate 8.75% 8.76% 8.31% 7.75% 7.75% 7.36% 7.74% Variable Rate $ 180,380 $ 247,499 $ 330,754 $ 69,784 $ 112,260 $ 90,143 $ 1,030,820 $ 1,031,276 Average interest rate 7.88% 7.68% 8.44% 9.45% 10.25% 11.05% 8.66% Total Return Swaps Variable Rate -- $ 3,000 -- $ 1,138 -- -- $ 4,138 $ 4,138 Average interest rate -- 20.56% -- 16.90% -- -- 19.55% Interest rate swaps Notional amounts $ 8,365 $ 34,234 $ 39,913 $ 36,773 $ 13,589 $ 385,717 $ 518,591 $ 15,504 Average fixed pay rate 5.06% 4.66% 5.08% 4.68% 5.04% 4.99% 4.96% Average variable receive rate 5.33% 5.33% 5.33% 5.33% 5.33% 5.33% 5.33% Liabilities: Repurchase obligations Variable Rate $ 30,423 -- $ 231,752 $ 71,702 -- -- $ 333,877 $ 333,877 Average interest rate 6.31% -- 6.54% 6.42% -- -- 6.49% Collateralized debt obligations Fixed Rate $ 427 $ 5,976 $ 5,030 $ 4,396 $ 2,603 $ 267,685 $ 286,117 $ 257,699 Average interest rate 6.82% 5.37% 5.65% 5.69% 5.28% 5.29% 5.31% Variable Rate $ 10,609 $ 24,255 $ 121,225 $ 201,424 $151,803 $ 452,766 $ 962,082 $ 962,082 Average interest rate 5.71% 5.71% 5.34% 5.55% 5.74% 5.83% 5.69%
-29- ITEM 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures An evaluation of the effectiveness of the design and operation of our "disclosure controls and procedures" (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this quarterly report was made under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (a) are effective to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act is timely recorded, processed, summarized and reported and (b) include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Changes in Internal Controls There have been no significant changes in our "internal control over financial reporting" (as defined in rule 13a-15(f) under the Securities Exchange Act) that occurred during the period covered by this quarterly report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. -30- PART II. OTHER INFORMATION ITEM 1: Legal Proceedings None ITEM 1A: Risk Factors There have been no material changes to the risk factors previously disclosed in Item 1A of our annual report on Form 10-K for the year ended December 31, 2005, filed on March 10, 2006 with the Securities and Exchange Commission. ITEM 2: Unregistered Sales of Equity Securities and Use of Proceeds None ITEM 3: Defaults Upon Senior Securities None ITEM 4: Submission of Matters to a Vote of Security Holders At the 2006 annual meeting of our shareholders held on June 14, 2006, shareholders considered and voted upon: 1. A proposal to elect nine directors (identified in the table below) to serve until the next annual meeting of shareholders and until such directors' successors are duly elected and qualify ("Proposal 1"); and 2. A proposal to ratify the appointment of Ernst & Young LLP as our independent auditors for the fiscal year ending December 31, 2006 ("Proposal 2"). The following table sets forth the number of votes in favor, the number of votes opposed, the number of abstentions (or votes withheld in the case of the election of directors) and broker non-votes with respect to each of the foregoing proposals.
Proposal Votes in Favor Votes Opposed Abstentions Broker Non-Votes (Withheld) Proposal 1 Samuel Zell 13,526,548 -- 187,489 -- Thomas E. Dobrowski 13,599,708 -- 114,329 -- Martin L. Edelman 12,603,006 -- 1,111,031 -- Craig M. Hatkoff 13,564,339 -- 149,698 -- Edward S. Hyman 13,608,640 -- 105,397 -- John R. Klopp 13,564,108 -- 149,929 -- Henry N. Nassau 13,602,258 -- 111,779 -- Joshua A. Polan 13,569,774 -- 144,263 -- Lynne B. Sagalyn 13,599,425 -- 114,612 -- Proposal 2 13,642,720 68,989 2,328 --
ITEM 5: Other Information On August 4, 2006 (the "Effective Date"), we entered into an employment agreement (the "Agreement"), with Thomas C. Ruffing, pursuant to which Mr. Ruffing will serve as our Chief Credit Officer and Head of Asset Management through December 31, 2008, (the "Expiration Date"), subject to earlier termination under certain circumstances as described below. Mr. Ruffing previously served as a Managing Director for us. -31- Under the Agreement, Mr. Ruffing will receive a base salary at an annual rate of $250,000, subject to possible increases by our board of directors. Pursuant to the Agreement, Mr. Ruffing, will receive for each year commencing with 2006, a cash bonus in an amount determined by our board of directors, but in no event less than $250,000 per year. Pursuant to the Agreement, Mr. Ruffing was granted, as of the Effective Date and pursuant to our amended and restated 2004 long-term incentive plan (the "2004 Plan"), an award of 19,510 restricted shares (the "Initial Grant"), 50% of which will be subject to time vesting in two equal installments on December 31, 2007 and December 31, 2008 and 50% of which will be issued as a performance compensation award and will vest on the Expiration Date if the total shareholder return, measured for the term of the Agreement, is at least 13% per annum. Mr. Ruffing was also awarded, as of the Effective Date and pursuant to the 2004 Plan, a performance compensation award (the "Fund III Performance Compensation Award") that provides for cash payments equal to 4% of the amount of cash we receive, if any, as incentive management fees from CT Mezzanine Partners III, Inc., that vests 65% as of the Effective Date and 35% upon our receipt of the incentive management fees. We may terminate Mr. Ruffing's employment upon his death, upon disability that has incapacitated him for at least 120 consecutive calendar days or for at least 180 calendar days, whether or not consecutive, in any 365 calendar day period, or for conduct defined as "cause" in the Agreement. Mr. Ruffing has the right to terminate the Agreement for "good reason" as defined in the Agreement, which includes, among other things, the substantial and adverse diminishment of his title and responsibilities and a change of control. In the event of our termination of Mr. Ruffing's employment without "cause" or Mr. Ruffing terminating his employment for "good reason," Mr. Ruffing is entitled to certain post termination benefits, including: a lump-sum cash payment equal to the greater of (i) the sum of base salary and annual bonus for the balance of the term of the Agreement or (ii) one year of base salary and the highest annual cash bonus paid during the term of the Agreement; the accelerated vesting in full of all restricted stock grants made prior thereto and the Initial Grant; the accelerated vesting in full of the Fund III Performance Compensation Award; stock options that were granted or first vest after 2004 may be exercised until the later of December 31 of the year of termination and the date two and one-half months after termination or the expiration of the options; and we shall pay medical insurance coverage premiums for the earlier of 18 months following termination or the date Mr. Ruffing receives comparable coverage from another employer. In addition, the Agreement also provides specified partial salary and bonus payments and benefits upon death or disability. The Agreement contains provisions relating to non-competition during the term of employment, protection of our confidential information and intellectual property, and non-solicitation of our employees, which provisions extend for up to12 months following termination in certain circumstances. -32- ITEM 6: Exhibits 3.1 Charter of Capital Trust, Inc. (filed as Exhibit 3.1.a to the Company's Current Report on Form 8-K (File No. 1-14788) filed on April 2, 2003 and incorporated herein by reference). 3.2 Amended and Restated Bylaws of Capital Trust, Inc. (filed as Exhibit 3.2 to the Company's Current Report on Form 8-K (File No. 1-14788) filed on January 29, 1999 and incorporated herein by reference). 3.3 First Amendment to Amended and Restated Bylaws of Capital Trust, Inc. (filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q (File No. 1-14788) filed on August 16, 2004 and incorporated herein by reference). 10.1 Ninth Amendment to the Master Repurchase Agreement, dated as of June 28, 2006, by and between the Company and Goldman Sachs Mortgage Company (filed as Exhibit 10.1 to Capital Trust, Inc.'s Current Report on Form 8-K (File No. 1-14788) filed on June 29, 2006 and incorporated herein by reference). o+10.2 Employment Agreement, dated as of August 4, 2006, by and between Capital Trust, Inc., CT Investment Management Co., LLC and Thomas C. Ruffing. 11.1 Statements regarding Computation of Earnings per Share (Data required by Statement of Financial Accounting Standard No. 128, Earnings per Share, is provided in Note 9 to the consolidated financial statements contained in this report). o31.1 Certification of John R. Klopp, Chief Executive Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. o31.2 Certification of Geoffrey G. Jervis, Chief Financial Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. o32.1 Certification of John R. Klopp, Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. o32.2 Certification of Geoffrey G. Jervis, Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. o99.1 Risk Factors ------------------------ o Filed herewith + Represents a management contract or compensatory plan or arrangement -33- SIGNATURES 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. CAPITAL TRUST, INC. August 8, 2006 /s/ John R. Klopp - -------------- ----------------- Date John R. Klopp Chief Executive Officer August 8, 2006 /s/ Geoffrey G. Jervis - -------------- ----------------------- Date Geoffrey G. Jervis Chief Financial Officer -34- EX-10 2 ex10-2.txt EXHIBIT 10.2: EMPLOYMENT AGREEMENT Exhibit 10.2 EMPLOYMENT AGREEMENT I, Thomas C. Ruffing, agree to the terms and conditions of employment with Capital Trust, Inc. ("CT") and CT Investment Management Co., LLC ("CTIMCO," and together with CT, the "Company") set forth in this Employment Agreement (this "Agreement") dated as of August 4, 2006 ("Effective Date"). 1. Term of Employment. My employment under this Agreement shall commence effective as of the Effective Date and shall end on December 31, 2008 ("Expiration Date") or such earlier date on which my employment is terminated under Section 5 of this Agreement (the period from the Effective Date through the Expiration Date, or such earlier termination as provided for herein being referred to herein as the "Term"). If the Company continues to employ me beyond the Expiration Date without entering into a written agreement extending the term of this Agreement, except as provided in a new written employment agreement between the Company and me, I shall continue to receive the base salary in effect as of the Expiration Date for as long as I remain employed by the Company, but all other obligations and rights under this Agreement shall prospectively lapse as of the Expiration Date, except my right to payment of compensation accrued or earned prior to the Expiration Date or any other rights which by their terms extend beyond the Expiration Date, including the Company's ongoing indemnification obligation under Section 4, any post-termination payment provisions under Section 5(a), my confidentiality and other obligations under Section 6, and our mutual arbitration obligations under Section 8, and I thereafter shall be an at-will employee of the Company. 2. Nature of Duties. I shall be the Company's Chief Credit Officer and Head of Asset Management and shall have all of the customary powers and duties associated with those positions. I shall devote my full business time and effort to the performance of my duties for the Company. I shall be subject to the Company's policies, procedures and approval practices, as generally in effect from time to time and made known to me, to the extent consistent with this Agreement. I shall not, while employed by the Company, engage in, accept employment from or provide services to any other person, firm, corporation, governmental agency or other entity; provided, however, that subject to Section 6(c) hereof, I may (a) devote a reasonable amount of time to civic activities, provided that such activities do not conflict with or detract from my diligent performance of my duties hereunder. 3. Place of Performance. I shall be based in New York City, except for required travel on the Company's business. 4. Compensation and Related Matters. (a) Base Salary. The Company shall pay me base salary at an annual rate of $250,000, subject to future upward adjustments at the discretion of the Company's Board of Directors ("Board"). My base salary shall be paid in conformity with the Company's salary payment practices generally applicable to senior Company executives. (b) Annual Bonuses; Annual Long Term Equity Incentive Grants. The Company shall pay me annual bonuses and grant me annual long term equity incentives, determined as follows: (i) For calendar year 2006 and each subsequent full calendar year of the Term, I shall be eligible to receive an annual bonus from the Company ("Annual Bonus"), payable no later than 90 days after the end of the calendar year in respect of which the bonus is awarded, in such amount as may be determined by the Board in its sole and absolute discretion, but in no event less than $250,000 per year. (ii) I shall be eligible for such other bonuses and other incentive compensation under bonus and incentive stock plans (including plans that provide for performance compensation tied to carried interest and incentive investment management fees from funds under management) generally available to other senior Company executives as the Compensation Committee determines in its sole discretion. (c) Restricted Stock. (i) As of the Effective Date, pursuant to the 2004 Long Term Incentive Plan (the "LTIP"), the Company shall grant to me 19,510 Restricted Shares of Class A common stock of CT (the "Initial Grant"). The Initial Grant shall (unless my employment has earlier terminated or as otherwise provided for herein) vest as follows: (I) 50% of the shares shall vest in two equal installments at the end of 2007 and 2008, and (II) 50% of the shares shall be structured as a "Performance Compensation Award" pursuant to Section 10(b) of the LTIP, and shall vest on the Expiration Date, subject to satisfaction of the Grant Performance Hurdle (as defined below), measured for the period commencing on the Effective Date and ending on the Expiration Date. For purposes of this Agreement, "Grant Performance Hurdle" shall mean a total shareholder return of 13% per annum (consisting of declared dividends, plus share price growth, plus any other property or consideration received by shareholders in connection with their ownership of Class A common stock of CT). All dividends that are earned and accrue with respect to all vested and unvested Restricted Shares issued pursuant to the Initial Grant shall be currently paid to me. For the purpose of calculating whether the Grant Performance Hurdle has been achieved, the starting and ending share price shall be determined based on the average closing price of the Class A common stock of CT for the ten trading day periods which end on the Effective Date and on the third anniversary of the Effective Date. (d) Performance Compensation Award. As of the Effective Date, pursuant to the LTIP, the Company shall grant to me a Performance Compensation Award that provides for cash payments to me equal to 4% of any payments received by the Company as incentive management fees paid by CT Mezzanine Partners III, Inc. ("Fund III") (representing 10% of the fees allocated to employees of the Company). The Performance Compensation Award shall (unless otherwise provided for herein) vest as follows: 65% shall be vested as of the Effective Date and the remaining 35% shall be vested upon the Company's receipt of the incentive management fees. -2- (e) Standard Benefits. During my employment, I shall be entitled to participate in all employee benefit plans and programs, including paid vacations, to the same extent generally available to other senior Company executives, in accordance with the terms of those plans and programs. (f) Indemnification. The Company shall extend to me the same indemnification arrangements as are generally provided to other senior Company executives, including after the termination of my employment. (g) Expenses. I shall be entitled to receive prompt reimbursement, which the Company shall make within two and one-half months after I submit adequate documentation, for all reasonable and customary travel and business expenses I incur in connection with my employment but I must incur and account for those expenses in accordance with the policies and procedures established by the Company. (h) Sarbanes-Oxley Act Loan Prohibition. To the extent that any Company benefit, program, practice, arrangement, or this Agreement would or might otherwise result in my receipt of an illegal loan ("Loan"), the Company shall use reasonable efforts to provide me with a substitute for the Loan that is lawful and of at least equal value to me. 5. Termination. (a) Rights and Duties. If my employment is terminated, I shall be entitled to the amounts or benefits shown on the applicable row of the following table, subject to the balance of this Section 5 and to the terms and conditions set forth in Section 13, below. The Company and I shall have no further obligations to each other, except the Company's ongoing indemnification obligation under Section 4, my confidentiality and other obligations under Section 6, and our mutual arbitration obligations under Section 8, or as set forth in any written agreement I subsequently enter into with the Company. - --------------------------- ---------------------------------------------------- DISCHARGE Payment or provision when due of (1) any unpaid base FOR CAUSE salary, expense reimbursements, and vacation days accrued prior to termination of employment, and (2) other unpaid vested amounts or benefits under Company compensation, incentive, and benefit plans (including, without limitation vested interests I may have with respect to Fund II and Fund III or any previous grant of equity). In addition, I may continue to exercise my vested options for up to the earlier of (a) the expiration date of such options or (b) the date 90 days following my termination. - --------------------------- ---------------------------------------------------- DISABILITY Same as for "Discharge for Cause" EXCEPT that (1) my base salary, less any payments I receive under any state-mandated or other disability insurance policy, shall continue for six months following my termination, (2) I shall be entitled to receive a pro-rated Annual Bonus for the year in which my disability became effective hereunder, based on the number of days I worked for the Company that year, (3) the Company shall pay the COBRA premiums associated with continuing medical insurance coverage for my benefit and the benefit of my - --------------------------- ---------------------------------------------------- -3- - --------------------------- ---------------------------------------------------- spouse and dependent children for one year following my disability effective date, and (IV) I will continue to vest for one year following my disability effective date in all awards previously granted to me, and in determining the Grant Performance Hurdle for any remaining performance vesting period, I will be credited with the shareholder return for the full year preceding the year of my disability effective date. In addition, I may continue to exercise my options that are granted or first vest after 2004 until the later of December 31 of the year in which my employment terminates and the date two and one-half months after my employment terminates (but in no event after the expiration date of such options). - --------------------------- ---------------------------------------------------- DISCHARGE OTHER THAN Same as for "Discharge for Cause" EXCEPT that, in FOR CAUSE OR DISABILITY exchange for my execution of a release in accordance with this section, (1) I shall be entitled to receive a lump-sum payment equal to the greater of (x) the sum of my base salary and Annual Bonus payable through December 31, 2008 or (y) the sum of (I) one year of my base salary and (II) the highest Annual Bonus paid to me during the Term, (2) all restricted stock grants made prior thereto and the Initial Grant shall immediately vest in full, (3) the Performance Compensation Award described in Section 4(d), above, shall immediately vest in full, (4) I may continue to exercise my options that are granted or first vest after 2004 until the later of December 31 of the year in which my employment terminates and the date two and one-half months after my employment terminates (but in no event after the expiration date of such options, and (5) the Company shall pay the COBRA premiums associated with continuing medical insurance coverage for my benefit and the benefit of my spouse and dependent children for 18 months following my date of discharge or such earlier time I shall obtain comparable coverage through another employer. - --------------------------- ---------------------------------------------------- RESIGNATION WITHOUT GOOD Same as for "Discharge for Cause." REASON - --------------------------- ---------------------------------------------------- RESIGNATION WITH GOOD Same as for "Discharge Other Than for Cause or REASON Disability." - --------------------------- ---------------------------------------------------- DEATH Same as for "Discharge for Cause" EXCEPT that (1) my legal representative shall be entitled to receive any death benefits payable under the life insurance maintained on my behalf by the Company as well as any earned but as of yet unpaid bonus amounts from the year preceding the date of my death, (2) any equity and performance compensation awards I have shall continue to vest for one year following the date of my death, and in determining the Grant Performance Hurdle for any remaining performance vesting period, my estate will be credited with the shareholder return for the full year preceding the year of my death, (3) the Company shall pay the COBRA premiums associated with continuing medical insurance - --------------------------- ---------------------------------------------------- -4- - --------------------------- ---------------------------------------------------- coverage for the benefit of my spouse and dependent children for one year following my date of death, and (4) my options that are granted or first vest after 2004 may continue to be exercised until the later of December 31 of the year in which my employment terminates and the date two and one-half months after my employment terminates (but in no event after the expiration date of such options. - --------------------------- ---------------------------------------------------- (b) Discharge for Cause. The Company may terminate my employment at any time if the Board has Cause to terminate me. For purposes of this Agreement, "Cause" is defined as: (i) Fraud and Dishonesty. My commission of a willful act of fraud, embezzlement or misappropriation of any money or properties of the Company or its affiliates (other than an insubstantial and unintentional misappropriation that has been remedied within 10 days after the Company provides me with notice of such misappropriation). (ii) Criminal Act. My conviction of a felony or any material violation of any federal or state securities law (whether by plea of nolo contendere or otherwise) or my being enjoined from violating any federal or state securities law or being determined to have violated any such law. (iii) Reckless Conduct. My engaging in willful or reckless misconduct in connection with any property or activity, the purpose or effect of which materially and adversely affects the Company and/or its subsidiaries and affiliates, and/or their predecessors and successors (collectively, the "Group"). (iv) Substance Abuse. My repeated and intemperate use of alcohol or illegal drugs after written notice from the Board that such use, if continued, would result in the termination of my employment hereunder. (v) Breach of Agreement. My failure to cure my material breach of any of my obligations under this Agreement (other than by reason of physical or mental illness, injury, or condition) after having received 10 days' notice from the Board of the breach. (vi) Barred from Office. My becoming barred or prohibited by the SEC from holding my position with the Company. (vii) Material Breach of Company Policy or Code of Ethics. My material breach of any Company policy (provided that I have been provided with a copy of or access to, or am otherwise aware of, the policy) or of the Company's Code of Ethics. (viii) Failure to Perform Duties. My continued failure or refusal to perform any material duty or responsibility under this Agreement (other than by -5- reason of physical or mental illness, injury, or condition) after having received 10 days' notice from the Board. (c) Termination for Disability. Except as prohibited by applicable law, the Company may terminate my employment on account of Disability, or may transfer me to inactive employment status, which shall have the same effect under this Agreement as a termination for Disability. "Disability" means a physical or mental illness, injury, or condition that prevents me from performing substantially all of my duties under this Agreement for at least 120 consecutive calendar days or for at least 180 calendar days, whether or not consecutive, in any 365 calendar day period, or is likely to do so, as certified by a physician selected by the Board. (d) Discharge Other Than for Cause or Disability. The Company may terminate my employment at any time for any reason, and without advance notice. If I am terminated by the Company other than for Cause under Section 5(b) or Disability under Section 5(c), I will only receive the special benefits provided for a Discharge other than for Cause or Disability under Section 5(a) if I sign a separation agreement and general release in the form attached hereto as Schedule A and do not thereafter revoke the release. (e) Resignation. If I resign other than for Good Reason, the Company may accept my resignation effective on the date set forth in my notice or any earlier date. If I resign other than for Good Reason, I agree that the Restricted Period (as defined in Section 6(b)) shall begin on the date of my resignation. If I resign for Good Reason, my employment will end on my last date of work and I will receive the benefits to which I am entitled under Section 5(a), but only if I sign the separation agreement and general release described in Section 5(d), above, and I do not thereafter revoke the release. "Good Reason" means that, without my express written consent and through no fault of my own, one or more of the following events occurred after my execution of this Agreement: (i) Demotion. My title and responsibilities are substantially and adversely diminished during the Term. (ii) Compensation Reduction. My cash compensation provided for under this Agreement is materially reduced. (iii) Relocation. The Company requires me, without my consent, to be based at any office or location outside of a 40-mile radius of midtown Manhattan, New York, New York. (iv) Breach of Promise. The Company fails to cure its material breach of this Agreement within thirty business days after I give it written notice thereof. -6- (v) No Comparable Offer Following Change of Control. The Company is involved in a Change in Control (as defined below) and I am not offered a position by the acquiring entity (or the Company's successor, as the case may be) comparable to the position I held with the Company prior to the Change in Control. For purposes of this section, "Change in Control" shall mean: (1) a merger or acquisition in which 50% or more of the Company's voting stock outstanding after the merger or acquisition is held by holders different from those who held the Company's voting stock immediately prior to such merger or acquisition; (2) the sale, transfer or other disposition of all or substantially all of the assets of the Company in liquidation or dissolution of the Company; (3) a transfer of all or substantially all of the Company's assets pursuant to a partnership or joint venture agreement or similar arrangement where the Company's resulting interest is or becomes less than 50%; (4) on or after the Effective Date, a change in ownership of the Company through an action or series of transactions, such that any person is or becomes the beneficial owner, directly or indirectly, of 50% or more of the Company's voting stock; or (5) a change occurs in the composition of the Board during any two-year period such that the individuals who, as of the beginning of such two-year period, constitute the Board (such Board shall be hereinafter referred to as the "Incumbent Board") cease for any reason to constitute at least a majority of the Board; provided, however, that for purposes of this definition, any individual who becomes a member of the Board subsequent to the beginning of the two-year period, whose election, or nomination for election by the Company's stockholders, was approved by a vote of at least a majority of those individuals who are members of the Board and who were also members of the Incumbent Board (or deemed to be such pursuant to this proviso) shall be considered as though such individual were a member of the Incumbent Board; and provided further, however, that any such individual whose initial assumption of office occurs as a result of or in connection with a solicitation subject to Rule 14a-12(c) of Regulation 14A promulgated under the Exchange Act of 1934, as amended, or other actual or threatened solicitation of proxies or consents by or on behalf of an entity other than the Board shall not be so considered as a member of the Incumbent Board. However, an event that is or would constitute Good Reason shall cease to be Good Reason if: (1) I do not give the Company written notice of my intent to terminate my employment within 45 days after I have objective notice that a Good Reason event has occurred; (2) the Company reverses the action or cures the default that constitutes Good Reason within 30 days after I notify it in writing that Good Reason exists before I terminate employment; or (3) I was a primary instigator of the Good Reason event and the circumstances make it inappropriate for me to receive Good Reason resignation benefits under this Agreement. -7- (f) Death. If I die while employed under this Agreement, the payments required by Section 5(a) in the event of my death shall be made. 6. Confidentiality and Other Obligations. (a) Confidential Information. During the term of my employment, in exchange for my promises to use such information solely for the Company's benefit, the Company has provided and will continue to provide me with Confidential Information concerning, among other things, its business, operations, clients, investors, and business partners. "Confidential Information" refers to information not generally known by others in the form in which it is used by the Company, and which gives the Company a competitive advantage over other companies which do not have access to this information, including secret, confidential, or proprietary information or trade secrets of the Company and its subsidiaries and affiliates, conveyed orally or reduced to a tangible form in any medium, including information concerning the operations, future plans, customers, business models, strategies, and business methods of the Company and its subsidiaries and affiliates, as well as information about the Company's active and prospective investors, clients and business partners and their respective investment preferences, risk tolerances, portfolio allocations and amounts, cash flow requirements, contact information, and other information about how to best serve their needs and preferences. "Confidential Information" does not include information that (i) I knew prior to my employment with the Company, (ii) subsequently came into my possession other than through my work for the Company and not as a result of a breach of any duty owed to the Company, or (iii) is generally known within the relevant industry. (b) Promise Not to Disclose. I promise never to use or disclose any Confidential Information before it has become generally known within the relevant industry through no fault of my own. I agree that this promise shall never expire. (c) Promise Not to Solicit. Because my position enables me to learn Confidential Information regarding the investors in the Company and its funds and how best to serve them, I further agree that, during the "Restricted Period" (as defined below) (1) as to any investor in the Company (or in any investment fund or vehicle owned, managed, or established by the Company) with whom I had dealings or about whom I acquired proprietary information during my employment, I will not solicit or attempt to solicit (or assist others to solicit) the investor to invest in or do business with any person, entity, or investment fund or vehicle other than the Company (or its funds or vehicles); and (2) I will not solicit or attempt to solicit (or assist others to solicit) for employment any person who is, or within the preceding six months was, an officer, manager, employee, or consultant of the Company. I agree that the restrictions set forth in this paragraph should not prohibit me from engaging in my livelihood and do not foreclose my working with investors not identified in this paragraph. The "Restricted Period" shall mean the period of my employment with the Company and: (i) Twelve (12) months after my termination for Cause under Section 5(b), resignation without Good Reason under Section 5(e), or resignation with Good Reason under Section 5(e)(v); and -8- (ii) Six (6) months after my resignation with Good Reason under Section 5(e)(i) through (iv). (d) Promise Not to Engage in Certain Employment. I agree that, during the Restricted Period, I will not, without the prior written consent of the Board, accept any employment, provide any services, advice or information; or assist or engage in any activity (whether as an employee, consultant, or in any other capacity, whether paid or unpaid) with (1) any specialty finance firm or investment management company focused on commercial real estate-related debt instruments or (2) any business that, as of the date of my termination, directly competes with the Company. (e) Return of Information. When my employment with the Company ends, I will promptly deliver to the Company, or, at its written instruction, destroy, all documents, data, drawings, manuals, letters, notes, reports, electronic mail, recordings, and copies thereof, of or pertaining to it or any other Group member in my possession or control. In addition, during my employment with the Company or the Group and thereafter, I agree to meet with Company personnel and, based on knowledge or insights I gained during my employment with the Company and the Group, answer any question they may have related to the Company or the Group. (f) Intellectual Property. Intellectual property (including such things as all ideas, concepts, inventions, plans, developments, software, data, configurations, materials (whether written or machine-readable), designs, drawings, illustrations, and photographs, that may be protectable, in whole or in part, under any patent, copyright, trademark, trade secret, or other intellectual property law), developed, created, conceived, made, or reduced to practice during my Company employment (except intellectual property that has no relation to the Group or any Group customer that I developed, etc., purely on my own time and at my own expense), shall be the sole and exclusive property of the Company, and I hereby assign all my rights, title, and interest in any such intellectual property to the Company. (g) Enforcement of This Section. This section shall survive the termination of this Agreement for any reason. I acknowledge that (a) my services are of a special, unique, and extraordinary character and it would be very difficult or impossible to replace them, (b) this section's terms are reasonable and necessary to protect the Company's legitimate interests, (c) this section's restrictions will not prevent me from earning or seeking a livelihood, (d) this section's restrictions shall apply wherever permitted by law, and (e) my violation of any of this section's terms would irreparably harm the Company. Accordingly, I agree that, if I violate any of the provisions of this section, the Company or any Group member may be entitled to seek, in addition to other remedies available to it, an injunction to be issued by any court of competent jurisdiction restraining me from committing or continuing any such violation. -9- 7. Notice. (a) To the Company. I will send all communications to the Company in writing, by mail, hand delivery or facsimile, addressed as follows (or in any other manner the Company notifies me to use): Capital Trust, Inc. Attention: Mr. John R. Klopp 410 Park Avenue, 14th Floor New York, New York 10022 Fax: (212) 655-0044 Tel.: (212) 655-0220 With copy to: Martin L. Edelman, Esq. Michael L. Zuppone, Esq. Paul, Hastings, Janofsky & Walker LLP 75 East 55th Street New York, New York 10022-3205 (b) To Me. All communications from the Company to me relating to this Agreement must be sent to me in writing at my Company office or in any other manner I notify the Company to use. (c) Time Notice Deemed Given. Notice shall be deemed to have been given when delivered or, if earlier (1) when mailed by United States certified or registered mail, return receipt requested, postage prepaid, or (2) faxed with confirmation of delivery, in either case, addressed as required in this section. 8. Arbitration of Disputes. Except for the Company's right to seek injunctive relief in accordance with Section 6(g), above, all disputes between the Company and me are to be resolved by final and binding arbitration in accordance with the separate Arbitration Agreement attached as Schedule B to this Agreement. This section shall remain in effect after the termination of this Agreement. 9. Amendment. No provisions of this Agreement may be modified, waived, or discharged except by a written document signed by a duly authorized Company officer and me. Thus, for example, promotions, commendations, and/or bonuses shall not, by themselves, modify, amend, or extend this Agreement. A waiver of any conditions or provisions of this Agreement in a given instance shall not be deemed a waiver of such conditions or provisions at any other time. 10. Interpretation; Exclusive Forum. The validity, interpretation, construction, and performance of this Agreement shall be governed by the laws of the state of New York (excluding any that mandate the use of another jurisdiction's laws). Any litigation, arbitration, or similar proceeding with respect to such matters only may be brought within that state, and all parties to this Agreement consent to that state's jurisdiction and agree that venue anywhere in that state would be proper. -10- 11. Successors. This Agreement shall be binding upon, and shall inure to the benefit of, me and my estate, but I may not assign or pledge this Agreement or any rights arising under it, except to the extent permitted under the terms of the benefit and compensation plans in which I participate. 12. Taxes. I am solely responsible for the payment of any tax liabilities (including any taxes and penalties arising under Section 409A of the Internal Revenue Code (the "Code") that may result from any payments or benefits that I receive pursuant to this Agreement. The Company shall not have any obligation to pay, mitigate, or protect me from any such tax liabilities. Nevertheless, if the Company reasonably determines that my receipt of payments or benefits pursuant to Section 5 above would cause me to incur liability for additional tax under Section 409A of the Code, then the Company may in its discretion suspend such payments or benefits until the end of the six-month period following termination of my employment (the "409A Suspension Period"). As soon as reasonably practical after the end of the 409A Suspension Period, the Company will make a lump sum payment to me, in cash, in an amount equal to any payments and benefits that the Company does not make during the 409A Suspension Period. Thereafter, I will receive any remaining payments and benefits due pursuant to Section 5 in accordance with the terms of that Section (as if there had not been any suspension beforehand). The Company shall withhold taxes from payments it makes pursuant to this Agreement as it determines to be required by applicable law. 13. Validity. The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, which shall remain in full force and effect. 14. Counterparts. This Agreement may be executed in one or more counterparts, each of which shall be deemed to be an original but all of which together shall constitute the same instrument. 15. Entire Agreement. All oral or written agreements or representations, express or implied, with respect to the subject matter of this Agreement are set forth in this Agreement. Notwithstanding the foregoing, I agree to comply with the Company's policies and Code of Ethics. -11- - -------------------------------------------------------------------------------- I ACKNOWLEDGE THAT ALL UNDERSTANDINGS AND AGREEMENTS BETWEEN THE COMPANY AND ME RELATING TO THE SUBJECTS COVERED IN THIS AGREEMENT ARE CONTAINED IN IT AND THAT I HAVE ENTERED INTO THIS AGREEMENT VOLUNTARILY AND NOT IN RELIANCE ON ANY PROMISES OR REPRESENTATIONS BY THE COMPANY OTHER THAN THOSE CONTAINED IN THIS AGREEMENT ITSELF. I FURTHER ACKNOWLEDGE THAT I HAVE CAREFULLY READ THIS AGREEMENT, THAT I UNDERSTAND ALL OF IT, AND THAT I HAVE BEEN GIVEN THE OPPORTUNITY TO DISCUSS THIS AGREEMENT WITH MY PRIVATE LEGAL COUNSEL AND HAVE AVAILED MYSELF OF THAT OPPORTUNITY TO THE EXTENT I WISHED TO DO SO. I UNDERSTAND THAT BY SIGNING THIS AGREEMENT I AM GIVING UP MY RIGHT TO A JURY TRIAL. - -------------------------------------------------------------------------------- Dated: August 4, 2006 CAPITAL TRUST, INC. By: /s/ John R. Klopp ------------------- Name: John R. Klopp Title: Chief Executive Officer Dated: August 4, 2006 CT INVESTMENT MANAGEMENT CO., LLC By: /s/ John R. Klopp ------------------- Name: John R. Klopp Title: Chief Executive Officer Dated: August 4, 2006 /s/ Thomas C. Ruffing --------------------- THOMAS C. RUFFING -12- SCHEDULE A SEPARATION AGREEMENT AND GENERAL RELEASE ---------------------------------------- This SEPARATION AGREEMENT AND GENERAL RELEASE ("Release") made this ___ day of _________, ____ by and between Capital Trust, Inc. ("CT") and CT Investment Management Co., LLC ("CTIMCO," and together with CT, the "Company"), on the one part, and Thomas C. Ruffing ("Executive"), on the other: In exchange for the mutual promises exchanged herein and other good and valid consideration, the receipt of which is hereby acknowledged, the parties agree as follows: 1. Employment Termination Executive agrees that his employment with the Company has ended or will end on [date]. Executive will be entitled to those separation and other benefits as set forth in his Employment Agreement with the Company dated as of [date]. 2. Claims Released In exchange for the benefits provided herein, Executive irrevocably and unconditionally releases the Company, its current or former parents, subsidiaries, or affiliates, their past, present, or future employees or agents, their successors, their benefit plans and the administrators of such plans (collectively, the "Released Parties"), from all known or unknown claims that Executive presently may have arising out of his employment with, or separation from, the Company, other than claims (i) seeking enforcement of this Release, (ii) for vested awards or benefits under the Company's employee benefit plans, including the 2004 Long-Term Incentive Program, and (iii) to indemnification and coverage under the Company's directors and officers' insurance policies ("Claims"). The Claims Executive is releasing include, without limitation, claims under the Age Discrimination in Employment Act of 1967 ("ADEA"), Title VII of the Civil Rights Act of 1964, the Americans with Disabilities Act, the Employee Retirement Income Security Act of 1974, the Fair Labor Standards Act, the Family and Medical Leave Act, the New York State Human Rights Law; the New York City Human Rights Law; or any other federal, state, or local common law, statute, regulation, or law of any other type. Executive acknowledges that he is releasing Claims he knows he has and Claims he may not know he has, and understands the significance of doing so. 3. Pursuit of Released Claims Executive agrees to withdraw with prejudice all complaints or charges, if any, he has filed against any Released Party with any agency or court. Executive agrees that he will never file any lawsuit or complaint against them based on the Claims purportedly released in this Release. Executive promises never to seek any damages, remedies, or other relief for himself personally (any right to which he hereby waives) by filing or prosecuting a charge with any administrative agency with respect to any Claim purportedly released by this Release. Executive A-1 promises to request any administrative agency or other body assuming jurisdiction of any such lawsuit, complaint, or charge to withdraw from the matter or dismiss the matter with prejudice. 4. Nonadmission of Liability Executive agrees that this Release is not an admission of guilt or wrongdoing by the Released Parties and acknowledges that the Released Parties do not believe or admit that they have done anything wrong. 5. Confidentiality and Non-Disparagement Executive agrees to keep the fact and terms of this Release in strict confidence. Executive agrees not to disclose this document, its contents or subject matter to any person other than his immediate family, attorney, accountant or income tax preparer, or otherwise as required by law. Executive agrees that he will not denigrate, disparage, defame, impugn, or otherwise damage or assail the reputation or integrity of the Company or any Released Party. 6. Consideration of Release Executive acknowledges that, before signing this Release, he was given at least 21 calendar days to consider this Release. Executive waives any right he might have to additional time beyond this consideration period within which to consider this Release. Executive acknowledges that: (a) he took advantage of that time to consider this Release before signing it; (b) he carefully read this Release; (c) he fully understands what this Release means; (d) he is entering into it voluntarily; (e) he is receiving valuable consideration in exchange for his execution of this Release that he would not otherwise be entitled to receive; and (f) the Company, in writing, encouraged him to discuss this Release with his attorney (at his own expense) before signing it, and that he did so to the extent he deemed appropriate. Executive may revoke his release of claims under the ADEA within seven (7) days after he signs this Release, in which case he will not be entitled to receive all of the benefits set forth herein. 7. Miscellaneous This Release sets forth the entire agreement between Executive and the Company pertaining to the subject matter of this Release. This Release may not be modified or canceled in any manner except by a writing signed by both Executive and an authorized Company official. Executive acknowledge that the Company has made no representations or promises to him other than those in this Release. If any provision in this Release is found to be unenforceable, all other provisions will remain fully enforceable. It is not necessary that the Company sign this Release for it to become binding on both Executive and the Company. This Release binds Executive's heirs, administrators, representatives, executors, successors, and assigns, and will inure to the benefit of the Released Parties and their heirs, administrators, representatives, executors, successors, and assigns. This Release shall be construed as a whole according to its fair meaning; it shall not be construed strictly for or against Executive or the Released Parties. Unless the context indicates otherwise, the term "or" shall be deemed to include the term "and" and the singular or plural number shall be deemed to include the other. Disputes under this A-2 Release are to be resolved in accordance with the existing arbitration agreement between the parties. Except to the extent governed by federal law, this Release shall be governed by the statutes and common law of the State of New York (excluding any that mandate the use of another jurisdiction's laws). Section headings in this Agreement are included for convenience of reference only and shall not be a part of this Agreement for any other purpose. - -------------------------------------------------------------------------------- TAKE THIS RELEASE HOME, READ IT, AND CAREFULLY CONSIDER ALL OF ITS PROVISIONS BEFORE SIGNING IT. THIS RELEASE INCLUDES A RELEASE OF KNOWN AND UNKNOWN CLAIMS. - -------------------------------------------------------------------------------- Date: ________________________ CAPITAL TRUST, INC. By: _______________________________ Name: _____________________________ Title: ____________________________ Date: ________________________ CT INVESTMENT MANAGEMENT CO., LLC By: _______________________________ Name: _____________________________ Title: ____________________________ Date: _____________________________ ___________________________________ THOMAS C. RUFFING A-3 SCHEDULE B MUTUAL AGREEMENT TO ARBITRATE CLAIMS ------------------------------------ I recognize that differences may arise between Capital Trust, Inc. ("CT") and CT Investment Management Co., LLC ("CTIMCO," and together with CT, the "Company"), on the one part, and me, on the other part, during or following my employment with the Company, and that those differences may or may not be related to my employment. I understand and agree that by entering into this Agreement to Arbitrate Claims ("Agreement"), I anticipate gaining the benefits of a speedy, impartial dispute-resolution procedure. Except as provided in this Agreement, the Federal Arbitration Act shall govern the interpretation, enforcement and all proceedings pursuant to this Agreement. To the extent that the Federal Arbitration Act either is inapplicable, or held not to require arbitration of a particular claim or claims, New York law pertaining to agreements to arbitrate shall apply. I understand that any reference in this Agreement to the Company will be a reference also to all of its subsidiary and affiliated entities, all benefit plans, the benefit plans' sponsors, fiduciaries, administrators, and affiliates, and all successors and assigns of any of them. Claims Covered by the Agreement The Company and I mutually consent to the resolution by arbitration of all claims or controversies ("claims"), past, present or future, which arise, directly or indirectly, out of my employment (or its termination) or the business of the Company, that the Company may have against me or that I may have against the Company or against its officers, directors, employees or agents in their capacity as such or otherwise. The claims covered by this Agreement include, but are not limited to, claims for wages or other compensation due; claims for breach of any contract or covenant (express or implied); tort claims; claims for discrimination (including, but not limited to, race, sex, sexual orientation, religion, national origin, age, marital status, or medical condition, handicap or disability); and claims for violation of any federal, state, or other governmental law, statute, regulation, or ordinance, except claims excluded elsewhere in this Agreement. Except as otherwise provided in this Agreement, both the Company and I agree that neither of us shall initiate or prosecute any lawsuit or administrative action (other than an administrative charge of discrimination to the EEOC or similar fair employment practices agency, or an administrative charge within the jurisdiction of the National Labor Relations Board or U.S. Department of Labor), in any way related to any claim covered by this Agreement. Claims Not Covered by the Agreement This Agreement does not cover claims for workers' compensation or unemployment compensation benefits; or any claim as to which final and binding arbitration cannot be required as a matter of law. Claims, either by the Company or by me, seeking injunctive relief for alleged violations of intellectual property rights and non-disclosure and non-solicitation covenants also B-1 are not covered by this Agreement (although all other aspects of such claims, including any claims for damages, are covered by this Agreement). Required Notice of All Claims and Statute of Limitations The Company and I agree that the aggrieved party must give written notice of any claim to the other party no later than the applicable Statute of Limitations as may be prescribed by law. Written notice to the Company, or its officers, directors, employees or agents, shall be sent to the addresses set forth in my Employment Agreement. I will be given written notice at the last address recorded in my personnel file. The written notice shall identify and describe the nature of all claims asserted and the facts upon which such claims are based. The notice shall be sent to the other party by certified or registered mail, return receipt requested. Representation Any party may be represented by an attorney or other representative selected by the party. Discovery Each party shall have the right to take the deposition of three (3) individuals and any expert witness designated by another party. Each party also shall have the right to make requests for production of documents to any party. The subpoena right specified below shall be applicable to discovery pursuant to this paragraph. Additional discovery may be had where the arbitrator selected pursuant to this Agreement so orders, upon an appropriate showing of justification. Designation of Witnesses At least 30 days before the arbitration, the parties must exchange lists of witnesses, including any expert, and copies of all exhibits intended to be used at the arbitration. Subpoenas Each party shall have the right to subpoena witnesses and documents for the arbitration. Arbitration Procedures The arbitration will be held under the auspices of the American Arbitration Association ("AAA"). The Company and I agree that, except as provided in this Agreement, the arbitration shall be in accordance with the AAA's National Rules for Resolution of Employment Disputes (or other then-current employment arbitration procedures). The arbitrator shall be either a retired judge, or an attorney licensed to practice law in the state in which the arbitration is convened and with demonstrated experience and expertise in executive compensation matters (the "Arbitrator"). The arbitration shall take place in or near the city in which I am or was last employed by the Company. B-2 The Arbitrator shall be selected as follows. The sponsoring organization shall give each party a list of 11 arbitrators drawn from its panel of employment dispute arbitrators. Each party may strike all names on the list it deems unacceptable. If only one common name remains on the lists of all parties, that individual shall be designated as the Arbitrator. If more than one common name remains on the lists of all parties, the parties shall strike names alternately from the list of common names until only one remains. The party who did not initiate the claim shall strike first. If no common name exists on the lists of all parties, the sponsoring organization shall furnish an additional list and the process shall be repeated. If no arbitrator has been selected after two lists have been distributed, then the parties shall strike alternately from a third list, with the party initiating the claim striking first, until only one name remains. That person shall be designated as the Arbitrator. The Arbitrator shall apply the substantive law (and the law of remedies, if applicable) of the state in which the claim arose, or federal law, or both, as applicable to the claim(s) asserted. If the parties' dispute concerns a contract in which the parties have included a choice of law provision, the Arbitrator shall apply the law as designated by the parties. The Arbitrator is without jurisdiction to apply any different substantive law, or law of remedies. The Arbitrator, and not any federal, state, or local court or agency, shall have exclusive authority to resolve any dispute relating to the interpretation, applicability, enforceability or formation of this Agreement, including but not limited to any claim that all or any part of this Agreement is void or voidable. The arbitration shall be final and binding upon the parties, except as provided in this Agreement. The Arbitrator shall have jurisdiction to hear and rule on pre-hearing disputes and is authorized to hold pre-hearing conferences by telephone or in person, as the Arbitrator deems necessary. The Arbitrator shall have the authority to entertain a motion to dismiss and/or a motion for summary judgment by any party and shall apply the standards governing such motions under the Federal Rules of Civil Procedure. Either party may obtain a court reporter to provide a stenographic record of proceedings. Either party, upon request at the close of hearing, shall be given leave to file a post-hearing brief. The time for filing such a brief shall be set by the Arbitrator. The Arbitrator shall render a written award and opinion in the form setting forth his/her findings and conclusions. Either party shall have the right, within 20 days of issuance of the Arbitrator's opinion, to file with the Arbitrator a motion to reconsider (accompanied by a supporting brief), and the other party shall have 20 days from the date of the motion to respond. The Arbitrator thereupon shall reconsider the issues raised by the motion and, promptly, either confirm or change the decision, which (except as provided by this Agreement) shall then be final and conclusive upon the parties. B-3 Arbitration Fees and Costs The Company will be responsible for paying any filing fee and the fees and costs of the Arbitrator and the arbitration; provided, however, that if I am the party initiating the claim, I am responsible for contributing an amount equal to the filing fee to initiate a claim in the court of general jurisdiction in the state in which I am (or was last) employed by the Company. Each party shall pay for its own costs and attorneys' fees, if any. However, if any party prevails on a statutory claim which affords the prevailing party attorneys' fees, or if there is a written agreement providing for fees, the Arbitrator may award reasonable fees to the prevailing party, under the standards for fee shifting provided by law. Judicial Review Either party may bring an action in any court of competent jurisdiction to compel arbitration under this Agreement and to enforce an arbitration award. Interstate Commerce I understand and agree that the Company is engaged in transactions involving interstate commerce and that the Federal Arbitration Act applies to this Agreement. Requirements for Modification or Revocation This Agreement to arbitrate shall survive the termination of my employment. It can only be revoked or modified by a writing signed by the parties which specifically states an intent to revoke or modify this Agreement. Sole and Entire Agreement This is the complete agreement of the parties on the subject of arbitration of disputes. This Agreement supersedes any prior or contemporaneous oral or written understandings on the subject. No party is relying on any representations, oral or written, on the subject of the effect, enforceability or meaning of this Agreement, except as specifically set forth in this Agreement. Severability If any provisions of this Agreement are adjudged to be void or otherwise unenforceable, in whole or in part, such adjudication shall not affect the validity of the remainder of the Agreement, as the parties hereto intend to create a binding agreement to arbitrate regardless of the unenforceability of any particular term or terms. Consideration The promises by the Company and by me to arbitrate differences, rather than litigate them before courts or other bodies, provide consideration for each other. B-4 Voluntary Agreement I ACKNOWLEDGE THAT I HAVE CAREFULLY READ THIS AGREEMENT, THAT I UNDERSTAND ITS TERMS, THAT ALL UNDERSTANDINGS AND AGREEMENTS BETWEEN THE COMPANY AND ME RELATING TO THE SUBJECTS COVERED IN THE AGREEMENT ARE CONTAINED IN IT, AND THAT I HAVE ENTERED INTO THE AGREEMENT VOLUNTARILY AND NOT IN RELIANCE ON ANY PROMISES OR REPRESENTATIONS BY THE COMPANY OTHER THAN THOSE CONTAINED IN THIS AGREEMENT ITSELF. I UNDERSTAND THAT BY SIGNING THIS AGREEMENT employee initials I AM GIVING UP MY RIGHT TO A JURY TRIAL. ----------------- I FURTHER ACKNOWLEDGE THAT I HAVE BEEN GIVEN THE OPPORTUNITY TO DISCUSS THIS AGREEMENT WITH MY PRIVATE LEGAL COUNSEL AND HAVE AVAILED MYSELF OF THAT OPPORTUNITY TO THE EXTENT I WISH TO DO SO. Dated: August __, 2006 CAPITAL TRUST, INC. By: ________________________ Name: John R. Klopp Title: Chief Executive Officer Dated: August __, 2006 CT INVESTMENT MANAGEMENT CO., LLC By: ________________________ Name: John R. Klopp Title: _____________________ Dated: August __, 2006 ____________________________ THOMAS C. RUFFING B-5 EX-31 3 ex31-1.txt EXHIBIT 31.1: 302 CERTIFICATION OF CEO Exhibit 31.1 CERTIFICATION PURSUANT TO 17 CFR 240.13a-14 PROMULGATED UNDER SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, John R. Klopp, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Capital Trust, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have: (a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 8, 2006 /s/ John R. Klopp ----------------- John R. Klopp Chief Executive Officer EX-31 4 ex31-2.txt EXHIBIT 31.2: 302 CERTIFICATION OF CFO Exhibit 31.2 CERTIFICATION PURSUANT TO 17 CFR 240.13a-14 PROMULGATED UNDER SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Geoffrey G. Jervis, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Capital Trust, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have: (a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 8, 2006 /s/ Geoffrey G. Jervis ---------------------- Geoffrey G. Jervis Chief Financial Officer EX-32 5 ex32-1.txt EXHIBIT 32.1: 906 CERTIFICATION OF CEO Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Capital Trust, Inc. (the "Company") on Form 10-Q for the period ending June 30, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, John R. Klopp, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: 1. The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ John R. Klopp ----------------- John R. Klopp Chief Executive Officer August 8, 2006 EX-32 6 ex32-2.txt EXHIBIT 32.2: 906 CERTIFICATION OF CFO Exhibit 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Capital Trust, Inc. (the "Company") on Form 10-Q for the period ending June 30, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Geoffrey G. Jervis, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: 1. The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Geoffrey G. Jervis ---------------------- Geoffrey G. Jervis Chief Financial Officer August 8, 2006 EX-99 7 ex99-1.txt EXHIBIT 99.1: RISK FACTORS Exhibit 99.1 FORWARD-LOOKING INFORMATION AND RISK FACTORS Our Annual Report on Form l0-K for the year ended December 31, 2005, our 2005 Annual Report to Shareholders, any of our Quarterly Reports on Form 10-Q or Current Reports on Form 8-K of the Company, or any other oral or written statements made in press releases or otherwise by or on behalf of Capital Trust, Inc., may contain forward-looking statements within the meaning of the Section 21E of the Securities and Exchange Act of 1934, as amended, which involve certain risks and uncertainties. Forward-looking statements predict or describe our future operations, our business plans, our business and investment strategies and portfolio management and the performance of our investments and funds under management. These forward-looking statements are identified by their use of such terms and phrases as "intends," "intend," "intended," "goal," "estimate," "estimates," "expects," "expect," "expected," "project," "projected," "projections," "plans," "seeks," "anticipates," "anticipated," "should," "could," "may," "will," "designed to," "foreseeable future," "believe," "believes" and "scheduled" and similar expressions. Our actual results or outcomes may differ materially from those anticipated. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date the statement was made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Our actual results may differ significantly from any results expressed or implied by these forward-looking statements. Some, but not all, of the factors that might cause such a difference include, but are not limited to: o the general political, economic and competitive conditions, in the United States; o the level and volatility of prevailing interest rates and credit spreads, adverse changes in general economic conditions and real estate markets, the deterioration of credit quality of borrowers and the risks associated with the ownership and operation of real estate; o a significant compression of the spreads of the interest rates earned on interest-earning assets over the interest rates paid on interest-bearing liabilities that adversely affects operating results; o adverse developments in the availability of desirable loan and investment opportunities and the ability to obtain and maintain targeted levels of leverage and borrowing costs; o adverse changes in local market conditions, competition, increases in operating expenses and uninsured losses affecting a property owner's ability to cover operating expenses and the debt service on financing provided by us; o authoritative generally accepted accounting principles or policy changes from such standard-setting bodies as the Financial Accounting Standards Board and the Securities and Exchange Commission; and o the risk factors set forth below. Risks Related to Our Investment Program Our existing loans and investments expose us to a high degree of risk associated with investing in commercial real estate-related assets. Real estate historically has experienced significant fluctuations and cycles in performance that may result in reductions in the value of our real estate-related investments. The performance and value of our loans and investments once originated or acquired by us depends on many factors beyond our control. The ultimate performance and value of our investments is subject to the varying degrees of risk generally 1 incident to the ownership and operation of the commercial properties which collateralize or support our investments. The ultimate performance and value of our loans and investments depends upon the commercial property owner's ability to operate the property so that it produces cash flows needed to pay the interest and principal due to us on our loans and investments. Revenues and cash flows may be adversely affected by: o changes in national economic conditions; o changes in local real estate market conditions due to changes in national or local economic conditions or changes in local property market characteristics; o competition from other properties offering the same or similar services; o changes in interest rates and in the availability of mortgage financing; o the ongoing need for capital improvements, particularly in older structures; o changes in real estate tax rates and other operating expenses; o adverse changes in governmental rules and fiscal policies, civil unrest, acts of God, including earthquakes, hurricanes and other natural disasters, acts of war or terrorism, which may decrease the availability of or increase the cost of insurance or result in uninsured losses; o adverse changes in zoning laws; o the impact of present or future environmental legislation and compliance with environmental laws; and o other factors that are beyond our control and the control of the commercial property owners. In the event that any of the properties underlying our loans or investments experiences any of the foregoing events or occurrences, the value of, and return on, such investments, our profitability and the market price of our class A common stock would be negatively impacted. We may change our investment strategy without shareholder consent which may result in riskier investments than our current investments. As part of our strategy, we may seek to expand our investment activities beyond real estate-related investments. We may change our investment activities at any time without the consent of our shareholders, which could result in our making investments that are different from, and possibly riskier than, our current real estate investments. New investments we may make outside of our area of expertise may not perform as well as our current portfolio of real estate investments. We are exposed to the risks involved with making subordinated investments. Our investments involve the risks attendant to investments consisting of subordinated loan positions. In many cases, management of our investments and our remedies with respect thereto, including the ability to foreclose on or direct decisions with respect to the collateral securing such investments, is subject to the rights of senior lenders and the rights set forth in inter-creditor or servicing agreements. We may not be able to obtain the level of leverage necessary to optimize our return on investment. Our return on investment depends, in part, upon our ability to grow our balance sheet portfolio of invested assets and those of our funds through the use of leverage at interest rates that are lower than the interest rates earned on our investments. We generally obtain leverage through bank credit facilities, repurchase agreements and other borrowings. Our ability to obtain the necessary leverage on attractive terms ultimately depends upon the quality of the portfolio assets that are being pledged and our ability to maintain interest coverage ratios meeting prevailing market underwriting standards which vary according to lenders' assessments of our and our funds' creditworthiness and the terms of the borrowings. Our failure to obtain and/or maintain leverage at desired levels, or to obtain leverage on attractive terms, could have a material adverse effect on our performance or that of our funds. Moreover, we are dependent upon a few lenders to provide the primary credit facilities for our origination or acquisition of loans and investments. Our ability to obtain financing through collateralized debt obligations is subject to conditions in the debt capital markets, which may be adverse from time to time, that affect the level of investor demand for such securities, which are impacted by factors beyond our control. -2- We are subject to the risks of holding leveraged investments. Leverage creates an opportunity for increased return on equity, but at the same time creates other risks. For example, leveraging magnifies changes in the net worth of our funds. We and our funds will leverage assets only when there is an expectation that leverage will enhance returns, although we cannot assure you that the use of leverage will prove to be beneficial. Increases in credit spreads in the market generally may adversely affect the market value of our investments. Because borrowings under our credit facilities are secured by our investments, the borrowings available to us may decline if the market value of our investments decline. Moreover, we cannot assure you that we and our funds will be able to meet debt service obligations and, to the extent such obligations are not met, there is a risk of loss of some or all of our and their assets through foreclosure or a financial loss if we or they are required to liquidate assets at a commercially inopportune time to satisfy our debt obligations. Our success depends on the availability of attractive investments and our ability to identify, structure, consummate, manage and realize returns on attractive investments. Our operating results are dependent upon the availability of, as well as our ability to identify, structure, consummate, manage and realize returns on, credit-sensitive investment opportunities. In general, the availability of desirable credit sensitive investment opportunities and, consequently, our balance sheet returns and our funds' investment returns, will be affected by the level and volatility of interest rates, by conditions in the financial markets, by general economic conditions, by the market and demand for credit-sensitive investment opportunities, and by the supply of capital for such investment opportunities. We cannot assure you that we will be successful in identifying and consummating investments which satisfy our rate of return objectives or that such investments, once consummated, will perform as anticipated. In addition, notwithstanding the fact that we earn base management fees based upon committed capital during the investment period, if we are not successful in investing all available equity capital for our funds, the potential revenues we earn, including base management fees that are charged on the amount of invested assets after the investment period and incentive management fees, will be reduced. We may expend significant time and resources in identifying and pursuing targeted investments, some of which may not be consummated. The real estate investment business is highly competitive. Our success depends on our ability to compete with other providers of capital for real estate investments. Our business is highly competitive. We compete for attractive investments with traditional lending sources, such as insurance companies and banks, as well as other REITs, specialty finance companies and private equity funds with similar investment objectives, which may make it more difficult for us to consummate our target investments. Many of our competitors have greater financial resources than us, which provides them with greater operating flexibility. Our loans and investments may be subject to fluctuations in interest rates which may not be adequately protected, or protected at all, by our hedging strategies. Our current balance sheet investment program emphasizes loans with "floating" interest rates to protect against fluctuations in interest rates. We do, however, from time to time make fixed rate loans and purchase fixed rate securities, which are subject to the risk of fluctuations in interest rates. Depending on market conditions, fixed rate assets may become a greater portion of our new loan originations. In such cases, we may employ various hedging strategies to limit the effects of changes in interest rates, including engaging in interest rate swaps, caps, floors and other interest rate derivative products. No strategy can completely insulate us or our funds from the risks associated with interest rate changes and there is a risk that they may provide no protection at all. Hedging transactions involve certain additional risks such as counterparty risk, the legal enforceability of hedging contracts, the early repayment of hedged transactions and the risk that unanticipated and significant changes in interest rates may cause a significant loss of basis in the contract and a change in current period expense. We cannot assure you that we will be able to enter into hedging transactions or that such hedging transactions will adequately protect us or our funds against the foregoing risks. In addition, cash flow hedges which are not perfectly correlated with a variable rate financing will impact our reported income as gains, and losses on the ineffective portion of such hedges will be recorded. Our loans and investments may be illiquid which will constrain our ability to vary our portfolio of -3- investments. Our real estate investments are relatively illiquid. Such illiquidity may limit our ability to vary our portfolio or our funds' portfolios of investments in response to changes in economic and other conditions. Illiquidity may result from the absence of an established market for investments as well as the legal or contractual restrictions on their resale. In addition, illiquidity may result from the decline in value of a property securing one of our or our funds' investments. We cannot assure you that the fair market value of any of the real property serving as security will not decrease in the future, leaving our or our funds' investments under-collateralized or not collateralized at all, which could impair the liquidity and value, as well as our return on such investments. We may not have control over certain of our loans and investments. Our ability to manage our portfolio of loans and investments may be limited by the form in which they are made. In certain situations, we or our funds may: o acquire investments subject to rights of senior classes and servicers under inter-creditor or servicing agreements; o acquire only a participation in an underlying investment; o co-invest with third parties through partnerships, joint ventures or other entities, thereby acquiring non-controlling interests; or o rely on independent third party management or strategic partners with respect to the management of an asset. Therefore, we may not be able to exercise control over the loan or investment. Such financial assets may involve risks not present in investments where senior creditors, servicers or third party controlling investors are not involved. Our rights to control the process following a borrower default may be subject to the rights of senior creditors or servicers whose interests may not be aligned with ours. A third party partner or co-venturer may have financial difficulties resulting in a negative impact on such asset, may have economic or business interests or goals which are inconsistent with ours and those of our funds, or may be in a position to take action contrary to our or our funds' investment objectives. In addition, we and our funds may, in certain circumstances, be liable for the actions of our third party partners or co-venturers. We may not achieve our targeted rate of return on our investments. We originate or acquire investments based on our estimates or projections of overall rates of return on such investments, which in turn are based on, among other considerations, assumptions regarding the performance of assets, the amount and terms of available financing to obtain desired leverage and the manner and timing of dispositions, including possible asset recovery and remediation strategies, all of which are subject to significant uncertainty. In addition, events or conditions that we have not anticipated may occur and may have a significant effect on the actual rate of return received on an investment. We are currently experiencing a low interest rate environment which negatively impacts our ability to originate or acquire investments that produce rates of returns similar to existing investments that were added to our portfolio during a higher interest rate environment. As we acquire or originate investments for our balance sheet portfolio, whether as new additions or as replacements for maturing investments, there can be no assurance that we will be able to originate or acquire investments that produce rates of return comparable to rates on our existing investments. The commercial mortgage and mezzanine loans we originate or acquire and the commercial mortgage loans underlying the CMBS in which we invest are subject to delinquency, foreclosure and loss, which could result in losses to us. Our commercial mortgage and mezzanine loans are secured by commercial property and are subject to risks of delinquency and foreclosure, and risks of loss that are greater than similar risks associated with loans made on the security of single-family residential property. The ability of a borrower to repay a loan secured by an income-producing property typically is dependent primarily upon the successful operation of the property rather than upon -4- the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower's ability to repay the loan may be impaired. Net operating income of an income-producing property can be affected by, among other things: tenant mix, success of tenant businesses, property management decisions, property location and condition, competition from comparable types of properties, changes in laws that increase operating expenses or limit rents that may be charged; any need to address environmental contamination at the property; changes in national, regional or local economic conditions and/or specific industry segments; declines in regional or local real estate values and declines in regional or local rental or occupancy rates; increases in interest rates, real estate tax rates and other operating expenses; and changes in governmental rules, regulations and fiscal policies, including environmental legislation, acts of God, terrorism, social unrest and civil disturbances. Our investments in subordinated CMBS are subject to losses. In general, losses on an asset securing a mortgage loan included in a securitization will be borne first by the equity holder of the property, then by a cash reserve fund or letter of credit, if any, and then by the most junior security holder. In the event of default and the exhaustion of any equity support, reserve fund, letter of credit and any classes of securities junior to those in which we invest, we may not be able to recover all of our investment in the securities we purchase. In addition, if the underlying mortgage portfolio has been overvalued by the originator, or if the values subsequently decline and, as a result, less collateral is available to satisfy interest and principal payments due on the related mortgage-backed securities, the securities in which we invest may incur significant losses. The prices of lower credit quality securities are generally less sensitive to interest rate changes than more highly rated investments, but more sensitive to adverse economic downturns and underlying borrower developments. A projection of an economic downturn, for example, could cause a decline in the price of lower credit quality securities because the ability of borrowers of the mortgages underlying the mortgage-backed securities to make principal and interest payments may be impaired. In such event, existing credit support in the securitization structure may be insufficient to protect us against loss of our principal on these securities. We may invest in troubled assets that are subject to a higher degree of financial risk. We may make investments in non-performing or other troubled assets that involve a higher degree of financial risk. We cannot assure you that our investment objectives will be realized or that there will be any return on our investment. Furthermore, investments in properties subject to work-out conditions or under bankruptcy protection laws may, in certain circumstances, be subject to additional potential liabilities that could exceed the value of our original investment, including equitable subordination and/or disallowance of claims or lender liability. We may not be able to acquire eligible investments for a collateralized debt obligation issuance, or may not be able to issue collateralized debt obligation securities on attractive terms, which may require us to utilize more costly financing for our investments. We intend to capitalize on opportunities to finance certain of our investments on a non-recourse, long-term basis, such as through the issuance of collateralized debt obligations. During the period that we are acquiring these investments, we intend to finance our purchases through our credit and repurchase obligation facilities. We use these facilities to finance our acquisition of investments until we have accumulated a sufficient quantity of investments, at which time we may refinance these lines through a securitization, such as a collateralized debt obligation issuance, or other types of long-term financing. As a result, we are subject to the risk that we will not be able to acquire a sufficient amount of eligible investments to maximize the efficiency of a collateralized debt obligation issuance. In addition, conditions in the capital markets may make the issuance of collateralized debt obligations less attractive to us when we do have a sufficient pool of collateral. If we are unable to issue a collateralized debt obligation to finance these investments, we may be required to utilize other forms of potentially less attractive financing. We may not be able to find suitable replacement investments for collateralized debt obligations with reinvestment periods. Some collateralized debt obligations have periods where principal proceeds received from assets securing the collateralized debt obligation can be reinvested for a defined period of time, commonly referred to as a reinvestment period. Our ability to find suitable investments during the reinvestment period that meet the criteria set forth in the collateralized debt obligation documentation and by rating agencies may determine the success of our collateralized debt obligation investments. Our potential inability to find suitable investments may cause, among -5- other things, interest deficiencies, hyper-amortization of the senior collateralized debt obligation liabilities and may cause us to reduce the life of our collateralized debt obligations and accelerate the amortization of certain fees and expenses. The use of collateralized debt obligation financings with over-collateralization and interest coverage requirements may have a negative impact on our cash flow. The terms of collateralized debt obligations will generally provide that the principal amount of investments must exceed the principal balance of the related bonds by a certain amount and that interest income exceeds interest expense by a certain amount. We anticipate that the collateralized debt obligation terms will provide that, if certain delinquencies and/or losses or other factors cause a decline in collateral or cash flow levels, the cash flow otherwise payable on our investment may be redirected to repay classes of CDOs senior to ours until the issuer or the collateral is in compliance with the terms of the governing documents. Other tests (based on delinquency levels or other criteria) may restrict our ability to receive net income from assets pledged to secure collateralized debt obligations. We cannot assure you that the performance tests will be satisfied. Nor can we assure you, in advance of completing negotiations with the rating agencies or other key transaction parties as to the actual terms of the delinquency tests, over-collateralization and interest coverage terms, cash flow release mechanisms or other significant factors upon which net income to us will be calculated. Failure to obtain favorable terms with regard to these matters may adversely affect the availability of net income to us. If our investments fail to perform as anticipated, our over-collateralization, interest coverage or other credit enhancement expense associated with our collateralized debt obligation financings will increase. We may be required to repurchase loans that we have sold or to indemnify holders of our collateralized debt obligations. If any of the loans we originate or acquire and sell or securitize through collateralized debt obligations do not comply with representations and warranties that we make about certain characteristics of the loans, the borrowers and the underlying properties, we may be required to repurchase those loans or replace them with substitute loans. In addition, in the case of loans that we have sold instead of retained, we may be required to indemnify persons for losses or expenses incurred as a result of a breach of a representation or warranty. Repurchased loans typically require a significant allocation of working capital to carry on our books, and our ability to borrow against such assets is limited. Any significant repurchases or indemnification payments could adversely affect our financial condition and operating results. The impact of the events of September 11, 2001 and the resulting effect on terrorism insurance expose us to certain risks. The terrorist attacks on September 11, 2001 disrupted the U.S. financial markets, including the real estate capital markets, and negatively impacted the U.S. economy in general. Any future terrorist attacks, the anticipation of any such attacks, and the consequences of any military or other response by the U.S. and its allies may have a further adverse impact on the U.S. financial markets and the economy generally. We cannot predict the severity of the effect that such future events would have on the U.S. financial markets, the economy or our business. In addition, the events of September 11 created significant uncertainty regarding the ability of real estate owners of high profile assets to obtain insurance coverage protecting against terrorist attacks at commercially reasonable rates, if at all. With the enactment of the Terrorism Risk Insurance Act of 2002, or TRIA, and the subsequent enactment of the Terrorism Risk Insurance Extension Act of 2005, which extended the TRIA through the end of 2007, insurers must make terrorism insurance available under their property and casualty insurance policies, but this legislation does not regulate the pricing of such insurance. The absence of affordable insurance coverage may adversely affect the general real estate lending market, lending volume and the market's overall liquidity and may reduce the number of suitable investment opportunities available to us and the pace at which we are able to make investments. If the properties that we invest in are unable to obtain affordable insurance coverage, the value of those investments could decline and in the event of an uninsured loss, we could lose all or a portion of our investment. The economic impact of any future terrorist attacks could also adversely affect the credit quality of some of our loans and investments. Some of our loans and investments will be more susceptible to the adverse effects than others, such as hotel loans, which may experience a significant reduction in occupancy rates following any future -6- attacks. We may suffer losses as a result of the adverse impact of any future attacks and these losses may adversely impact our results of operations. Risks Related to Our Investment Management Business We are subject to risks and uncertainties associated with operating our investment management business, and we may not achieve from this business the investment returns that we expect. We will encounter risks and difficulties as we operate our investment management business. In order to achieve our goals as an investment manager, we must: o manage our funds successfully by investing a majority of our funds' capital in suitable investments that meet the funds' specified investment criteria; o actively manage the assets in our portfolios in order to realize targeted performance; o incentivize our management and professional staff to the task of developing and operating the investment management business; and o Structure, sponsor and capitalize future funds and other investment products under our management that provide investors with attractive investment opportunities. If we do not successfully operate our investment management business to achieve the investment returns that we or the market anticipates, our results of operations may be adversely impacted. We may pursue fund management opportunities related to other classes of investments where we do not have prior investment experience. We may expand our fund management business to the management of private equity funds involving other investment classes where we do not have prior investment experience. We may find it difficult to attract third party investors without a performance track record involving such investments. Even if we attract third party investment, there can be no assurance that we will be successful in deploying the capital to achieve targeted returns on the investments. We face substantial competition from established participants in the private equity market as we offer mezzanine and other funds to third party investors. We face significant competition from large financial and other institutions that have proven track records in marketing and managing private equity investment funds and otherwise have a competitive advantage over us because they have access to pre-existing third party investor networks into which they can channel competing investment opportunities. If our competitors offer investment products that are competitive with the mezzanine and other fund investments offered by us, we will find it more difficult to attract investors and to capitalize our mezzanine and other funds. Our funds are subject to the risk of defaults by third party investors on their capital commitments. The capital commitments made by third party investors to our funds represent unsecured promises by those investors to contribute cash to the funds from time to time as investments are made by the funds. Accordingly, we are subject to general credit risks that the investors may default on their capital commitments. If defaults occur, we may not be able to close loans and investments we have identified and negotiated which could materially and adversely affect the funds' investment program or make us liable for breach of contract, in either case to the detriment of our franchise in the private equity market. Risks Related to Our Company We are dependent upon our senior management team to develop and operate our business. Our ability to develop and operate our business depends to a substantial extent upon the experience, relationships and expertise of our senior management and key employees. We cannot assure you that these -7- individuals will remain in our employ. The employment agreement with our chief executive officer, John R. Klopp, expires on December 31, 2008, unless further extended. The employment agreement with our chief operating officer, Stephen D. Plavin, expires on December 28, 2008, unless further extended. The loss of the services of our senior management and key employees could have a material adverse effect on our operations. There may be conflicts between the interests of our investment funds and us. We are subject to a number of potential conflicts between our interests and the interests of our managed investment funds. Although we have agreed to offer Fund III the first opportunity to invest in investment opportunities which have characteristics and projected leveraged returns which meet Fund III's investment and return objectives, we are subject to potential conflicts of interest in the allocation of investment opportunities between our balance sheet and our managed funds. In addition, we may make investments that are senior or junior to, participations in, or have rights and interests different from or adverse to, the investments made by our managed funds. Our interests in such investments may conflict with the interests of our managed funds in related investments at the time of origination or in the event of a default or restructuring of the investment. In the event a default occurs with respect to such an investment, the directors of Fund III appointed by us have agreed to recuse themselves from any vote of the board of Fund III concerning such investment and our co-sponsor's controlled advisor to Fund III will assume and perform our asset management responsibility with respect to such investment. Finally, our officers and employees may have conflicts in allocating their time and services among us and our managed funds. We must manage our portfolio in a manner that allows us to rely on an exception from registration under the Investment Company Act of 1940 in order to avoid the consequences of regulation under that Act. We rely on an exception from registration as an investment company afforded by Section 3(c)(5)(C) of the Investment Company Act of 1940. Under this exception, we are required to maintain, on the basis of positions taken by the SEC staff in interpretive and no-action letters, a minimum of 55% of the value of the total assets of our portfolio in "mortgages and other liens on and interests in real estate," which we refer to as "Qualifying Interests" and a minimum of 80% in an Qualifying Interests and real estate-related assets. Because registration as an investment company would significantly affect our ability to engage in certain transactions or to organize ourselves in the manner we are currently organized, we intend to maintain our qualification for this exception from registration. In the past, when required due to the mix of assets in our balance sheet portfolio, we have purchased all of the outstanding interests in pools of whole residential mortgage loans, which we treat as Qualifying Interests based on SEC staff positions. Investments in such pools of whole residential mortgage loans may not represent an optimum use of our investable capital when compared to the available investments we target pursuant to our investment strategy. We continue to analyze our investments and may acquire other pools of whole loan mortgage-backed securities when and if required for compliance purposes. In addition, certain of our investments in subordinated CMBS have terms which we believe allow them to be categorized as Qualifying Interests, including rights to cure any defaults on senior CMBS classes, rights to acquire such senior classes in the event of a default and special servicing rights to service defaulted mortgage loans, including rights to control the oversight and management of the resolution of such 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. We also believe that certain of our investments in B Notes will have terms that are similar to those listed above for subordinated CMBS investments that will allow them to be treated as Qualifying Interests. In addition, we treat certain of our investments in mezzanine loans as Qualifying Interests when these investments are secured by a first priority, perfected security interest in all of the outstanding beneficial ownership interests in a limited liability company or limited partnership that directly or indirectly owns real property (or a leasehold interest in real property) and engages in no other business but ownership of the real property. We also consider participations in mezzanine loans as Qualifying Interests if these investments have terms that are similar to those listed above for subordinated CMBS and B Notes. We emphasize that we have not obtained an exemptive order or no-action letter or other form of interpretive guidance from the SEC or its staff to support our positions. Therefore, any decision by the SEC or its staff which advances a position contrary to any of our positions would require us to no longer treat our investments in subordinated CMBS, B Notes, mezzanine loans or participations in mezzanine loans as Qualifying Interests. If our portfolio does not comply with the requirements of the exception we rely upon, we could be forced to -8- alter our portfolio by selling or otherwise disposing of a substantial portion of the assets that are not Qualifying Interests or by acquiring a significant position in assets that are Qualifying Interests. Altering our portfolio in this manner may have a material adverse effect on our investments if we are forced to dispose of or acquire assets in an unfavorable market and may materially and adversely affect our stock price. If it were established that we were an unregistered investment company, there would be a risk that we would be subject to monetary penalties and injunctive relief in an action brought by the SEC, that we would be unable to enforce contracts with third parties and that third parties could seek to obtain rescission of transactions undertaken during the period it was established that we were an unregistered investment company. We may expand our franchise through business acquisitions and the recruitment of financial professionals, which may present additional costs and other challenges and may not prove successful. Our business plan contemplates expansion of our franchise into complementary investment strategies involving other credit-sensitive structured financial products. We may undertake such expansion through business acquisitions or the recruitment of financial professionals with experience in other products. We may also expend a substantial amount of time and capital pursuing opportunities to expand into complementary investment strategies that we do not consummate. The expansion of our operations could place a significant strain on our management, financial and other resources. Our ability to manage future expansion will depend upon our ability to monitor operations, maintain effective quality controls and significantly expand our internal management and technical and accounting systems, all of which could result in higher operating expenses and could adversely affect our current business, financial condition and results of operations. We cannot assure you that we will be able to identify and integrate businesses or professional teams we acquire to pursue complementary investment strategies and expand our business. Moreover, any decision to pursue expansion into businesses with complementary investment strategies will be in the discretion of our management and may be consummated without prior notice or shareholder approval. In such instances, shareholders will be relying on our management to assess the relative benefits and risks associated with any such expansion. Risks Relating to Our Class A Common Stock Because a limited number of shareholders, including members of our management team, own a substantial number of our shares, they may make decisions or take actions that may be detrimental to your interests. By virtue of their direct and indirect share ownership, John R. Klopp, a director and our president and chief executive officer, Craig M. Hatkoff, a director and former officer, and other shareholders indirectly owned by trusts for the benefit of our chairman of the board, Samuel Zell, have the power to significantly influence our affairs and are able to influence the outcome of matters required to be submitted to shareholders for approval, including the election of our directors, amendments to our charter, mergers, sales of assets and other acquisitions or sales. The influence exerted by these shareholders over our affairs might not be consistent with the interests of some or all of our other shareholders. We cannot assure you that these shareholders will not exercise their influence over us in a manner detrimental to your interests. As of June 30, 2006, these shareholders collectively own and control 2,599,689 shares of our class A common stock representing approximately 16.6% of our outstanding class A common stock. This concentration of ownership may have the effect of delaying or preventing a change in control of our company, including transactions in which you might otherwise receive a premium for your class A common stock, and might negatively affect the market price of our class A common stock. W. R. Berkley Corporation owns 2,000,000 shares of our class A common stock which represents 13.0% of our outstanding class A common stock. An officer of Berkley serves on our board of directors and, therefore, has the power to significantly influence our affairs. In addition, Vornado Realty, L.P. owns 1,424,474 shares of our class A common stock which represents 9.3% of our outstanding class A common stock. Through their significant ownership of our class A common stock, these security holders may have the ability to influence the outcome of matters submitted for shareholder approval. Some provisions of our charter and bylaws, and Maryland law may deter takeover attempts, which may limit the opportunity of our shareholders to sell their shares at a favorable price. -9- Some of the provisions of our charter and bylaws and Maryland law discussed below could make it more difficult for a third party to acquire us, even if doing so might be beneficial to our shareholders by providing them with the opportunity to sell their shares at a premium to the then current market price. Issuance of Preferred Stock Without Shareholder Approval. Our charter authorizes our board of directors to authorize the issuance of up to 100,000,000 shares of preferred stock and up to 100,000,000 shares of class A common stock. Our charter also authorizes our board of directors, without shareholder approval, to classify or reclassify any unissued shares of our class A common stock and preferred stock into other classes or series of stock and to amend our charter to increase or decrease the aggregate number of shares of stock of any class or series that may be issued. Our board of directors, therefore, can exercise its power to reclassify our stock to increase the number of shares of preferred stock we may issue without shareholder approval. Preferred stock may be issued in one or more series, the terms of which may be determined without further action by shareholders. These terms may include preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends or other distributions, qualifications or terms or conditions of redemption. The issuance of any preferred stock, however, could materially adversely affect the rights of holders of our class A common stock and, therefore, could reduce the value of the class A common stock. In addition, specific rights granted to future holders of our preferred stock could be used to restrict our ability to merge with, or sell assets to, a third party. The power of our board of directors to issue preferred stock could make it more difficult, delay, discourage, prevent or make it more costly to acquire or effect a change in control, thereby preserving the current shareholders' control. Advance Notice Bylaw. Our bylaws contain advance notice procedures for the introduction of business and the nomination of directors. These provisions could discourage proxy contests and make it more difficult for you and other shareholders to elect shareholder-nominated directors and to propose and approve shareholder proposals opposed by management. Maryland Takeover Statutes. We are subject to the Maryland Business Combination Act which could delay or prevent an unsolicited takeover of us. The statute substantially restricts the ability of third parties who acquire, or seek to acquire, control of us to complete mergers and other business combinations without the approval of our board of directors even if such transaction would be beneficial to shareholders. "Business combinations" between such a third party acquiror or its affiliate and us are prohibited for five years after the most recent date on which the acquiror or its affiliate becomes an "interested shareholder." An "interested shareholder" is defined as any person who beneficially owns 10 percent or more of our shareholder voting power or an affiliate or associate of ours who, at any time within the two-year period prior to the date interested shareholder status is determined, was the beneficial owner of 10 percent or more of our shareholder voting power. If our board of directors approved in advance the transaction that would otherwise give rise to the acquiror or its affiliate attaining such status, such as the issuance of shares of our class A common stock to Berkley, the acquiror or its affiliate would not become an interested shareholder and, as a result, it could enter into a business combination with us. Our board of directors could choose not to negotiate with an acquirer if the board determined in its business judgment that considering such an acquisition was not in our strategic interests. Even after the lapse of the five-year prohibition period, any business combination with an interested shareholder must be recommended by our board of directors and approved by the affirmative vote of at least: o 80% of the votes entitled to be cast by shareholders; and o two-thirds of the votes entitled to be cast by shareholders other than the interested shareholder and affiliates and associates thereof. The super-majority vote requirements do not apply if the transaction complies with a minimum price requirement prescribed by the statute. The statute permits various exemptions from its provisions, including business combinations that are exempted by the board of directors prior to the time that an interested shareholder becomes an interested shareholder. Our board of directors has exempted any business combination involving family partnerships controlled separately by John R. Klopp and Craig M. Hatkoff, and a limited liability company indirectly controlled by a trust for the benefit of Samuel Zell and his family. As a result, these persons and Berkley may enter into business combinations with us without compliance with the super-majority vote requirements and the other provisions of the statute. We are subject to the Maryland Control Share Acquisition Act. With certain exceptions, the Maryland -10- General Corporation Law provides that "control shares" of a Maryland corporation acquired in a control share acquisition have no voting rights except to the extent approved by a vote of two-thirds of the votes entitled to be cast on the matter, excluding shares owned by the acquiring person or by our officers or directors who are our employees, and may be redeemed by us. "Control shares" are voting shares which, if aggregated with all other shares owned or voted by the acquirer, would entitle the acquirer to exercise voting power in electing directors within one of the specified ranges of voting power. A person who has made or proposes to make a control share acquisition, upon satisfaction of certain conditions, including an undertaking to pay expenses, may compel our board to call a special meeting of shareholders to be held within 50 days of demand to consider the voting rights of the "control shares" in question. If no request for a meeting is made, we may present the question at any shareholders' meeting. If voting rights are not approved at the shareholders' meeting or if the acquiring person does not deliver the statement required by Maryland law, then, subject to certain conditions and limitations, we may redeem for fair value any or all of the control shares, except those for which voting rights have previously been approved. If voting rights for control shares are approved at a shareholders' meeting and the acquirer may then vote a majority of the shares entitled to vote, then all other shareholders may exercise appraisal rights. The fair value of the shares for purposes of these appraisal rights may not be less than the highest price per share paid by the acquirer in the control share acquisition. The control share acquisition statute does not apply to shares acquired in a merger, consolidation or share exchange if we are a party to the transaction, nor does it apply to acquisitions approved or exempted by our charter or bylaws. Our bylaws contain a provision exempting certain holders identified in our bylaws from this statute which exemptions extend to Berkley, family partnerships controlled separately by John R. Klopp and Craig M. Hatkoff, and a limited liability company indirectly controlled by a trust for the benefit of Samuel Zell and his family. We are also subject to the Maryland Unsolicited Takeovers Act which permits our board of directors, among other things and notwithstanding any provision in our charter or bylaws, to elect on our behalf to stagger the terms of directors, to increase the shareholder vote required to remove a director and to provide that shareholder-requested meetings may be called only upon the request of shareholders entitled to cast at least a majority of the votes entitled to be cast at the meeting. Such an election would significantly restrict the ability of third parties to wage a proxy fight for control of our board of directors as a means of advancing a takeover offer. If an acquirer was discouraged from offering to acquire us, or prevented from successfully completing a hostile acquisition, you could lose the opportunity to sell your shares at a favorable price. The market value of our class A common stock may be adversely affected by many factors. As with any public company, a number of factors may adversely influence the price of our class A common stock, many of which are beyond our control. These factors include: o the level of institutional interest in us; o the perception of REITs generally and REITs with portfolios similar to ours, in particular, by market professionals; o the attractiveness of securities of REITs in comparison to other companies; and o the market's perception of our growth potential and potential future cash dividends. An increase in market interest rates may lead prospective purchasers of our class A common stock to expect a higher dividend yield, which would adversely affect the market price of our class A common stock. One of the factors that will influence the price of our class A common stock will be the dividend yield on our stock (distributions as a percentage of the price of our stock) relative to market interest rates. An increase in market interest rates may lead prospective purchasers of our class A common stock to expect a higher dividend yield, which would adversely affect the market price of our class A common stock. Your ability to sell a substantial number of shares of our class A common stock may be restricted by the low trading volume historically experienced by our class A common stock. Although our class A common stock is listed on the New York Stock Exchange, the daily trading volume of our shares of class A common stock has historically been lower than the trading volume for certain other -11- companies. As a result, the ability of a holder to sell a substantial number of shares of our class A common stock in a timely manner without causing a substantial decline in the market of the shares, especially by means of a large block trade, may be restricted by the limited trading volume of the shares of our class A common stock. Risks Related to our REIT Status Our charter does not permit any individual to own more than over 2.5% of our class A common stock, and attempts to acquire our class A common stock in excess of the 2.5% limit would be void without the prior approval of our board of directors. For the purpose of preserving our qualification as a REIT for federal income tax purposes, our charter prohibits direct or constructive ownership by any individual of more than 2.5% of the lesser of the total number or value of the outstanding shares of our class A common stock as a means of preventing ownership of more than 50% of our class A common stock by five or fewer individuals. The charter's constructive ownership rules are complex and may cause the outstanding class A common stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual. As a result, the acquisition of less than 2.5% of our outstanding class A common stock by an individual or entity could cause an individual to own constructively in excess of 2.5% of our outstanding class A common stock, and thus be subject to the charter's ownership limit. There can be no assurance that our board of directors, as permitted in the charter, will increase this ownership limit in the future. Any attempt to own or transfer shares of our class A common stock in excess of the ownership limit without the consent of our board of directors will be void, and will result in the shares being transferred by operation of law to a charitable trust, and the person who acquired such excess shares will not be entitled to any distributions thereon or to vote such excess shares. Our charter contains a provision that exempts certain of our officers, directors and their related persons from this ownership limit and we increased the limit for William R. Berkley to 6.0% and for one other major shareholder of Berkley identified to us to 4.0%. The 2.5% ownership limit may have the effect of precluding a change in control of us by a third party without the consent of our board of directors, even if such change in control would be in the interest of our shareholders or would result in a premium to the price of our class A common stock (and even if such change in control would not reasonably jeopardize our REIT status). The ownership limit exemptions and the reset limits granted to date would limit our board of directors' ability to reset limits in the future and at the same time maintain compliance with the REIT qualification requirement prohibiting ownership of more than 50% of our class A common stock by five or fewer individuals. There are no assurances that we will be able to pay dividends in the future. We intend to pay quarterly dividends and to make distributions to our shareholders in amounts such that all or substantially all of our taxable income in each year, subject to certain adjustments, is distributed. This, along with other factors, should enable us to qualify for the tax benefits accorded to a REIT under the Internal Revenue Code. All distributions will be made at the discretion of our board of directors and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time. There are no assurances that we will be able to pay dividends in the future. In addition, some of our distributions may include a return of capital, which would reduce the amount of capital available to operate our business. We will be dependent on external sources of capital to finance our growth. As with other REITs, but unlike corporations generally, our ability to finance our growth must largely be funded by external sources of capital because we generally will have to distribute to our shareholders 90% of our taxable income in order to qualify as a REIT, including taxable income where we do not receive corresponding cash. Our access to external capital will depend upon a number of factors, including general market conditions, the market's perception of our growth potential, our current and potential future earnings, cash distributions and the market price of our class A common stock. If we do not maintain our qualification as a REIT, we will be subject to tax as a regular corporation and face a substantial tax liability. Our taxable REIT subsidiaries will be subject to income tax. -12- We expect to operate so as to qualify as a REIT under the Internal Revenue Code. However, qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only a limited number of judicial or administrative interpretations exist. Even a technical or inadvertent mistake could jeopardize our REIT status. Furthermore, new tax legislation, administrative guidance or court decisions, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to qualify as a REIT. If we fail to qualify as a REIT in any tax year, then: o we would be taxed as a regular domestic corporation, which under current laws, among other things, means being unable to deduct distributions to shareholders in computing taxable income and being subject to federal income tax on our taxable income at regular corporate rates; o any resulting tax liability could be substantial, could have a material adverse effect on our book value and could reduce the amount of cash available for distribution to shareholders; and o unless we were entitled to relief under applicable statutory provisions, we would be required to pay taxes, and thus, our cash available for distribution to shareholders would be reduced for each of the years during which we did not qualify as a REIT. Income from our fund management business is expected to be realized by one of our taxable REIT subsidiaries, and, accordingly, will be subject to income tax. Complying with REIT requirements may cause us to forego otherwise attractive opportunities. In order to qualify as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other things, our sources of income, the nature of our investments in commercial real estate and related assets, the amounts we distribute to our shareholders and the ownership of our stock. We may also be required to make distributions to shareholders at disadvantageous times or when we do not have funds readily available for distribution. Thus, compliance with REIT requirements may hinder our ability to operate solely on the basis of maximizing profits. Complying with REIT requirements may force us to liquidate or restructure otherwise attractive investments. In order to qualify as a REIT, we must also ensure that at the end of each calendar quarter, at least 75% of the value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of our investments in securities cannot include more than 10% of the outstanding voting securities of any one issuer or 10% of the total value of the outstanding securities of any one issuer. In addition, no more than 5% of the value of our assets can consist of the securities of any one issuer. If we fail to comply with these requirements, we must dispose of a portion of our assets within 30 days after the end of the calendar quarter in order to avoid losing our REIT status and suffering adverse tax consequences. Complying with REIT requirements may force us to borrow to make distributions to shareholders. From time to time, our taxable income may be greater than our cash flow available for distribution to shareholders. If we do not have other funds available in these situations, we may be unable to distribute substantially all of our taxable income as required by the REIT provisions of the Internal Revenue Code. Thus, we could be required to borrow funds, sell a portion of our assets at disadvantageous prices or find another alternative. These options could increase our costs or reduce our equity. The "taxable mortgage pool" rules may limit the manner in which we effect future securitizations. Certain of our securitizations could be considered taxable mortgage pools for federal income tax purposes. Since we conduct our operations to qualify as a REIT, so long as we own 100% of the equity interests in a taxable mortgage pool, we should not be adversely affected by the characterization of the securitization as a taxable mortgage pool (assuming that we do not have any shareholders who might cause a corporate income tax to be imposed upon us by reason of our owning a taxable mortgage pool). We would be precluded, however, from selling -13- to outside investors equity interests in such securitizations or from selling any debt securities issued in connection with such securitizations that might be considered to be equity interests for tax purposes. These limitations will preclude us from using certain techniques to maximize our returns from securitization transactions. If the securitization vehicles in which we participate were considered a taxable mortgage pool, shareholders who are tax-exempt and shareholders who are not United States persons may be required to pay tax on their share of any excess inclusion income. -----END PRIVACY-ENHANCED MESSAGE-----