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Executives

Gordon F. DuGan - Chief Executive Officer, Director and Chairman of Investment Committee

Benjamin P. Harris - President

Jon W. Clark - Chief Financial Officer, Chief Accounting Officer and Treasurer

Analysts

Mitchell B. Germain - JMP Securities LLC, Research Division

Jonathan Feldman - Nomura Securities Co. Ltd., Research Division

Matthew Dodson

Lawrence Raiman

Gramercy Property Trust (GPT) Q2 2013 Earnings Call August 6, 2013 2:00 PM ET

Operator

Thank you, everybody for joining us. And welcome to Gramercy Property Trust's Second Quarter 2013 Financial Results Conference Call. As a reminder, presentation materials and a supplemental for the call are posted on the company's website, www.gptreit.com in the Investor Center section, in the Events & Presentations tab. [Operator Instructions] Please note that this conference is being recorded.

The company would like to remind the listeners that during the call, management may make forward-looking statements. Actual results may differ materially from the predictions that management may make today. Additional information regarding the factors that could cause such differences appear in the MD&A section of the company's Form 10-K and other reports filed with the Securities and Exchange Commission.

Also, during today's conference call, the company may discuss non-GAAP financial measures as defined by the SEC Regulation G. The GAAP financial measures most directly comparable to each non-GAAP financial measures discussed and a reconciliation of differences between each non-GAAP financial measure and the comparable GAAP financial measures can be found in the company's press release announcing second quarter earnings, a copy of which can be found on the company's website, www.gptreit.com.

Before turning the call over to Gordon DuGan, Chief Executive Officer of Gramercy Property Trust, we would like to ask those participating in the Q&A portion of the call to please limit yourself to 2 questions per person. Thank you, and please go ahead, Mr. DuGan.

Gordon F. DuGan

Thank you very much, and good afternoon, everyone. Thank you for joining us. Let me start by saying I'm very, very pleased with our results for Q2. And I'll elaborate on why in the various aspects of the progress that we're making, and why I'm so happy with it. I would also say, like some of you, I was struck by how our GAAP financials, our quarterly filings lagged the progress we're making. And I think some of this is intuitive that, that would be the case. You start from a base of 0. You build up a business. There's going to be a lag with backward-looking financials. And then there were also a couple of peculiar items with respect to us that are in Q2 that I'll talk about. But the combination of those 2 just struck me when I looked at the -- when we had the release and we did our financials, that there is still this lag. And the lag is considerable relative to what the company looks going forward. I was thinking of different analogies for that this morning. And the analogy that struck me the most was, if you'll bear with me for a moment, it's like a renovation project where if anyone's ever renovated a home or apartment, you demo the space. That's the sort of 0 baseline work begins. And as progress goes on, you may go in and you maybe 80% through on your project, but when you go in to see the work and the milestone, based upon the 80% milestone, you can be underwhelmed because the thing doesn't look ready to move in to. And I think that's a little bit of what's happening with Gramercy. We won't get that "aha" moment until closer to the end of the renovation. But with respect to the financial statements, I think that in this case, all it takes is a little bit of work to get through what I'd call some of these construction problems and see where we are in terms of progress. And that progress is very discernible in the second quarter. We'll be more discernible in the third quarter. And again, it's starting from a 0. The lag's starting from a low base, and then a couple of peculiarities for us. And so rather than just talk about them or analogize them, let's just jump in. And I think you'll see what I mean.

The first one, investment volume. Probably the thing I was happiest about is our ability to transact in the second quarter on a number of different transactions, deals that we just feel great about, 11 different transactions. As we've talked about, we have this differentiated approach to the net lease business, focusing not only on the credit in the lease term, but also on the quality of the real estate. And I think we're doing a better job of that than anybody else that I see in the market. And then we'll talk more about the investment side. But we're also focused on smaller deals where we're creating a lot of value through aggregation. But here's the quirk in our investment volume for Q2. So for Q2, we closed $111 million, but that $111 million had a 10-day average outstanding in the quarter. In other words, it's as if it all closed 10 days before the end of the quarter. We understand there's a lag effect when you're building up off a base, having the $111 million close later in the quarter than obviously we'd like. The 10-day average outstanding though, another way to think about it, it's as if we did a $12 million or $13 million deal at the beginning of the quarter on day 1, and didn't do anything else for the rest of the quarter. It was only a portion of the quarter that we had the earnings power of that $111 million. So the lag effect is significant. Obviously, closing $111 million 10 days before the end of the quarter on an average basis is much more meaningful than closing a $12 million deal at the beginning of Q1 or the beginning of Q2, day 1 of Q2. But the economic effect for Q2 is the same. So I thought that was an interesting point.

The second thing on our own portfolio, another quirk is the 5-below building that we own in Memphis. The way that lease is structured, there's a 6-month free rent period in the lease. The way we accounted for that or the way that we handled it in the acquisition is we took a full undiscounted credit at closing. So we took a cash credit for that free rent period and reduced our purchase price. So in essence, we got our cash paid off upfront. If you look at our AFFO number for Q2, we have a straight-line rent adjustment, which typically is going to be smaller dollars. But of that straight-line rent adjustment, roughly $490,000 of it relates to 5 below. And that rent adjustment, we've actually already been paid in cash upfront. So what we show is a basis on our schedules, is the full purchase price. And then we repaid this cash upfront, in this case by the landlord rather than the tenant, but it doesn't matter if you get paid upfront who it comes from. So in my view, the AFFO is probably more realistically $490,000 higher than what we're showing. I don't think the -- I think we'll either have some additional disclosure going forward or something to help highlight things like that because I think it's the unnecessary punishment to our AFFO for something that we already -- it's different than other straight-line rent. We actually already received cash and we're pulling it all out of our income. So I thought that, that was another quirk as we look at our Q2. By far, the biggest quirk or biggest aspect of the GAAP financials relative to how we're really doing, and I'll get into some of those financial metrics later, is the Bank of America JV. And if you have at your disposal, we put it both on our website and have filed it with the SEC our supplemental report. And let me say, I'm sorry that we didn't get those filed with the press release. I promise we will do our best to file those with the press release going forward. But if you go to Page 16 of that supplement, what we show in our Q2 financial statement is a loss from joint venture of roughly $2.6 million. That's what shows up on -- the press release runs through all the numbers that you see. There's no other number in there other than that. And that's the exact right accounting for what transpired. But let's go to Page 16 because I'll tell you a little bit about what really happened from an economic standpoint. We have 3 different pools in the Bank of America JV. We have our core properties there. We have a public number of a $10 million NOI. If you take the net income and add back the depreciation and annualize it, we were running slightly better than a $10 million NOI. So Q2, we were a little bit ahead of our NOI figure. So that's the most important number, where the $10 million or $2.5 million a quarter, we're slightly ahead up for Q2. So that's what happened in Q2. Our held-for-sale property show up in our additional reporting as the held-for-sale properties. We have made tremendous progress on those, as you all know. We're almost out of all of those properties. And as you see there, we get a little bit of income while we hold them. So that's just additional income in the Bank of America portfolio. And then lastly, we have this thing called defeasance pools, which is, again, the correct accounting for this. But that throws off a significant loss for the JV. That flows through to our loss that shows on our financial statements from this. We have sold the defeasance pool, and I'll get back to that, but it's the correct accounting. But just so that everybody's reminded of what the economics was of that third bucket, we paid $1. We spent no money while we held it. And then we sold it for $3.6 million in the JV. Our allocated pro rata portion is $1.8 million. So we paid $1, sold it for $3.6 million. Half of that's ours. That's what the economic effect of holding that defeasance pool was. Unfortunately, there's a booked net loss impact. But I think you'd all agree it's well worth it to make money on the other part of that, on the economic side of that equation. So again, the BofA JV is probably the biggest effect. The good news is the defeasance pools are sold. So that will not be reflected in Q3. The held-for-sale properties were almost all the way through. They have a negligible effect, so it doesn't matter. But going forward, the BofA JV will start to look through in a way that better reflects the economics of what it is we own. The last thing I'd say on the asset management side, I'll talk a little bit more about it. I'm going to just hit -- we filed a new investor update. There are a few of those pages that I want to talk about. But the incentive fee flows through what you see in the press release. The core operations had an uptick in profitability in Q2 versus Q1. So we're happy with that, and I'll talk a little bit about that later. But the core profitability, as we think about, it's overstated through that incentive fee. And we'll go through those numbers later. So there are a number of things, I think, flowing through Q2. Some of which will go away for Q3, thanks goodness, that are making it more work to reconcile the progress that we're making with sort of backward-looking statements. Not a big surprise, but just something I wanted to point out.

With that, let me turn it over to Ben Harris to give an investment update. I will be back to give a quick asset management, MG&A update, go through a couple of financial slides, that again are in the investor presentation on our website and filed with the SEC. And then Jon Clark, our CFO, will finish with a detailed discussion of the quarterly results. So with that, let me turn it over to Ben Harris.

Benjamin P. Harris

Thank you, Gordon. As Gordon mentioned, during the second quarter, we closed 11 discrete transactions totaling a little bit over $110 million, $111 million. That was at an average cap rate of roughly a little bit over 10% on a GAAP basis. And again, I would characterize this environment as really an asset-selecting, or asset-picking market. We are finding the most interesting opportunities on small assets. We think that there's a discount or a premium that buyers are paying as transactions get larger. So the value -- we're seeing a lot better value in $5 million to $10 million transactions than we are in $50 million to $100 million transactions. We hope that dynamic changes because it's a lot of work to buy $5 million and $10 million properties. But as of right now, we're seeing a lot of value in aggregating the portfolio. And it's really -- it's an environment where there's a lot of capital. Transaction activity has picked up because of that. We think it's become a little bit of a shakier environment because of the rate, the increase in interest rates, which has in some ways, created more opportunities. But it's really -- it's an environment where you really have to sort of pick your individual transactions. And then if you're willing to put in the work and dig through and pick assets, you can really find some interesting things. So we're very pleased with the assets that we've been able to find. It's really across a range of opportunities, we've been investing around a couple of different themes. One, around sort of a critical asset theme, so I would characterize our truck terminals is that these are assets that are very difficult to replicate. They're located in infill locations with high barriers to entry for other people. They are very difficult to build and almost never built on spec and we're acquiring them at significant discounts to replacement cost. So we -- when you add up those metrics, we think those are terrific assets. We've been buying cold storage assets, which is an asset class that we have a lot of experience in. Again, cold storage space in good markets where it's in demand has intrinsic use to not only the in-place tenant, but also other tenants. It never gets built back. And if you own high-quality freezers, you can have a high likelihood of not only tenant renewal, but also repositioning if something were to go wrong. So again, our team is spending the time to pick through. We've been finding a lot of interesting opportunities. And the pipeline is very robust going forward. So we're excited about what we're seeing.

Gordon F. DuGan

Thanks, Ben. Let me go on to asset management update. If you go to the investor presentation update that we filed, and you don't have to read along with this, and I promise I won't read the slide to you, but let me touch on some highlights of where the business is.

On Page 20, we are now managing these financial service office buildings and bank branches for a number of clients. There's obviously KBS, Garrison Investments and 2 others. We have a very good relationship with these clients in part because it's a very high value-added business. We do a lot of -- the team here does a lot of really great work on behalf of them. We have special expertise in this financial institution, real estate through the heritage of the old American Financial Realty. And so we have a team of people and an area of expertise that, I don't say this lightly, really is not replicable easily by anybody. We really have better insight into this financial institution real estate than anybody. So we've been able to parlay that into not only contracts with KBS and Garrison, but other clients as well.

Page 21, if you strip out the incentive fee portion of the results that go through our GAAP financials, you'll see that the baseline revenue and expenses continue to tick along. I wouldn't read too much into this bump-up in profitability. I would say that it's going to vary quarter-to-quarter, but it will be in this range. I think the contribution number that we gave everyone at the beginning of the year was just over $5.5 million. And we're comfortably on our way to that. That's a pretax number. These earnings are earned in a taxable REIT subsidiary because it's not a REIT asset. And that -- so there is some tax associated with that. We'll talk about that in a second. But the results, we've had a nice -- another nice quarter of results from that.

If we go to Page 22, you'll see that we're managing quite a few assets on behalf of a variety of different clients. Again, we like this business because it's profitable. We see investment opportunity out of it. And it's sticky because of the nature of the financial institution assets that we manage is really quite difficult and quite a specific skill set that we think we have, as well as anybody in the country.

MG&A. We've talked a lot about the need to reduce MG&A. This is a quick snapshot. This is, to get to this number, if you'll bear with me, you need to go to the supplemental, Page 13 of the supplemental -- I'm sorry, Page 12 of the supplemental, and compare basically the breakout of the asset management business and the ownership business and the basic breakdown -- I'm sorry, Page 14, I can't read, my eyesight is going, page 14, which you'll see there if you'll scroll down, is on the revenues and expenses side, we allocate MG&A between our realty corporate business and our asset management business. The $3.267 million is the annualized number. That's our corporate MG&A as of that quarter. We said that we would get it to a core target of below $13 million. We're well on our way. We'll see a reduction in that for Q3. And so we're making very good progress. I've said I'm also hopeful we can get it below $12 million. And that's our goal going forward.

If you go to Page 25, here are a couple of the components. We've been able to find synergies both in our corporate investment office here in New York, as well as in our asset management area. And so some of what's happened has been through headcount. But if you look down below, there's some very interesting things. By simplifying the business, by getting out of the CDO business, focusing on the property ownership business through the net lease strategy that we're employing, you see substantial savings across the professional fee spectrum where we're able to drive down the cost of running the business day-to-day. And when we came here in the beginning of last year, beginning of the second quarter last year, we said this was a priority for us. And I think we're really doing a very good job of finding cost savings for shareholders there.

Moving along, let me hit on these slides because I think these are a couple of the key slides. Page 27, we did this in Q1. We did it again in Q2. This and 28 are kind of a reconciliation of the core -- what the core business is generating. And if you'll see in Q1 versus Q2, an uptick in revenue on the net lease side, that's to be expected. Again, the lag effect of closing $111 million with an average day outstanding of 10 days meant that, that didn't tick up as much as it would've, but expect that to tick up again even more in Q3. The asset management business is a steady-state business. The expenses related to that for the net lease side or MG&A and interest and for the asset management side property management expenses, as well as asset management MG&A. So what you see bottom line is the contribution, as one would expect as we buy assets and manage the asset management business. We have a nice uptick in both segments from -- for Q2 over Q1. We expect an even greater uptick on the net lease side for Q3 due to having the full learning power of that $111 million acquisition activity. So again, as you tick through, and then you see a tax line, that tax line is the line that's allocated amount to that quarter's contribution in Q2 for our asset management business. So again, it's in the TRS. We do pay taxes. And that's how it flows through. But what you see is that we've made substantial progress, more progress to be made in Q3 in terms of covering all of the expenses of the business, again, depreciation, amortization and acquisition expenses or FX or AFFO. So this was almost a proxy AFFO number.

Page 28, the only thing I'd say on the FFO is you'll see that very large straight-line rent adjustment, which is primarily the Memphis property. Page 29, quickly, we've gotten a lot of questions about this. So we thought we'd put a slide together with it, just a summary financial analysis of what the CDO equity is, and equity is a little bit of a misnomer. It's J bonds, K bonds, preferred and common stock in the various CDOs. But you'll see the initial deal size. The initial equity was Gramercy, old Gramercy's investment amount. And you'll see the leverage ratio. And not surprisingly, as you went from '05 to '07, a significant uptick in leverage in each CDO, a lower initial equity check was required. So a fairly interesting business is the equity investor. Although, obviously, riskier assets with more leverage meant the margin of error got smaller and smaller. And what you'll see on Page 29 is the base case model recovery number of $29 million. That's all in CDO 1. But the numbers are so tight that the capital structure of this CDO is still leveraged, that just a 5% asset recovery increase significantly changes the base case equity recovery, as you see, up to about $83 million. And then a minus 5% asset recovery has a significant decrease. And I think I've said when we put it on our books, we have it on our books at roughly $7.6 million. Now it's 0 in a blink of an eye. And it's, as you see, $85 million in a blink of an eye. So having it on our books at $7.6 million, we have a 25% discount rate from this equity recovery amount, what we think is properly conservative. And it's anyone's best guess whether we see increases in asset recoveries, decreases in asset recoveries. But we thought this would be helpful for investors to be able to put their own mark on that number to the extent they want to see what's behind the CDO equity.

Page 30, if you look at our GAAP financial statement, this is a very simplified version of it, just to give a quick snapshot of the capitalization and the asset side of the balance sheet. But what you see is this is real estate owned, which is a combination of assets on the balance sheet, the intangibles related to real estate, as well as our investment in the JV. It's not a great number because the investment in the JV is equity investment in minus the distributions. So that number will actually go to 0 even though it's a very valuable investment. And so the JV is not consolidated. It's only equity accounting for the JV. You'll see cash. This is the 7.29 number, so it differs from the 6.30. You see CDO advances in the KBS promote on our books. And those are both on our books now going forward, as well as the CDO equity. On the right side, you'll see all the debt that we have on the balance sheet at that point is fixed rate. But again, this is GAAP, so it's not consolidating the BofA or Philips JVs. But we wanted to give a quick snapshot at GAAP. Now if we go to 31, this is a cut at market value. It's not an estimate of value. It's just a way to delineate what's on the balance sheet and what's not on the balance sheet. This is all real estate including consolidating our JV assets onto the balance sheet at a 7% cap on GAAP NOI. People can use their own number for that. There's cash. There are CDO advances and assets held-for-sale. The KBS promote, that's the full amount that we expect to recognize next June 30. Jon will talk a little bit about it. It's accounted for differently, but that's the market value as of next June 30. The CDO equity, we have it here, what we have it on a book basis, you can look at the numbers and take a guess at what a fair value is. We have not tried to do that because it's discounted at 25%. We would expect it to accrete up over time on a book basis. But it also depends on what's going to happen in the portfolio. And as you saw, it's very highly levered. So it's not an easy thing to value. And then what isn't valued, what's not on our books are the value of the KBS contracts, the value of the Garrison contract and promote. We do say that our current estimate of the Garrison promote is $10 million. And then we have the value of the other asset management contracts, what we're able to extract from those both today and going forward. So there are a number assets that aren't valued on our books at all either at book or at fair market. And we would just point investors to that. And then the negative intangible just reflects that at a $284 million common equity market cap before the value of these illiquid assets that are on our books, we do not -- we're trading below the fair value of those assets. On the right-hand side, I would just point out. Capitalization today, we have some fixed rate debt with an average debt term of about 7 years. We have floating rate debt, which is that Bank of America JV. The plan there is to try to restructure the leases and term out that debt whether we're able to restructure the leases or not. That would be the plan. But as you look at the balance sheet, it's really a very strong balance sheet. It's a small balance sheet, but it's a very strong balance sheet, not very leveraged, liquid, with a number of various other assets that are attractive, and not, again, very leveraged. So we're very happy with that going forward.

Page 32, you've seen this before. This is sort of our capacity, our dry powder analysis. This is just an updated number at 7.29. We update this periodically. This reflects some cash in. You'll see the CDO advances got paid down. We received some of our CDO advances in the third quarter. And then moving along, as I've taken enough time, and I'll turn it over to Jon, net lease environment, all I'd point out is even after the recent rate moves and rate scares, net lease companies continue to trade at very attractive valuations. I think a lot of the, if you look through properly structured net lease assets, the income streams are still very, very attractive. Our Bank of America joint venture, which has an 11-year lease term on good real estate at a 7% cap rate is over a 10% current return. That compares to a BofA 10-year bond of about 4%. So there's still a very large premium embedded in well-structured net leases relative to other income-oriented investments depending on whether they're structured properly. And I could go on about that for a long time, so I won't.

Page 35, we can skip over that. It's self-explanatory. Let me finish on 36 and turn it over to Jon to go through the detailed analysis. This is just to say we are entering Q3. Q3 is, we are entering what I would call the growth phase of the business. So capital is going to be part of the growth plan. We are, as we've mentioned before, working on a credit facility. We said we'd have an announcement hopefully early Q3. We are working on something. Nothing to announce yet. So we're going to enter the growth period of our -- of the business plan. And then the last piece of that business plan is the dividend piece. We are -- what we've said publicly is we expect to be paying dividends relatively soon. And that's about as far as we can go. Assuming we continue to make progress, we'll have updates on that as we go, but it's not yet on either the preferred or the common. But the whole business plan is based around being a durable cash flow business that pays very attractive dividends for investors. So that's next. So growth and dividends come next. Ben, did you want to say something?

Benjamin P. Harris

I just wanted to make a clarification about the second quarter activity, and I apologize about the sort of jumbled message. On Page 6 of the supplemental, the acquisition price, $111 million, that is the asset purchases funded as of the end of the quarter. In that number, there's a build-to-suit, the build-to-suit that we're doing down in Miami. If you include the total cost of that build-to-suit, which is expected to be completed in Q1, it's $131 million of acquisitions. The $11.9 million NOI relates to the full portfolio. So that number relates to the full $131 million of investments. So it's an average cap rate of about 9%. We'll issue a correction in the supplemental, but I just wanted to call people's attention to that. The NOI excluding the preferred freezer transaction is $9.5 million. And then the purchase price of assets excluding that build-to-suit is $106 million, also roughly a 9% cap rate. So I just wanted to make that clarification. It's a little bit confusing if you look at Slide 6 because we're talking about apples and oranges on purchase price and NOI.

With that, I'll turn it over to Jon to go through the financials.

Jon W. Clark

Thank you, Ben. I just wanted to provide just a few financial highlights of the results for the quarter. And I also just wanted to note that in this call, we've discussed certain non-GAAP financial measures, including funds from operations and adjusted funds from operations. And I just wanted to draw everyone's attention to reconciliations of the non-GAAP measures to what is the most direct comparable GAAP measure, which is net income to shareholders. And that reconciliation is in both of our press release, as well as our supplemental. We've added this quarter an adjusted FFO figure or AFFO to our quarterly earnings. As we believe, this is an additional measure that will be helpful to be able to evaluate the company and provide the basis for comparison to some of our peers. I'd just like to also point out that not all REITs compute AFFO the same way. And the reconciliation is very helpful to see the items that we put into our AFFO reconciliation.

Our headline FFO figure for the quarter that we reported this morning was a negative $3.5 million or $0.06 per diluted common share. And our adjusted FFO was essentially flat, a negative $35,000 or $0.00 per common share. And again, you can see this reconciliation that we put in our press release to draw that back to GAAP income.

During the quarter, we recorded total revenues of $16.3 million. That compares to $9.3 million in the prior quarter. The largest component in the increase in total revenues is the recognition of an additional $5.4 million in incentive fees based on our expectation that the underlying value of the KBS managed portfolio now exceeds its threshold. The incentive fee, according to the contracted cap at a $12 million level. To date, we recognized $7.8 million of incentive fees. And we expect to recognize the remaining $4.2 million over the remaining life of the contract, which the initial term is through June 2014. I'd also like to draw attention to the fact that our asset management business is conducted in a taxable subsidiary. And net of the tax affect, the incentive fee contributed approximately $3.2 million to revenue to this quarter or about $0.05 per common share.

The asset management business that we have is essentially bad income to REITs. REITs are allowed to have a certain extent of that income. However, this is a pretty significant component of our total revenues. And thus, we conduct this business inside of a taxable subsidiary away from the REIT. And accordingly, because of that, we do have a significant tax expense, perhaps a little higher than what you'd expect to ought to be typical REIT or a larger REIT that might be able to have this type of business inside the REIT sheltered by other revenues that they have.

As Gordon pointed out, in the second quarter, substantially all of our acquisitions were completed towards the end of the quarter, including 4 which closed in the very last week. And accordingly, our rental revenues in the second quarter just do not reflect the scope of the acquisitions that we made. You should note, similar circumstances existed in the first quarter. We had all 3 acquisitions in the first quarter occurred in March and one in the last week of March. I just wanted to highlight, on the expense side, the impairment that we recorded for the CDO bonds. We reduced the carrying value of the retained CDO bonds by approximately $1 million to be at carrying value of $7.6 million as of the end of the quarter. The impairment is primarily driven by a sharp increase in the interest rates during the quarter. The LIBOR curve essentially it's steepened by about 50 basis points. And steep increases in interest rates affect our classes really in 2 ways. The most significant is that as the underlying liabilities in the CDOs are floating rate, more cash flow now is expected to be necessary to pay interest to those senior bondholders. And that just leaves less cash flow available to the classes that we own, which are the junior-most classes. Another component is that increases in interest rate cause the fair value of fixed-rate CMBS within the CDOs to decline. Although those declines in CMBS might not ultimately be realized as the trustee could hold those bonds to maturity. They do affect the current carrying value.

In addition to the changes in interest rates, there were also 2 large underlying investments within the CDOs that are now expected to be realized a little later than what the initial projections were. One investment was a loan that was anticipated to be repaid at a maturity, which was now extended, pushing those cash flows out a year. And the other was a sale of an REO, which was expected to incur -- occur in 2013. And now that may occur in 2014, unlikely it will happen in 2013. So the delay in cash flows, particularly with respect to the fact that we're using a 25% discount rate, causes a near-term impairment. On the income statement, when you see the impairment, it's a larger number than the $1 million that is reflected on the balance sheet. But that's only because we accreted income for the quarter and then measured the impairment at the end of the quarter, which is what you do in these circumstances.

As Gordon showed in the chart that's in his presentation, which was on Page 29, the expected cash flows from these CDO bonds are just highly variable, dependent upon resolutions of every individual investment in the underlying CDO, none of which we are in direct control of. And accordingly, we record income on these bonds and accrete these bonds up to what we think is the expected base case recovery value, which would be $29 million. But it's somewhat unlikely given the variability of the cash flows that this will accrete in a straight line to $29 million. It's possible that in future periods, these CDO bonds get marked up or down. And we'll reevaluate that each quarter as we close our books.

Gordon talked about management and administrative expenses. So I'd just like to turn quickly just to the balance sheet and just highlight that the changes in carrying values that you see for real estate, cash, acquired lease assets, accounts payable and other intangibles just reflect the acquisition activity reported for the quarter. Also, I'd like to point out the servicing advances receivable, which as of June 30, remained essentially unchanged from the prior quarter. However, we did receive approximately 4.2 -- or $4.7 million of cash subsequent to quarter-end once an asset inside the CDO was sold. So now that is currently lower by $4.7 million. The decrease in the carrying value of the retained CDO bonds I referred to earlier, and the only other significant item that I wanted to point out on the balance sheet, is the mortgage note payable balance, which is now $48.7 million at the end of the quarter. And that essentially reflects 3 new borrowings during the quarter. We did close on the financing of the Indianapolis industrial portfolio, which is a $14.5 million, 5-year fixed-rate mortgage. That has a rate of about 3.28%. Also, the purchase of the auto auction facility in Texas included the assumption of a first mortgage of approximately $26.3 million. That's an amortizing first mortgage. It has a fixed rate of about 6.95%. Annual principal payments on that are approximately $825,000.

Finally, the last component inside the mortgage note payable balance is we entered into a 0 coupon mortgage of about $4.9 million for the land, for the build-to-suit transaction in Florida.

Gordon. With that, Gordon?

Gordon F. DuGan

I think that wraps up the comments we wanted to make. I'm sure there are some questions from the people online. So we'd like to move now to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Mitch Germain from JMP Securities.

Mitchell B. Germain - JMP Securities LLC, Research Division

I guess, Ben, you'd mentioned increasing levels of product for sale given the recent rise. I just wanted to flush that information out a little more, if you could. Is it just motivated sellers? Is it corporations looking for sale-leaseback? Any information regarding who is out there selling product, I'd really appreciate it.

Benjamin P. Harris

Sure. It's in a couple of areas. I think the first is we have seen an uptick in sale-leaseback activity. The sale-leaseback market has been very, very slow over the last several years. I think that's been driven by a couple of things. One it's been a relatively slow M&A environment. Two, it's been a very robust credit environment for corporates over the last couple of years. So they've had a lot of liquidity and very low borrowing costs. So the benefit of the sale-leaseback were difficult to demonstrate to a CFO who's financing themselves inexpensively in the bond market. What you've seen is somewhat of a change. So companies, there's enough of a scare of sort of a medium-term rate increase that companies are looking at their options to, in essence, term out financing and look at long-term structures like a sale-leaseback. So we've seen a lot of inbound interest. And we expect that to continue. I would say, another factor, there's been a funny lesson that people have learned over the last, call it, 3 years. That every time they waited and delayed a decision to sell an asset, it's turned out to be a good decision. Cap rates have continued to -- or asset values have continued to recover and cap rates have continued to drop since the '09, 2010 timeframe. I think that thinking has reversed. Now people are -- sellers are more likely to actually transact even if the market feedback isn't what they want to hear in terms of asset pricing. So I think both of those factors will drive additional activity. And we've seen that coming through in the pipeline.

Mitchell B. Germain - JMP Securities LLC, Research Division

And have you seen any upward pressure on cap rates?

Benjamin P. Harris

We have. I think we've been talking about this a lot in the core asset area. So very high quality, infill assets using -- just picking sort of a random example, but high-quality industrial assets in the port of L.A. There's very little impact from the rate increase that we've seen to-date. We've seen a little bit of cooling, but it has not translated into increases in cap rates. Assets that were heavily dependent on the CMBS market, we have seen a movement, and in some cases, a pretty material movement. But it has not translated into a big change in pricing for higher quality infill assets. And that, I think, one of the drivers, the CMBS market has seen, call it 100 basis point move all in interest rate cost, if you do the back of the envelope calculation of where CMBS breakevens are today. That increase in borrowing is not in line with what we've seen from life insurance companies. So for higher quality assets that can access life insurance company debt, you've seen less of an increase in the cost of borrowing. So it's -- I'd say, it mirrors what's happened in the corporate credit markets. Frankly, there's less of an impact on higher quality assets than there is on more marginal assets.

Mitchell B. Germain - JMP Securities LLC, Research Division

Okay. And then just final question in terms of financing deals moving forward, I might have missed it, what you guys said. I know the line is still in process. They're not finalized yet. Should we assume that you're just going to maybe add -- take on some property level financing to close some of the deals that recently closed? Or are you going to wait to get a line in place and then use that as your funding mechanism to create some capacity.

Gordon F. DuGan

I would assume it's going to be a mix, but a line is still our primary objective, wouldn't be a primary financing vehicle for a period of time, right? A line is not permanent capital. It's to be used to either -- a bridge to either some of kind of raise, either equity or debt. So we'd either term it out and pay down the line or raise money and pay down the line. So credit facility, assuming we get it in place here, is going to be very key. But we also do use deal-by-deal debt. And I would expect a mix of that going forward, but it will -- we're also cognizant of keeping as much fixed-rate financing in place as we can. So that's been our background. So I would assume a credit facility be the primary means of financing near-term, but it's always going to be a bridge to either terming it out through other kinds of debt financing or other capital raises.

Operator

Our next question comes from Jonathan Feldman from Nomura Securities.

Jonathan Feldman - Nomura Securities Co. Ltd., Research Division

Just a couple of questions. And the first was just on the KBS management agreement. What do you guys see as the duration of that agreement? And can you translate the fees that you're getting from KBS to a bottom line number or a bottom line number that you see on sort of a normalized basis?

Gordon F. DuGan

Yes. If you go back to our -- let me take both piece of that. The relationship we have with KBS is terrific. They're a terrific organization. And we are in the asset management business with them for the foreseeable future. And right now, the contract runs through 2015. And we don't have any update on that. But as you've seen from our -- the way the asset management contracts travel with the assets, I would assume that these are relatively sticky asset management contracts. And we hope to get more clarity around that. But that -- assume we have that ticking along through 2015, we gave a guidance earlier this year of a $5.6 million contribution number from the asset management business. That's a pretax number. So take roughly 1/3 of that away and we're, as you saw Q1, Q2, we're tracking well ahead of that. But that's probably in the realm of the right number to track through 2015.

Jonathan Feldman - Nomura Securities Co. Ltd., Research Division

Okay. And then just one follow-up on that angle and that is, is that a business that you think we should think of you guys growing that as the asset management business more broadly? Or is that just sort of the bridge to a sort of temporary accretive cash flow benefit that is likely to not persist over the medium to longer term?

Gordon F. DuGan

I think it's going to persist over the medium term. It's a good question. I think we're not -- we haven't made any conclusion with respect to that. I think at worst, it's a bridge where it's profitable. It provides acquisition opportunities for us. I think that's the worst case scenario. I think there is a possibility that it's here much longer than any of us can really foresee, which is it's hard to foresee exactly in what form and for which client. So I would say we don't have a definitive view of that. It is, at worst, a medium-term business. That's a nice profitable bridge with -- providing us with acquisition opportunities. And let me just say, of all the -- I think it's a very complicated, cumbersome business to run. These are very complicated contracts with very large institutions. So it's not easy to run. It's almost impossible to replicate, but I would say of all the things that we've been surprised by coming in to Gramercy, I would say I've been surprised on, not by how cumbersome it is, because that's proven to be true, but I've been surprised by the amount of value-added service we give to our clients in helping them manage those assets. And then the flip side of that, how nicely profitable it is, and how acquisition opportunities fall out of that business. So it's been a net-net-net big positive for us. And we think we'll continue to be in the near future. And by the way, not without being quite difficult to manage, but we have a great team of people to do that.

Jonathan Feldman - Nomura Securities Co. Ltd., Research Division

Great. And then one follow-up, and that is just to continue with the previous questioner. Have you gotten any -- I'm sure you have, but what are your thoughts in terms of the leverage that you intend to utilize on a going-forward basis just in terms of whether it'd be credit facility debt or unsecured debt? And do you also think in terms of raising additional capital prospectively that you might seek to raise debt capital or convertible debt in addition to or instead of equity capital?

Gordon F. DuGan

No. So what's our big picture? The leverage issue is a very interesting one in the real estate world. Basically, the amount of -- in our view, the amount of leverage that a company should operate with should reflect the volatility of the cash flows of the assets underlying that business. Okay, that sounds great, but what does it mean? So a hotel business should operate with very low leverage in our experience. Otherwise, every time there's a downturn, it's bankrupt, right? And we've seen that time and time again. I think in my own view, office buildings should operate with lower leverage. They have so much inherent leverage in the operations of the business and capital expenditure requirements. Net lease, if you put it on the spectrum, can operate with a higher amount of leverage due to the lack of volatility in its cash flows, the lack of capital expenditure requirements on a relative basis, right? It should be in that top quadrant in terms of the type of leverage it can operate under. That having been said, what the long term has shown is companies that operate with moderate amounts of leverage outperform over a long period of time. So our view is our long-term leverage should be in the realm of 40% longer-term, shorter-term, in the realm of 50% to bridge us to the point that we expect to be, and it'll take us a bit of time, but we expect to be an unsecured investment-grade borrower. And that we will take the steps to go from here to that point over a period of time. But so net lease, in general, should operate a little higher leverage, 40% to 50%, in my own view. But again, we're going to take the steps to get there over time. Right now, we're operating with a little bit less depending on how you look at it. So in terms of other debt, we're very open-minded about how to grow the capital base, whether it's convertible or straight debt and all of the other variations on it. So it is a goal to grow the capital base. We're going to do it very thoughtfully. Our bottom line goal as a management team and our incentive is tied directly to it, is an earnings per share and value per share creation. And again, that's, as everyone has seen, that's how our incentive plan is structured. So we're very focused on doing accretive capital raises/investments. And so everything has to dial back to value per share. And that's directly how we're compensated. So that's the mindset with which we think about going forward how to access capital.

Operator

Our next question comes from Matthew Dodson from JWest, LLC.

Matthew Dodson

You guys mentioned a couple of times that the market's still pretty robust out there. Can you give us some idea of kind of your pipeline you're looking at? You did $110 million this quarter. Can we expect more than that in the third quarter?

Benjamin P. Harris

It's always so lumpy. We've been doing this -- this is -- I've been doing this for 25 years. And every time I've tried to project that number, I've been wrong. I would say that the -- our ability to do similar volumes, meaning maybe more, maybe less, is very well proven not only in the second quarter. Q4 of last year, we closed the BofA JV. That was a headline purchase price of $485 million. Because of the lumpiness of it, it's hard to give a quarter-by-quarter number. What I would say is that if you annualize Q2, I think that's probably a pretty manageable run rate for us as a business. That doesn't mean we'll do it or won't do it, but it's just -- that's very manageable for us near-term.

Matthew Dodson

Got it. And is that predicated on you getting this credit facility secured up and maybe raising additional equity?

Gordon F. DuGan

No, not necessarily. I think the credit facility that we're working on is the most efficient means of financing things. But we're buying good assets, good credit, good locations. So there's, even with the noise in the marketplace, there's plenty of debt available. So, no, I would not say that. At the levels we're borrowing, on the assets we're borrowing on, it's not predicated on that. It's just that's the preferred route because it's by far, the most efficient means, for us to grow quickly is through a single credit facility.

Matthew Dodson

And my last question, you talked about your goals were to get a dividend in place. You didn't give a timeframe. Could we expect maybe a dividend by the end of the year?

Gordon F. DuGan

I'm going to say that, well, I'll say this about that. Obviously, we're building up cash flows to the point where we'll be able to pay a dividend. The initiation of the dividend and the timing of it is up to our board. We realize as fellow shareholders that shareholders are keenly interested in that. So just bear with us a little bit longer with that. But that's a board decision that we have no update on. And while I think it's -- and we understand it's a very key concern for shareholders. And I would say lastly that we're doing everything we can to bring it about as soon as possible and as large as possible.

Matthew Dodson

On the preferred, are you guys thinking about just restarting that and paying back the accrued later throughout the year or in the future? Or are you going to take it out in one lump sum?

Gordon F. DuGan

Technically, you can't. You need to do it all in one lump sum, I believe. Jon, correct me if that's wrong.

Jon W. Clark

Just to clarify, are you talking about taking out the -- just the accrued piece or the entire preferred?

Matthew Dodson

Just the accrued.

Jon W. Clark

The preferred -- the accrued piece, in order to pay a common dividend, we would have to true up the entire...

Gordon F. DuGan

Or a preferred dividend.

Jon W. Clark

Yes. Or to pay any dividend, we have to pay that accrued back first. And that's in whole. So you'd have to pay back the entire accrued portion before you could fund any dividend. So that's obviously one of the pieces that's...

Gordon F. DuGan

It's kind of a funny win-win, right? For the common shareholders, it's a good deal to have that preferred accruing. You can't accrue forever, we all know that. And the preferred itself is a kind of money, a good piece of paper. So it will get paid at some point, and off we go. But that's -- we don't have any update on the timing of that.

Operator

Our next question comes from Larry Raiman from LDR Capital Management.

Lawrence Raiman

I know this is getting long. I appreciate everything that you're talking about, and trying to reconcile the GAAP statements with kind of the economic realities of the business as it currently stands. And just to kind of recap, if I could, and tell me whether I've taken the different points and brought them together. The core investment portfolio, as you've depicted in your presentation, has about $32 million of NOI. The asset management NOI, obviously putting aside some, whether it's kind of incentives, I'm assuming about $6 million. And then you just have guided very nicely in your overhead interest. So when you bring it all together, you net up over $15 million of NOI, more like $18 million of NOI. Is that about, when I put the different data points together, where we are at right now?

Jon W. Clark

That sounds about right, Larry. The only thing I would say is against the one below the line item that we have to keep in mind is there is a tax liability against the asset management stream. I would take 1/3 for the time being as the number, 1/3 of whatever the net contribution. So if $6 million, I'd take 1/3 of that off.

Lawrence Raiman

So we'll assume net of about $4 million annualized at the management company level?

Gordon F. DuGan

That's right.

Lawrence Raiman

Okay, good. I appreciate that. And I appreciate all your comments with regard to building up the company and getting back to dividend-paying entity with durable cash flows. Keep it up. You're doing a great job.

Gordon F. DuGan

Thanks, Larry, and nice to hear your voice again.

Operator

We have no further questions in the queue at this time.

Gordon F. DuGan

Well, that concludes our call. As usual, it's -- as any Gramercy Property Trust call, it tends to be a little bit lengthy. We appreciate everybody hanging in there with us, spending time with us. And we really appreciate your support. Know that we're all working tirelessly for you, and we look forward to speaking in the future. Thanks, again.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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