Executives
Richard J. McCready – Chief Operating Officer & Executive Vice President
David T. Hamamoto – Chairman of the Board, President and Chief Executive Officer
Andrew C. Richardson – Chief Financial Officer, Executive Vice President and Treasurer
Daniel R. Gilbert – Executive Vice President
Albert Tylis – General Counsel
Analysts
Joshua Barber – Stifel Nicolaus & Company
Jim Shanahan – Wachovia Capital Markets
Northstar Realty Finance Corp. (NRF) Q1 2009 Earnings Call May 7, 2009 10:00 AM ET
Operator
Welcome to the Northstar Realty Finance first quarter 2009 earnings conference call. (Operator Instructions) At this time I will turn the call over to the Chief Operating Officer, Richard J. McCready, for opening remarks.
Richard J. McCready
Before the call begins I'd like to remind everyone that certain statements made in the course of this call are not based on historical information and may constitute forward-looking statements. These statements are based on management's current expectations and beliefs and are subject to a number of trends and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements.
So I refer you to the company's filings made with the SEC for a more detailed discussion of the risks and factors that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today. The company undertakes no duty to update any forward-looking statements that may be made in the course of this call.
Additionally certain non-GAAP financial measures will be discussed on this conference call. A presentation of this information is not intended to be considered an isolation or as a substitute to the financial information presented in accordance with generally accepted accounting principles. Reconciliations of these non-GAAP financial measures to the most comparable measures compared in accordance with generally accepted accounting principles can be accessed through our filings with the SEC at www.sec.gov.
With that I'm now going to turn the call over to our Chairman and Chief Executive Office, David Hamamoto. David?
David T. Hamamoto
In addition to Rick McCready, our COO, I'm joined today by Andy Richardson, CFO, Dan Gilbert, our Chief Investment Officer, and Al Tylis, our General Counsel. Northstar's first quarter results reflected continuing challenges faced by the financial services and real estate sectors. These challenges include the continuation of weakening economic conditions, unemployment reaching levels last seen during the early '80s and very difficult capital market conditions negatively impacting commercial real estate fundamentals.
As the banking sector continues to struggle with inadequate equity capital level that capital remains scarce, exacerbated by the virtual shutdown of the asset-backed and high yield credit markets. As a result of these conditions investors with cash are continuing to be cautious in making new commitments, while those who hold real estate equity or debt generally remain unwilling to sell at cheap prices.
Potential sellers view the levels at which buyers are bidding for assets as artificially low to short-term and unsustainably low market levels of debt capital available at unattractive costs. Because of the continuing live bid-ask spread, those sellers who are able to delay transactions are doing so. By the same token, lenders are generally hesitant to foreclose on assets particularly assets where cash flow covers current interest because they believe that selling in current market conditions will result in poor recovery levels.
Consequently the private real estate market is at a standstill with very few transactions. There is however a growing backlog of motivated sellers who we believe will begin to transact later this year and who will establish market pricing as deals are completed. The FDIC has already seized 31 banks this year, and many predict this to be the beginning of the wave of seizure.
The U.S. government is not capable of and is unwilling to be the long-term owner and operator of real estate assets. It will inevitably have to offer increasingly attractive terms to the private sector in order to dispose of these assets. The government also knows that non-performing assets on bank balance sheets strap capital that otherwise could be lent to spur an economic recovery, so it also has a strong interest in more market liquidity and normally functioning capital markets.
At this point, after two years in which the markets have progressively become worse through the quarter, we believe that recent initiatives launched by the Treasury and Fed should begin a process for healing the commercial real estate finance markets. Specifically, the Public-Private Investment Partnership program, combined with leverage available under the expanded TALF, should bring investors and some liquidity into the market.
We expect the government will initially partner with a few large asset managers in the PPIP programs and the resulting demand for high quality CMBS securities could drive down the cost of capital in the secured type markets to a level where banks may eventually begin lending again. Northstar could benefit from this because our borrowers could more easily access refinancing capital to repay us.
In addition, the value of our assets should increase as credit spreads tighten. Already credit spreads for highly rated CMBS's have materially decreased in anticipation of the expanded TALF Program and new PPIP investors that are entering the market. For Northstar, our approach remains consistent with prior quarters. Liquidity and credit risk management are the top priorities.
We have differentiated our company from other market participants during these difficult times by aggressively raising capital and exercising extreme caution in deploying capital. The extent of the challenges and depth of this economic recession are much more severe than anyone could have reasonably expected. With the strength of our balance sheet and diversity of our real estate investment platform creates opportunities to prospectively make outstanding investments that generate exceptional returns.
Increasingly, this market feels more like the early days of the last major real estate recession of the late '80s and early '90s. At that time, a growing tidal wave of bank failures and asset seizures, combined with a limited universe of experienced and well capitalized investors, resulted in the government offering attractive incentives for private capital through loss sharing and other structures. I believe the strength and track record of the Northstar platform should allow us to participate in these opportunities.
We benefit as a team from our prior experience in distressed asset acquisitions and management from the RTC, our CMBS and loan investment expertise, as well as from our liability and asset management capabilities. Our liquidity position remains strong and the only discretionary investments we are making include repurchasing our issued debt at discount, as well as strategically providing capital to facilitate the sale of our assets where such sale is part of our credit risk management strategy.
Year-to-date, we acquired $72 million paid of our 7.25% corporate debt for an average of 58% discount to par. These purchases represented an over 40% yield to the June 2012 put date and reduced Northstar's leverage in future debt maturity obligations. During the first quarter, we also made a $21 million net new loan commitment as part of the sale of a $71 billion portfolio, five loan assets, that we identified as having higher credit risk than Northstar.
The sold loans, as well as the new collateral property with significant borrower equity, serves as credit enhancement for the financing we've provided to the purchaser. Although our priorities remain liquidity and credit risk management, we continue to seek new sources of capital and fee streams for our franchise. To that end, during the first quarter, we created a new REIT called Northstar Real Estate Income Trust and filed an S-11 with the SEC to register the stock in this company.
The new company will be managed by a subsidiary of Northstar and we intend to raise equity capital in the non-listed REIT market. The new REIT's investment objectives will be initially focused on lower leveraged commercial real estate finance assets and equity investment and we expect that its cost of capital to be significantly lower than Northstar's is today. The process for obtaining all of the necessary federal and state regulatory hurdles is a long one, so the end of this year is the earliest we expect to begin raising capital for this company.
As owners of approximately 11% of Northstar's common equity, we are keenly aware of the importance of balancing long-term liquidity planning in an uncertain market with the desire to deliver a current cash return. Many of the recent business challenges are outside of our control and no company can be immune to these difficult market conditions. Nevertheless, so far this year, we have declared two quarterly dividends. This quarter's was all cash and I believe we are the only company within our competitive set who has recently delivered a quarterly common dividend.
The new legislation allowing companies to defer cancellation of debt income for five years should provide Northstar the flexibility to pay out a dividend that we believe is appropriate in light of our near and longer term objectives. Briefly covering the first quarter, we deployed approximately $34 million of equity capital of which $8 million are related to prior period loan commitments and was non-discretionary and $26 million were for Northstar corporate securities repurchases.
Repayment activity, as expected, remains very slow, with just $5 million received this quarter. We expect repayment volume to remain at low levels for the remainder of 2009. To conclude my prepared remarks, Northstar continues to do the blocking and tackling necessary to survive in these very difficult market conditions, as well as seeking new ways to collectively take advantage of the opportunities to increase our franchise value.
Now, I'd like to turn the call over to Andy, who will review our results for the quarter, Andy?
Andrew C. Richardson
Thanks, David. For the first quarter, our GAAP net income includes the FAS 159 adjustment, with $84.6 million or $1.32 per share. AFFO for the quarter was $22.6 million or $0.31 per share. We invested approximately $34 million of equity capital during the first quarter and did not receive any equity capital from loans repayments.
Net interest income, which is interest rental and advisory fee revenues, less interest expense, property operating costs and asset management fees were $33.1 million and approximately a $3 million decrease from $35.9 million in the fourth quarter. The decrease was related to lower net interest income due to a drop in average LIBOR and less rental income due to WaMu vacating our properties in Chatsworth, California.
Prepayment penalties and other income totaled about $200,000 during the first quarter, approximately $1.8 million lower than the fourth quarter of 2008. The decrease was due to the recognition of participation income in the prior quarter. General and administrative expenses, excluding non-cash stock-based compensation, totaled $12.3 million for the first quarter. Auditing and professional fees were approximately $2.3 million, nearly flat for the fourth quarter due a portion of the 2008 annual audit fees being expensed in the prior quarter.
During the first quarter, net mark-to-market adjustments and adoption of ATB 14-1 decreased Northstar's book value by approximately $21 million. ATB 14-1, effective as of January 1st this year, prohibits mark-to-market treatment of convertible debt under FAS 159. We now carry our convertible debt as historical costs and bifurcate the straight debt value as of the issuance date from the warrant value embedded in the conversion options.
The ATB 14-1 adjustment decreased book value by approximately $113 million. All other mark-to-market adjustments increased book value by a net $92 million. The increase this quarter was again principally driven by a $136 million decrease in the value of our issued CDO notes. These securities continued to become cheaper during the first quarter due to credit rating downgrades and very little liquidity in the asset backed real estate market.
Overall, our GAAP book value as of March 31, was $18.05 per share. The earnings release contains the detailed reconciliation between our fourth quarter of 2008 and first quarter of 2009 book values. If all mark-to-market adjustments and accumulated depreciation were excluded the book value would be $8.21 per share as of March 31st.
Once again, our major discretionary use of capital this quarter was to acquire Northstar debt securities. We purchased a $61 million space of our convertible notes at an average 58% discount to par resulting in $34 million of extinguishment gain net of accelerated deferred financing expenses and a $61 million reduction in outstanding debt.
These acquisitions continue to be made opportunistically and as we see attractive offers in the market. They also happen to represent some of the best return opportunities with our first quarter purchases representing more than a 40% yield to effective maturity. Since the beginning of 2008, we have acquired debt issued by Northstar at an aggregate $97 million discount to its base amount. These repurchase gains increased book value, decreased leverage and reduced maturity risk, as well as create a cushion for credit losses.
Because our lenders agreed to sell most of our credit at discount, we've so far have borne the first $97 million of any credit impairment rather than our common stockholders. During the first quarter, we funded $36 million of commitments under existing loans representing approximately $8 million equity capital and we made no new net leases or joint venture investments during the quarter.
Our $1.2 billion of real estate assets, based on undepreciated book value, are subject to long-term net leases that have a weighted average remaining term of approximately 8.3 years as of March 31st. Of the $1.2 billion, $752 million represent healthcare related assets, which are fully leased at March 31. The remaining $483 million of assets, exclusive of the Chatsworth, California properties formerly leased to WaMu, are office industrial and retail net leased properties.
As discussed during our last earnings call, WaMu vacated our facilities on March 23rd and we decided to transfer the building through a non-recourse first mortgage lender rather than to carry and attempt to release the building in a weak office market. We are working with the first mortgage special servicer to transfer the asset and last quarter we took a $5.6 million impairment charge caused by the WaMu vacancy.
Our carrying value is now approximately equal to the first mortgage debt balance, so expect no material impact on our financial statement from the transfer. For details on these facilities, including the related non-recourse debt financings, please see the tables in the back of this quarter's earnings release. On the securities front, and as expected, each of the three major rating agencies downgraded approximately a billion dollars of our securities year-to-date based on changes to the ratings model.
As we discussed last quarter, virtually all vintages of securities were affected, but deals issued since 2006 were more significantly impacted. Such downgrades may not necessarily be indicative of the current performance of the securities. This quarter's ratings actions resulted in $1.1 billion of downgrade and $12 million of upgrade in Northstar's $3.1 billion managed portfolio. The weighted average credit rating decreased one notch to double B plus at March 31st from triple B minus at December 31st.
Approximately $700 million of our managed securities are consolidated and $2.4 billion are accounted for in off balance sheet financing. Many are seasoned, with 79% of the REIT CMBS portfolio issued in 2005 or prior years. Notwithstanding these massive downgrade actions, all of the CMBS securities are current and paying according to their contractual term.
Our securities are marked to market each quarter and the portfolio has continued to decrease in value as market credit spreads have widened. Virtually all of our securities are financed to maturity in CDO term financing or are held unleveraged, so we not only have the intent but also the ability to hold these assets to maturity.
At March 31st, we had $2 billion of commercial real estate loans consisting of 109 separate loans. Collateral performance has weakened largely due to extremely poor macro economic conditions. Historically, low interest rates have partially offset declining cash flow performance and for loans which do not currently have positive debt service coverage.
We have approximately 19 months of debt service remaining on a weighted average basis based on current LIBOR rates. Funded reserves underlying our loans totaled $95 million at March 31st. As we said in our earnings call two months ago, we are also working with borrowers who cannot otherwise refinance or sell in this market to obtain additional collateral and/or partial pay out in return for extensions.
We are generally able to work directly with our borrowers because approximately 78% of our portfolio loan balance was directly originated by Northstar. This means that we typically have more control and credit enhancements built into these loans than was available from Wall Street products.
Furthermore, approximately 41% of our loans have some sort of recourse obligation to the sponsors, such as debt service reserve funding, and our experience has been that the ability to go after recourse guarantee provides significant leverage in negotiations with borrowers.
Repayment activity this year is likely to be light and we have just $55 million of final maturities in 2009, exclusive of our non-performing loans, and assuming all of our borrowers meet and exercise extension options in their loan. We continually evaluate the opportunity costs of repayment and we expect to more aggressively seek to sell, or otherwise elect to receive amounts less than we are contractually entitled to, if the economic return from redeploying the proceeds is more attractive than no repayment at all.
This quarter we sold $71 million of weaker performing loan assets at par to a buyer with experience in owning and operating the types of collateral properties underlying the sold loans. As part of this sale, we financed the buyer's acquisition of these loans and provided refinancing proceeds against one of the buyer's properties. In return, we received cross-collateralization and significant subordinate equity capital further enhancing the credit support to our loan basis.
During the first quarter, we recorded $21.5 million of new credit loss reserves relating to 10 loans, bringing our total loan credit loss reserves to $32.7 million as of March 31st. We also had two non-performing loans at March 31st totaling $49.8 million, both with maturity default.
One of the NPLs was recovered during the year-end conference call is a $21 million first mortgage secure buyer, permitted and approved condo/hotel development site in Manhattan. The first mortgage also was secured by recourse guarantee, it's from the sponsor and its investors, and we are pursuing several options with respect to preserving our capital, including a possible recapitalization with a new equity sponsor.
The second NPL is a $29 million B-note secured by a master planned community located in Orlando, Florida. The loan has a maturity default. The special servicer of the loan is in restructuring discussions with the borrower, which likely will include amortization in return for an extension, although there is no assurance any restructuring will be completed or completed on terms favorable to us. As of March 31st, we have reserves totaling $6 million for these two assets. After quarter end, two additional loans totaling $23 million reached NPL status due to maturity default.
We are fully reserved for one of the loans, a $9 million mezzanine loans on a multi-family development site in Washington, D.C. The second loan is a $14 million first mortgage secured by a condo development site in New York City having the same sponsor as the $21 million previously discussed NPL. The loan has a $1 million reserve as of March 31st. We are also reviewing alternatives with respect to maximizing recovery of our capital in this loan.
On the right side of the balance sheet the secured credit facility with JP Morgan reaches initial maturity in August this year. The facility has a one-year extension at the lender's option and we have just $13 million outstanding on the line as of March 31st. We have begun extension discussions, but have adequate liquidity to fully repay the debt if we cannot agree to terms.
Our next significant final debt maturity does not occur until October of 2010. At March 31st, we were in compliance with the financial covenant in our debt facility and our CDO financings were in compliance with the related interest and collateral coverage tests. The table contained in the supplemental information section of the earnings release shows the status of the CDO coverage tests.
If we were to fail any of these tests, cash flow from the respective financing would be temporarily diverted from Northstar to repay senior debt until the failed test is back in compliance. Credit ratings downgrades of CMBS collateral backing our security CDOs can negatively impact OC tests if downgrades reach certain levels, even if the security is fully performing. Typically, a CDO can have a maximum amount of triple C rated securities before OC deteriorates.
This quarter the CMBS's market experienced massive ratings downgrade actions as the rating agencies changed their rating models to incorporate more severe economic assumptions, higher default and lower recovery rates. Notwithstanding these actions, our security CDOs continued to comply with their coverage tests.
Going forward, CDOs one and two currently have no reinvestment limiting, so their OC and IP coverages are more susceptible to ratings downgrades and default because we cannot sell securities with ratings issues and purchase higher quality securities with the proceeds.
For the quarter ended March 31st, the cash distributions we received from CDOs one and two were only $406,000 and $343,000, respectively. In addition, a continuing negative ratings action trend for CMBS will make it increasingly difficult to maintain the existing [CNID] cushion. Now, our loan CDOs, actual loans, defaults negatively impacted OC. The agencies may also downgrade our issued CDO notes, but such downgrades would have no liquidity impact on Northstar.
Consolidated assets totaled $3.8 billion at March 31st, down slightly from $3.9 billion last quarter, due principally to mark-to-market adjustments. Northstar had approximately $121 million of unrestricted cash and $80 million of uninvested cash in our CDO term financing for total liquidity of $201 million at March 31st down slightly from $216 million at year end.
Future funding commitments under our loan investments remain our only nondiscretionary future funding obligation. Typically borrowers must meet performance hurdles to obtain additional funds, and we expect that some will not be able to draw on these amounts in the future. All future fundings and loans that are financed in our CDOs will be funded 100% within the CDO by a revolving class of notes, which means there is no cash requirement from Northstar.
Of our $241 million of future funding requirements as of March 31st, $113 million will be funded in our CDOs. We must fund the unfinanced portion of loans that are collateral for our credit facilities and term loans, assuming all loans that have future fundings meet the terms to qualify for such funding. We currently expect to fund approximately $58 million from available liquidity through the end of 2009.
This concludes our prepared remarks for today. Now let's the open up the call for questions. Operator?
Question-and-Answer Session
Operator
Thank you. (Operator instructions). Your first question comes from Joshua Barber from Stifel Nicolaus.
Joshua Barber – Stifel Nicolaus & Company
Good morning. I was wondering if you could tell us how your CMBS CDOs, I believe it's CDO3 and CDO7, their over collateralization has actually increased since issuance.
Andrew C. Richardson
The reason why that's increased is that we've taken available cash in those CDOs and purchased higher quality securities at large discounts that are available in today's market. And for the purpose of the OC test we get benefit for the full par amount of the security until such time as there is a downgrade rating action that would cause us to decrease the amount that we're getting credit for.
Joshua Barber – Stifel Nicolaus & Company
Okay, thanks. Could you also tell us, what are your 2010 cash funding needs to meet your commitments outside of the CDOs?
Andrew C. Richardson
Yes, I can tell you that. It's another $40 million, approximately. We have about $95 million of equity needs over the next couple quarters. I think we estimate about $58 million for this year, so the remainder we would expect to be funded in 2010.
Joshua Barber – Stifel Nicolaus & Company
Great thanks. And one more question, in regard to the non-traded REIT, I realize it's not anything that's probably going to be anytime soon but will there any equity commitment from Northstar or is it just going to be a pure third party management?
David T. Hamamoto
Just a small commitment, Josh. The co-investment is under a million bucks, I think, in that deal.
Operator
Your next question comes from Jim Shanahan – Wachovia. Please go ahead with your question.
Jim Shanahan – Wachovia Capital Markets
Hi, good morning. I had a question about the REIT as well. Should we assume that this is a traditional externally managed REIT model where there will be a base and incentive management fees that would accrue to Northstar as the manager of the REIT?
Andrew C. Richardson
Yes.
Jim Shanahan – Wachovia Capital Markets
Okay, and is there a targeted amount of capital that you either expect or hope to raise?
Andrew C. Richardson
Yes, the filing was for $1.1 billion.
Jim Shanahan – Wachovia Capital Markets
$1.1 billion. What about the economics on it. Could we look at, say the economics on some other externally managed real estate finance companies that are structured as REIT and can get an estimate or a ball park of the fee structure or is the filing out there and I just need to dig it up and look through it?
David T. Hamamoto
Yes Jim, the filing's out there. The fee structure has a few differences from some of the externally advised REITs that are publically traded. There is a base management fee, but in addition the manager would get acquisition fees and dispositions fees, and the incentive fee is more like a traditional private equity incentive fee, so it's not paid currently. It would be paid after investors receive a base return hurdle plus their capital back.
Jim Shanahan – Wachovia Capital Markets
Okay, and you said kind of a question and we'd like your commentary just with regards to credit. It seems that to me a couple of your peers have reported, still others do in the next few days or so, and there seems to be a real bifurcation with regards to credit. We are seeing generally a lift in delinquencies and perhaps nonperforming loans, but we're seeing a real separation with companies with regards to specifically charge off activity.
There's a lot of provisioning and delinquencies, and everything's kind of going the same way generally, but why would it be the case that there would be, in some cases, quite massive charge off activity and in other cases lifted delinquencies and perhaps no charge off activity even to date. It seems a little bit odd to me, and I'm wondering if there's something about the work out or the way you might manage the balance sheet or delinquent loan inventories that might explain some of that?
David T. Hamamoto
I think, Jim, obviously everyone has seen a relative increase in nonperformers, as Andy went through on the call, we have four nonperformers now. And I think on a relative basis that's a small number compared to some of our competitors. I think as we said all along, we believe that part of that was driven by a more conservative lending strategy where the bulk of our loans were originated directly by us as opposed to purchased from the street.
And a greater proportion of what we did were first mortgages as opposed to small slices in the junior portion of a very big capital stack where to the extent there was a blow up it's a very difficult thing for a company of our size to cure. And also the magnitude of the loss is pretty significant, because you're such a thin slice of the capital stack, and we tended to stay away from that type of paper and focus more on originating our own.
I think the other thing with respect to some of the transitional assets that we made loans on was we focused on structure, and as Andy said, the level of reserve that we required from our borrowers, which I think today is about 19 months of interest reserve on a weighted average basis coupled with a significant amount of recourse from generally well capitalized sponsors that served us well in terms of maintaining credit, and to the extent there are issues that the property have enabled us to restructure in a way that maintains the performing loan status of the asset.
Operator
(Operator instructions) There appears to be no further questions. Please continue with any further points you wish to raise.
Andrew C. Richardson
No further points. Thanks to everyone for joining the call. We'll talk to you next quarter.
Operator
This concludes the Northstar Realty Finance first quarter conference call on the 7th of May, 2009. Thank you for participating and you may now disconnect.
Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.
THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.
If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!