Note 11 — Fair Value of Financial Instruments

The Company determines fair value based on quoted prices when available or through the use of alternative approaches, such as discounting the expected cash flows using market interest rates commensurate with the credit quality and duration of the investment. The guidance defines three levels of inputs that may be used to measure fair value:

Level 1 — Quoted prices in active markets for identical assets and liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 — Inputs other than quoted prices included within Level 1 that are observable for the asset and liability or can be corroborated with observable market data for substantially the entire contractual term of the asset or liability.

Level 3 — Unobservable inputs that reflect the entity’s own assumptions about the assumptions that market participants would use in the pricing of the asset or liability and are consequently not based on market activity, but rather through particular valuation techniques.

The determination of where an asset or liability falls in the hierarchy requires significant judgment and considers factors specific to the asset or liability. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company evaluates its hierarchy disclosures each quarter and depending on various factors, it is possible that an asset or liability may be classified differently from quarter to quarter. However, the Company expects that changes in classifications between levels will be infrequent.

Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with those derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by the Company and its counterparties. However, as of March 31, 2014, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of the Company’s derivatives. As a result, the Company has determined that its derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy. As of March 31, 2014, the Company’s interest rate cap derivative measured at fair value on a recurring basis was zero and was classified in Level 2 of the fair value hierarchy.

During the year ended December 31, 2013, real estate assets with carrying amounts of $4.5 million related to two properties were deemed to be impaired and their carrying amounts were reduced to their estimated fair value, resulting in an impairment charge of $3.3 million. No impairments of real estate assets were recorded during the three months ended March 31, 2014 or 2013, respectively.

The Company’s estimated fair values of its real estate assets were primarily based upon an income approach utilizing a present value technique to discount the expected cash flows using market participant assumptions for market rent and terminal values, which are considered to be Level 3 inputs, or based upon recent comparable sales transactions, which are considered to be Level 2 inputs. The aggregate fair value of impaired real estate assets as of December 31, 2013 was $1.2 million.

The following table presents information about the Company’s assets and liabilities (including derivatives that are presented net) measured at fair value on a recurring basis as of March 31, 2014 and December 31, 2013, aggregated by the level in the fair value hierarchy within which those instruments fall (in thousands):


	Quoted Prices in Active Markets Level 1		Significant Other Observable Inputs Level 2			Significant Unobservable Inputs Level 3			Balance as of March 31, 2014
Assets:
Investments in real estate fund	$	—	$	1,648		$	—		$	1,648
CMBS		—		—			212,155			212,155
Interest rate swap assets		—		9,829			—			9,829

Total assets	$	—	$	11,477		$	212,155		$	223,632

Liabilities:
Interest rate swap liabilities	$	—	$	(8,737	)	$	—		$	(8,737	)
Series D Preferred Stock embedded derivative		—		—			(26,734	)		(26,734	)
Contingent consideration arrangements		—		—			(4,903	)		(4,903	)

Total liabilities	$	—	$	(8,737	)	$	(31,637	)	$	(40,374	)


	Quoted Prices in Active Markets Level 1		Significant Other Observable Inputs Level 2			Significant Unobservable Inputs Level 3			Balance as of December 31, 2013
Assets:
Investments in real estate fund	$	—	$	1,484		$	—		$	1,484
CMBS		—		—			60,583			60,583
Interest rate swap assets		—		9,189			—			9,189

Total assets	$	—	$	10,673		$	60,583		$	71,256

Liabilities:
Interest rate swap liabilities	$	—	$	(1,719	)	$	—		$	(1,719	)
Series D Preferred Stock embedded derivative		—		—			(16,736	)		(16,736	)

Total liabilities	$	—	$	(1,719	)	$	(16,736	)	$	(18,455	)

Investments in real estate fund — The fair value of the Company’s investments in real estate fund are based published pricing.

CMBS — The fair values of the Company’s CMBS are valued using broker quotations, collateral values, subordination levels and liquidity of the individual securities.

Derivatives — The valuation of derivative instruments is determined using a discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, as well as observable market-based inputs, including interest rate curves and implied volatilities. In addition, credit valuation adjustments are incorporated into the fair values to account for the Company’s potential nonperformance risk and the performance risk of the counterparties.

Series D Preferred Stock embedded derivative — The valuation of this derivative instrument is determined using a binomial option pricing model. Key inputs in the model include the expected term, risk-free interest rate, volatility and dividend yield.

Contingent Consideration Arrangements — The contingent consideration arrangements are carried at fair value and are valued using Level 3 inputs. The fair value of the contingent payments related to property acquisitions is determined based on the estimated timing and probability of successfully leasing vacant space subsequent to the Company’s acquisition of certain properties. The estimated fair value of the property-related contingent consideration arrangements totaled $4.9 million as of March 31, 2014 and is included in the accompanying consolidated balance sheet in deferred rent, derivative and other liabilities. There were no property related contingent consideration arrangements as of December 31, 2013.

The fair value of short-term financial instruments such as cash and cash equivalents, restricted cash, due to affiliates and accounts payable approximate their carrying value on the accompanying consolidated balance sheets due to their short-term nature and are classified as Level 1 under the fair value hierarchy.

A review of the fair value hierarchy classification is conducted on a quarterly basis. Changes in the type of inputs may result in a reclassification for certain assets. There were no transfers between Level 1 and Level 2 or Level 3 of the fair value hierarchy during the three months ended March 31, 2014.

The following is a reconciliation of the beginning and ending balance for the changes in instruments with Level 3 inputs in the fair value hierarchy for the three months ended March 31, 2014 (in thousands):


	CMBS			Series D Preferred Stock Embedded Derivative			Contingent Consideration Arrangements			Total
Beginning Balance as of December 31, 2013	$	60,583		$	(16,736	)	$	—		$	43,847
Total gains and losses:
Unrealized gain included in other comprehensive income, net		2,948			—			—			2,948
Changes in fair value included in net income, net		—			(9,998	)		(1,297	)		(11,295	)
Purchases, issuances, settlements and amortization:
Purchases/issuances		151,197			—			(3,606	)		147,591
Amortization included in net income, net		(2,573	)	$	—			—			(2,573	)

Ending balance as of March 31, 2014	$	212,155		$	(26,734	)	$	(4,903	)	$	180,518

The fair values of the Company’s financial instruments that are not reported at fair value on the consolidated balance sheets are reported below (dollar amounts in thousands):


	Level	Carrying Amount at March 31, 2014		Fair Value at March 31, 2014		Carrying Amount at December 31, 2013		Fair Value at December 31, 2013
Assets:
Loans held for investment	3	$	98,185	$	98,652	$	26,279	$	26,435

Liabilities:
Mortgage notes payable, net	3	$	4,234,074	$	4,265,230	$	1,301,114	$	1,305,823
Corporate bonds, net	3		2,545,884		2,545,884		—		—
Convertible debt, net	3		973,737		976,629		972,490		976,629
Senior corporate credit facility	3		2,265,800		2,265,800		1,819,800		1,819,800
Secured term loan	3		53,958		54,035		58,979		59,049
Trust preferred notes	3		26,563		23,485		26,548		23,345
Unsecured credit facility	3		150,000		150,000		150,000		150,000
Other debt	3		68,288		68,414		19,278		19,350

Total liabilities		$	10,318,304	$	10,349,477	$	4,348,209	$	4,353,996

Loans held for investment — The fair value of the Company’s fixed-rate loan portfolio is estimated with a discounted cash flow analysis, utilizing scheduled cash flows and discount rates estimated by management to approximate those that a willing buyer and seller might use.

Credit facilities — Management believes that the stated interest rates (which float based on short-term interest rates) approximate market rates. As such, the fair values of these obligations are estimated to be equal to the outstanding principal amounts.

Convertible notes, mortgage notes payable and secured term loan — The fair value of mortgages payable on real estate investments and the secured term loan is estimated by an independent third party using a discounted cash flow analysis, based on management’s estimates of market interest rates.

Trust preferred notes — The fair value of the Company’s other long-term debt is estimated using a discounted cash flow analysis, based on management’s estimates of market interest rates.