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NorthStar Realty Finance Corp. (NYSE:NRF)

Q3 2010 Earnings Call

November 04, 2010 10:00 am ET

Executives

Al Tylis - COO & General Counsel

David Hamamoto - Chairman & CEO

Andy Richardon - EVP, CFO & Treasurer

Analysts

Joshua Barber - Stifel Nicolaus

James Shanahan - Wells Fargo

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the NorthStar Realty Finance third quarter 2010 results conference call. During today’s presentation, all parties will be in a listen-only mode and following the presentation, the conference will be open for questions. (Operator instructions) This conference is being recorded today, Thursday, November 4th of 2010.

I would like to turn the conference over to Al Tylis, Chief Operating Officer & General Counsel for NorthStar Realty Finance. Please go ahead, sir.

Al Tylis

Thank you very much. Welcome to NorthStar third quarter 2010 quarterly conference call. Before the call begins, I would 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.

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 maybe made in the course of this call.

Additionally, certain non-GAAP financial measures will be discussed on this conference call. Our presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with Generally Accepted Accounting Principles. Reconciliations of these non-GAAP financial measures to the most comparable measures prepared 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 Officer, David Hamamoto. David?

David Hamamoto

Thanks Al and thanks everyone for joining us this morning. In addition to Al, I am joined today by Andy Richardson, our CFO and Dan Gilbert, our CIO. During the third quarter, we saw some interesting dynamics in the commercial real estate markets with greater capital inflows seeking yields, driving down credit risk premiums and increasing liquidity for the sector, light fundamentals remaining weak. Although we continue to be cautious in our macroeconomic expectations to sustain low interest rate environment is finally drawing investor interest to commercial real estate, the multi-borrower CMBS market is healing with most experts predicting over $10 billion of new issuance in 2010 compared to 9 in 2009.

Yet this market is far from meeting the needs of the vast majority of borrower space in debt maturity. This increased liquidity and risk tolerance by investors is positively impacting our portfolio. In the third quarter, we sold a $32 million mezzanine loan backed by hotel collateral maturing next year for 80% of par and looking at the first few weeks of our fourth quarter, we recently sold a 21 million B-note on an office building at par. While credit risk management remains challenging, we continue to build credit reserves against our loan assets, we believe that the Fed commitment to low interest rates for the foreseeable future should be a positive driver for commercial real estate conditions until an economic recovery gains traction.

During the third quarter, we integrated the capital first loan CDO in our portfolio management platform and received approximately 1.3 million of deeds from this 7 million acquisition. Through active portfolio management, we believe that we have already increased value in the CDO.

As a result, the over-collateralization debt that was reduced from a 152 million at closing to 124 million at December 30th and as of this October recording date the deficit was further reduced to approximately 27 million. In September, the two non-traded debt sponsored and advised by NorthStar agreed to merge. At quarter end, we had raised approximately 35 million of equity capital in a non-traded REIT for credit and investment, a majority of whose shareholders in October approved the merger into NorthStar Real Estate Income Trust or NS REIT. This is a registered REIT whose perspective was declared effective in July.

NS REIT is targeting to raise over a billion dollars and its stock is being distributed by our wholly-owned broker dealer NRF Capital markets. We have received significant interest in our real estate debt product from the independent broker dealer community and believe that NorthStar’s unique position as a publicly traded advisor to this market should enable us to successfully raise equity capital and to generate management fee revenue that enhance the value of our platform and enhance shareholder value.

Turning to the WAMU property legal situation there is no update from last quarter. As discussed, the field process timing is difficult to predict, it could take a year or more. We are continuing to pursue all avenues available to us to resolve the matter in our favor. I would like to turn the call over to Andy right now. Thanks. Andy?

Andy Richardon

Thanks David. For the third quarter, our GAAP net loss inclusive of a negative $169 million of non-cash mark-to-market adjustment principally caused by tighter credit spreads increasing the value of our liabilities with a $144 million or $1.87 per share. AFFO for the third quarter was 12 million or $0.15 per share. We invested approximately 18 million of equity capital and received approximately $43 million of net loan sales and repayment proceeds during the third quarter exclusive of the CapitalSource CDO loans.

In addition, we received a $161 million of repayment in the CapitalSource CDO during the third quarter. Third quarter net investment income which is interest, rental and advisory fee revenue, less interest expense, swap interest expense, property operating costs and asset management fees was $51 million compared to 27 million in the second quarter of 2010.

The increase was principally due to $16 million of net investment income generated by the CapitalSource CDO acquired in the third quarter, $4 million from the consolidation of CDO-9 and $3 million of interest expense savings as a result of the Wells Bank debt payoff last quarter. General and administrative expenses for the third quarter excluding non-cash stock-based compensation totaled approximately 16 million, approximately a million dollars lower than the second quarter of 2010.

The decrease was mostly related to the incurrence in the second quarter, entire transaction costs including costs relating to the CapitalSource CDO acquisition. Realized gains totaled a net 27 million for the third quarter of 2010 compared to $82 million in the second quarter.

Our second quarter gains include approximately $60 million of gains relating to the bank debt extinguishment. The decrease in credit spreads allowed us to generate gains from our securities portfolio during the third quarter. Going forward we cannot predict the amount if any and timing of realized gains that maybe generated from our portfolio. This type of income is dependant on many factors including several factors outside of our control such as market credit spreads and general market conditions.

During the third quarter, we invested approximately $18 million of equity capital using unrestricted cash including $7 million to acquire the CapitalSource CDO and $3 million to acquire the equity and original non-investment grades notes and management fees of CDO-9.

NorthStar also acquired for $2 million approximately $28 million base of notes issued by the CapitalSource CDO and originally rated investment grade. During the third quarter, NorthStar also invested $6 million in an equal partnership with a third party to acquire a defaulted $30 million first mortgage loan participation in which NorthStar also held a net $70 million REO position prior to the purchase.

At September 30th and exclusive of the CapitalSource loan, we had 5 NPLs totaling $78 million and having a $29 million book value net of loan loss reserves, an increase from two loans totaling 50 million at June 30th. The CapitalSource CDO had nine loans on NPL status having a $15 million carrying value. In October after the close of the third quarter we completed the sale for $11 million of a $21 million non-performing first mortgage that had been adequately reserved for in prior periods.

During the third quarter, a $93 million first mortgage participation interest having a net book value of $70 million had a maturity default and the lender group took effective ownership of the collaterals during the third quarter. The assets have carried as an investment in non-consolidated joint venture as of September 30th. The CapitalSource CDO also had three REO assets having an estimated $6 million fair market value and an aggregate $22 million outstanding principal balance at September 30th. At the end of the third quarter and inclusive of the CapitalSource REO loans, NorthStar had five REO assets having an 89 million aggregate book value.

Third quarter loan loss provision totaled 43 million and approximately $7 million of the charge relates to the mezzanine loan sale and the remaining 36 million of the third quarter provision relates to the six loans and a $0.5 million credit on the 21 million non-performing loans billed in October. Loan loss reserves totaled a 175 million as of September 30th or approximately 10% of the 1.8 billion NorthStar loan portfolio exclusive of the CapitalSource loans.

In addition to the previously discussed non-performing CapitalSource at closing the CDO also had $811 million of performing loans. We recorded these loans at an aggregate $380 million fair market value representing a 47% of outstanding principal balance. As of September 30th the performing CapitalSource loans had a 704 million outstanding principal balance and 273 million book value due to principal repayments during the third quarter. The acquisition discount which totaled $656 million at September 30th represents a build in reserve for credit issues and we believe that our recorded value appropriately reflects reasonable recovery at maturity and market yield assumptions.

Although market liquidity is increasing and risk premiums are decreasing, we continue to expect the commercial real estate fundamentals will generally remain weak for the remainder of 2010 and into 2011. Furthermore obtaining debt capital at reasonable terms continues to be a challenge for most of our borrowers. NorthStar’s credit provisioning and reserve levels are based on the best information available to us. However we are continuing to work through a number of assets as outcomes are difficult to predict and continuing uncertain economic conditions make it difficult to forecast when credit conditions should meaningfully improve.

NorthStar continues to manage a $1.1 billion net lease real estate portfolio consisting of (inaudible) housing and healthcare related properties and 31 suburban office industrial and retail properties. The overall portfolio is 89% leased and has an approximate seven-year weighted average remaining lease term. Our 3.3 billion commercial real estate securities portfolio had approximately 400 million of downgrade action starting in the third quarter continuing to reflect the ongoing difficult real estate environment. The weighted average rating of our real estate securities portfolio was D plus at September 30th, down from BB minus at June 30th. Ratings actions are not necessarily indicative of current economic performance and a vast majority of our CMBS securities are current and standing according to their contractual terms.

During the third quarter, CDOs 1 and 2 for which we received a minimal cash flow during the first six months of 2010 and which had no reinvestment rights filled their own fee for over collateralization tasks. We do not expect to receive significant further equity distributions from these CDOs in the foreseeable future, although we currently expect the return of capital from both CDOs due to the high quality of assets underlying the CDOs.

All of our other CDOs with the exception of the CapitalSource CDO remain in compliance with their OC and IC test. Consolidated assets totaled $5.2 billion at September 30th, an $800 million increase from $4.4 billion at June 30th, approximately $600 million relates to the CapitalSource CDO and 300 million relates to the CDO-9 acquisition during the third quarter.

For the third quarter NorthStar’s book value increased by approximately $4 million from June 30th to $15.78 per share at September 30th. The earnings release contains a detailed reconciliation between our second and third quarter 2010 book values. Higher market credit spreads generally increased the value of our liabilities for which we elected FAS 159 resulting in a $79 million decrease to book value from the second quarter. This negative adjustment was more than offset by the consolidation of CDO-9.

The fair market value of the securities consolidated exceeded the fair market value of the liabilities assumed and a purchase price of nearly 151 million. This amount was recorded as a positive adjustment to retain earnings. All unrealized mark-to-market adjustments non-cash credit loss reserves and accumulated depreciation were excluded, book value would be $7.58 per share at September 30th. NorthStar had approximately $265 million of total liquidity at September 30th comprised of a 135 million of unrestricted cash and a 130 million of uninvested cash in our CDOs.

We currently have approximately $4 million of non-discretionary future unrestricted cash needs relating to loan. And we had no corporate debt maturities until June 2012. This concludes our prepared remarks for today and now let’s open up the call for questions. Operator?

Operator

(Operator Instructions). Our first question comes from the line of Joshua Barber with Stifel Nicolaus. Please go ahead.

Joshua Barber - Stifel Nicolaus

I was wondering with the progress that you guys have been making on the CapitalSource CDO which is pretty impressive to date. First of all, how did the OC test get so much better, did they have a lot to do with you guys actually buying back some of the rated or formally rated tranches during the quarter and B, what the cash flow would be to NorthStar if you ended up getting the OC test back into compliance.

Al Tylis

Regarding your first question, I think it has been a fair amount of proactive asset management and working with borrowers and restructuring some loans that will hopefully have long-term value for the CDO that’s impacted the OC positively. I think as well as purchases of securities at discounts to face that we feel have a high likelihood of our recoveries that have also impacted the OC.

Andy Richardson

I will answer the cash flow question. Based on current interest rate the per annum number could be in excess of 30 million based on the asset mix today.

Joshua Barber - Stifel Nicolaus

Regarding [Xanadu], can you tell us I know that you converted that from you took a writedown and converted it basically from debt to equity. Is there any further writedowns that are associated with that and what do you think the plan is with that asset going forward both from the asset and from NorthStar’s end?

David Hamamoto

Yes I think that we have taken control of the asset and we are in the process of recapitalizing and bringing in a developer and I think the good news is that our basis there is a fair amount of interest both from the development community as well as from the capital markets. So I think at this point we don’t anticipate any further writedowns and we should be able to resolve the situation sometime in the next six months in terms of what the go forward plan is?

Joshua Barber - Stifel Nicolaus

Do you think there will be additional investments from NorthStar and from the remainder of the equity group?

David Hamamoto

I think we will look at it as an option. I think we feel that it could be an interesting investment opportunity and as you have seen we have a fair amount of capital on our balance sheet and we are going to be opportunistic as to where we put that capital.

Joshua Barber - Stifel Nicolaus

Can you just give us a little bit more detail on where the realized gains came from? I don’t know that I heard it if you had mentioned it before.

Andy Richardson

Most the gains came from security sales from our CMBS portfolio.

Joshua Barber - Stifel Nicolaus

And can we assume that those were out of CDOs 1 and 2?

Andy Richardson

No they were pretty much across the board?

Operator

(Operator Instructions). Our next question comes from the line of James Shanahan with Wells Fargo.

James Shanahan - Wells Fargo

I had a question about your comment Andy. I think that you mentioned that aside from the CapitalSource CDO that NorthStar was in compliance with all OC and IC test, is that correct?

Andy Richardson

That is one and two.

Operator

(Operator Instructions). There are no further questions in queue. I would like to turn the call back over to management for closing remarks.

David Hamamoto

Okay thanks everyone and I will talk to you next quarter.

Operator

Ladies and gentlemen, this does conclude our conference for today. If you'd like to listen to a replay of today's conference, please dial 800-406-7325 or 303-590-3030 and enter the access code 4371258. We’d like to thank you for your participation and you may now disconnect.

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