Gramercy Capital Management Discusses Q2 2012 Results - Earnings Call Transcript

| About: Gramercy Property (GPT)

Gramercy Capital (GKK) Q2 2012 Earnings Call August 9, 2012 2:00 PM ET


Gordon F. DuGan - Chief Executive Officer and Director

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


Matthew Renaud

Joseph Di Scala

Colin Wilson Murphy


Thank you, everybody, for joining us, and welcome to Gramercy Capital Corp. Second Quarter 2012 Financial Results Conference Call. [Operator Instructions] Please note that this conference is being recorded.

At this time, the company would like to remind listeners that during the call, management may make forward-looking statements. Actual results may differ 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-Q 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 measure 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,

[Operator Instructions] Thank you, and please go ahead, Mr. DuGan.

Gordon F. DuGan

Thank you very much. Good afternoon, everyone. Thanks for joining us today. This is my first call and our first call in sometime, so we're glad to be here. I'm kind of the new person in town, so I've been here just over 30 days, and we've been working very hard to get our arms around the business and to start implementing our new investment strategy. And I'm very excited to talk about that today. I'm here with Jon Clark. Jon will discuss the Q2 results in detail. And I thought that I'd start by hitting on 4 topics:

One, a summary of the vision for Gramercy as we go forward. Two, my quick overview on the legacy assets that we have, the existing assets. Number three, discuss in a little bit more detail our new investment strategy and what it will look [Audio Gap] in other times.

So what we've noticed is -- apparently, there were some technical glitch, are we all set? Sorry. So our first call starts with a technical glitch, please excuse us.

Again, I'm Gordon DuGan, I wanted to -- we're going to go -- John Clark is going to go through the detail of our Q2 results. I wanted to start off with an overview of 4 topics: My vision for the company; my very -- summary review of our existing assets, our legacy businesses; discuss our new investment strategy, what that looks like, what that's going to be; and then four, bring everybody up-to-date on the operational review that we announced in our press release we'd be conducting.

From a vision standpoint, Gramercy in the future, Gramercy 2.0 as I've heard it called, what we want to do is create a company that uses moderate leverage to create recurring durable cash flows from net lease real estate. Net lease real estate is the equity ownership of real estate that typically has a long-term lease with a corporation. It's typically net leased, meaning the majority of the operating costs and taxes and insurance, maintenance, et cetera, are done by the tenant.

What I found in my career is that by putting together a well-chosen portfolio of net leases, we can create a company that provides steady income and uses only moderate leverage to do so. By doing that, what we've seen happen, and we've seen this time and time again, companies that have done that well are able to access capital, grow their equity base and become more and more profitable for the shareholders.

Our strategy of net lease is one that I've been doing for 24 years, joining me are Ben Harris and Nick Pell, with whom I've worked for many years. We are all lifelong net-lease people and the focus is going to be, again, finding equity real estate that creates these durable cash flows that will create a dividend stream for investors. And I'll talk a little bit more about that later.

Just in terms of where we are today, John will go through the details, as I mentioned again. But let just start by saying our liquidity position is fantastic. Today, we have cash just under $200 million. We have securities -- marketable securities that have a value of roughly $38 million and we have CDO advances of just over $8 million. That's also an important number because those are advances that should be money good. They're restricted. We don't get to pull the money out as we choose, but it's almost like a restricted cash account.

And so as you look at that liquidity, it's the best liquidity position Gramercy has been in, in years. It's almost like a new IPO of the company. There's no recourse debt. All the debt that you see on our financial statements is the consolidating debt of the CDOs. And one of the things I've noticed that I'm sure all of you have noticed, our financial statements, with the consolidation of the CDO business, it's hard exactly to tell what's what. And if you look at Page 2 in the press release, there's a nice de-consolidation that hopefully will help investors pick out which piece of the consolidated balance sheet is the CDO business and what the rest of the business looks like x that consolidation, because it does tend to make it look like we have, one, more assets, but, two, more leverage. And that leverage is not recourse to the parent company. Our hope going forward is to continue to bolster our disclosure to make the company more understandable, and I'll come to that also in a little bit.

On the CDO side, Jon will talk in great detail about that. What I like about that business is we manage roughly $2 billion of assets under management. We get recurring management fees. In cases where there's special servicing, we get a portion of the special servicing fees. It's a business where there is value in those management contracts. Though it does cause our balance sheet and income statement to be more difficult to decipher, we shouldn't forget that there's value in those businesses.

On the Realty side, we have the asset management contract that all of you know about with KBS. It is a profitable contract. It's a nice source of revenue for us. In addition to that, we have a property management division that is billed back to tenants, and that property management division is also a source of revenue. And then thirdly, we have ownership of 3 legacy equity investments. One of those investments is multiple properties, but it's a singular investment. And of those 3, one's held-for-sale. One -- all of those legacy investments, none of them really fit into our long-term plan in terms of the types of assets we want to buy that have a very high vacancy, typically 100% vacancy, long-term leases. These assets are not that, they are a cash drag. We did make some progress in the second quarter disposing of a number of those properties that are dragging down -- that are drag-on-cash. And basically, those are assets that, at some point, without necessarily -- while maximizing value, we'd like to move those assets and again, stay in the core of what our new investment strategy is going to be going forward.

To discuss that specifically, the new investment strategy of creating steady cash flows from net leased real estate, it will be focused primarily on office and industrial assets across the United States. Ben Harris, Nick Pell and myself have done billions of dollars of this. We plan to use leverage. When I describe moderate leverage, I mean approximately 50% leverage. It will typically be non-recourse fixed rate financing with various terms depending on our anticipated hold period, among other things. That's typically what we've done in the past. We would expect the portfolio to have an average lease term in excess of 10 years. There may be some slightly shorter, some quite a bit longer, but we want to maintain an average portfolio lease term of greater than 10 years.

And again, what we've found is that there's a lot of value in assembling a portfolio of various net lease assets that provide these steady cash flows with long lease terms. Because in a yield starved environment such as the one that we're in, the ownership of the equity real estate with a long-term lease that's providing cash flow, we think is a very valuable asset and a diversified portfolio of these assets, again, will hopefully provide that steady cash flow that we've been discussing. That's the theme of what we're trying to do. We've already begun our effort on the investment side. We have a pipeline that we're building every day. We're reviewing deals as we speak. We're -- as always, in the deal business, it's hard to know what investments will close and what won't. But we're going to be using the deep contacts we have in the net lease marketplace having been in the business for many, many years. We have experienced closing a wide variety of investments, so we're in the process of building up that pipeline. And from that pipeline, hoping to select what we think are the best risk return investments in that pipeline. We will be selective in terms of what assets we invest in. But having a large pipeline is the best way to ensure that we'll be able to take the liquidity, the capital that we have on our balance sheet and translate that into assets that have recurring cash flow.

In terms of the timeframe to deploy the capital on balance sheet, we think conservatively we can have it fully deployed within 12 to 15 months. Hopefully, sooner. Obviously, we are incented to do that as quickly as possible, but within the context of putting it out into assets that meet our rigorous underwriting standards.

I wanted to talk a little bit about the operational review that's ongoing. We said in the press release that working with the board, we would conduct a 60-day operational review. We've been working with the board on that review. The results of that operational review will be, as we've again mentioned in the press release, will be available in an investor presentation that we'll be posting in September. We're making substantial progress on a number of areas that we believe will move the company forward in a good direction, the right direction. We will have more detail of the results of this review in that investor presentation, but I just wanted to touch on some of the overview of that.

We've identified 4 basic goals for the company: The first, manage liquidity and increase the capital base. And we are currently looking at several options to do both of those things, which is keep a strong liquidity position and increase the capital base. Secondly, reduce costs. Simply put, bring down the cost to reflect a smaller Gramercy. Third, create recurring cash flows for future dividends. I talked a bit about the investment strategy, net leased assets, primarily industrial, office, 10-year lease -- average lease term and better. We want to create those recurring cash flows, so that we can create dividends for our investors. And then the last, fourth goal is simplifying -- streamline the business. We want to make the business more understandable, more investor-friendly, more transparent. And we think that has benefits for existing investors. We think it has benefits for lenders to the company. We think it has benefits for future investors in Gramercy, so that's a key priority.

In terms of reducing costs, let me turn and touch on a couple of these goals. On the cost reduction side, we're starting with senior management. Bringing cash compensation down, increasing alignment through compensation that's equity-based and based upon increases in stock price and reducing the amount of cash compensation for senior management to better align the compensation with shareholders in general. Not that it hasn't been aligned in the past, but we think this is better alignment for a smaller Gramercy. And that's -- so that's area number one.

Number two, bring down personnel costs. There are ways to -- that we can do that with minimum disruption to our business, but in general, bring down personnel costs.

Three, focus on our systems and other areas where there may be costs that we can wring out of the business to lower the cost base to reflect again a smaller, simpler Gramercy as of today. Hopefully, again growing over time, but to reflect a smaller base.

And then lastly, professional fees and the like. We think that there's room to bring down the -- to find cost savings. Again, some of it reflecting a smaller base and some of it reflecting an attempt to be more frugal as we go forward. So reducing costs is a key goal of the company as we go forward.

The other thing is -- that I've talked about, as a goal, create recurring cash flows for future dividends. I've talked a bit about how we're going to create recurring cash flows, the investment type that we'll be focusing on. But let me also talk about future dividends. We get a lot of questions about future dividends. Our philosophy on dividends is very straightforward. Dividends are paid out of recurring cash flows. They're not paid out of cash. They're not a return of capital. They are a distribution of an investor share of recurring cash flows. So our immediate goal is to create those recurring cash flows, so that we can provide a dividend to our preferred and common shareholders. But the sequence in which that's done, of course, is to create the recurring cash flows first and then we can provide dividends in the future.

Just based on the variables involved in this, we can't predict when will that happen. I'm sure a lot of people would like to know specifically when the recurring cash flows will kick in to dividend payments. And the answer is, we don't know, and it's not predictable because there are a number of variables. But it is our goal to create those recurring cash flows so that we can create dividends for our investors.

The last area I wanted to touch on was simplifying -- streamline the company, make it more understandable for investors. I think it's a frustration of a number of people that it's hard to understand Gramercy. It's a frustration that we want to work to solve. There are various options we're exploring to significantly simplify and streamline the business. We don't have anything to announce on that. We hope to have some of that fleshed out for the presentation that we'll be making in September to investors as we said in our press release. And we'll have more details in that investor presentation. But there are number of ways that we can simplify and streamline this business.

I'm sure a number of people are anxious for more information as quickly as possible. I would ask everybody to have a bit of patience. We've been -- I've been on the job now with my team, 38 days. I think we've made a lot of progress in this time, but we are pulling together the presentation that we'll have for you in September. So again, I ask everyone have a little bit of patience. I know a number of investors have been patient. And I want, before I close, just to say, I want to thank the efforts of all the professionals here at Gramercy who have fought through a very hard several years to put us in a position where we can relaunch with this new investment strategy. That includes the former management team of Roger and Tim, and it includes all of the people that have been at Gramercy or all the people that are in Gramercy today. A tremendous amount of hard work has gone to keep Gramercy moving forward, to put us in the position we're in today, which is having the most liquidity we've had in anybody's recent memory around here. And certainly, the most liquidity we've had in years. And a lot of hard work has gone into that. I want to thank everybody for that. There's a lot of hard work going into the next generation of Gramercy. And I can promise you that everybody at Gramercy is putting their full effort into making the next chapter our best chapter.

I'd like to finish before Jon gets into the details of the financial results, just by saying I hope it also was noticed in the press release that I'm putting my money where my mouth is. I purchased 1 million shares of GKK at $2.52. So I'm very focused on pushing the company forward. I am anxious and impatient to do so as you are. And so we have the focus and energy of everybody here at Gramercy. And I am completely dedicated to moving us forward and wanted to show that again by putting my checkbook where my mouth is.

With all of that, I will turn it over to Jon to discuss the financial results of the second quarter and give a little bit more detail on the liquidity position.

Jon W. Clark

Thanks, Gordon. I'd like to walk through our balance sheet by our legacy business segments. It's been quite sometime since we've had the ability to do this in this forum. And as Gordon described earlier, our balance sheet on our GAAP financial statements has always been very complex due to accounting consolidation rules with respect to our CDOs. So as Gordon described earlier, we have provided in our press release on Page 2 a summary statement that presents our balance sheet by business unit, which you may find helpful in gaining a better understanding of our company.

Let's start with the finance segment. We manage a portfolio of approximately $2 billion of loans and other lending investments and commercial mortgage-backed securities or CMBS, which are financed through 3 nonrecourse collateralized debt obligations or we call them CDOs. This currently comprises a substantial portion of our assets and liabilities on our balance sheet. In addition, our finance segment also owns 6 interests in real estate acquired through foreclosure, or REOs as we call them, all but 2 of which are within our CDOs. Substantially, all of these loans and other lending investments in REO serve as the collateral for the nonrecourse CDO liabilities, and the income or principal repayments generated from these investments is used to fund interests and principal obligations of those CDO securities. And the remaining income, if any, is retained by the company. We also serve as the collateral manager of these CDOs, and we receive certain fees for our -- from our CDOs for performing these services.

These are the senior collateral management fees, subordinate fees and various servicing fees. These fees and distributions do not appear on our statement of operations as revenue due to the consolidation, which eliminates the revenue received by our collateral manager subsidiary and the corresponding expense that's paid by our CDOs. Really, the only place the fees show up on our financial statements is on the balance sheet. And the fees and distributions are reflective of the transfer of restricted cash from within our CDOs to unrestricted cash at corporate.

To date, a substantial portion of the company's cash flows has been generated by distributions from its CDOs within this Gramercy Finance division. Our CDOs contain minimum interest coverage and asset overcollateralization covenants that must be met for the company to actually receive those cash flows and to receive the subordinate collateral management fees. During periods when these covenants are not satisfied for a particular CDO, certain cash flows from that CDO that would otherwise be paid to the company are diverted from this company to repay principal and interest on the senior most outstanding CDO bonds. We do continue to receive senior collateral management fees and servicing fees when the overcollateralization tests are not met.

As of July 2012, which was the most recent distribution date, our 2006 CDO is in compliance with interest coverage and asset overcollateralization covenants. However, the compliance margins were narrow. Company's 2005 CDO failed its overcollateralization test in the July 2012 distribution. And it had previously failed its overcollateralization test at October 2011, April 2011, January 2011 distribution dates.

We believe that our 2005 and/or our 2006 CDOs will likely fail its overcollateralization test at the October 2012 distribution date. Although the overcollateralization test can be self-correcting as the cash flows that we otherwise would receive are used to reduce the amount of liabilities outstanding and thus, may improve your overcollateralization margin. An expectation that CDOs might recover in the near-term is speculative.

The company's 2007 CDOs failed its overcollateralization test beginning in November 2009. And it's unlikely that the 2007 CDO overcollateralization test will be satisfied in the foreseeable future. To date, in 2012, our CDOs have paid cash flow to us of approximately $38.2 million. In the current quarter, our CDOs are expected to provide cash flows to the company of approximately $9.7 million substantially, which have all been collected today.

Regarding credit quality within our CDOs, we recorded loan loss provisions in the second quarter of $6 million as compared to $2.5 million in the previous quarter. In the previous quarter, the provision was net of 2 reversals totaling approximately $2.5 million, which was related to repayments that were in excess of our impaired carrying value on these loans.

We also recorded a $1 million impairment on a loan designated as held-for-sale, and that loan with a carrying value of approximately $15.3 million was sold subsequent to quarter end. With the additional provisions recorded in the second quarter, our reserve for loan losses as of June 30, 2012, was $203.7 million, which relate to 12 separate loans. The net carrying value of the loans with reserves as of June 30 was $263.6 million.

At June 30, we had one nonperforming loan with an unpaid principal balance of $51.4 million, net of reserves of $17.5 million. We define sub performing loans as loans that are not performing in material accordance with their terms, but they do not yet qualify as nonperforming loans. The specific circumstances of these loans may cause them to develop into a nonperforming loan within the next 90 days. At June 30, 9 loans and other lending investments with an aggregate carrying value of approximately $69.7 million, net of reserves of approximately $160.3 million, were classified as sub-performing.

Overall, the credit quality of the loans and other lending investments are improving from 2011 and 2010 levels and a corresponding provision for loan losses has declined. Credit quality with respect to our CMBS continues to decline, particularly with respect to 2007 vintage CMBS contained in our 2007 CDO. During the quarter, we recorded impairment charges of $15 million related to 7 CMBS investments with an aggregate carrying value of $37.4 million.

Interest expense on our consolidated statement of operations is entirely attributable to our CDO liabilities. For the second quarter of 2012, interest expense was approximately $20.2 million, down slightly from the $20.4 million incurred in the prior quarter.

So in addition to our finance business segment, we also have a legacy Realty business, the platform of which will be used to launch the company's new business strategy. We own a portfolio of 44 buildings with a carrying value of approximately $28.6 million. This portfolio is cash flow negative and we have been working to reduce this drag by disposing of those properties that offer little opportunity for substantive improvement in net cash flow. This portfolio was encumbered by a first mortgage of approximately $27.2 million with our consolidated CDO as the lender. During the quarter, we disposed of 11 of the most difficult buildings in the owned portfolio. Substantially, all cash flows generated from these sales were used to pay down the portfolio's outstanding debt to the CDOs.

The most substantive and important part of our realty business is our asset management arrangement with KBS. We manage approximately $2 billion of real estate, which is primarily comprised of 524 bank branches and 278 office buildings. This managed portfolio aggregates approximately 20.5 million of rentable square feet. We earn management fees, administrative fees and asset management fees, which are recorded on our operating statement, and during the second quarter of 2012, these fees aggregated approximately $9.6 million.

The management fee and administrative fees are essentially designed to be a recovery of costs incurred while the asset management fee is profitable to us. Associated operating costs, excluding tax expense for the owned and managed portfolio aggregated approximately $6.4 million. On our operating statement, property operating expenses aggregate approximately $9.4 million. And the difference is attributable to costs related to REO owned by the finance segment and specifically our CDOs, not the assets in the company's realty division.

Once our legacy finance and realty business segments are separated, our corporate balance sheet is far easier to see. We have a cash balance at corporate of $192.6 million. We also own an aggregate of $47.4 million of par value of the senior-most bonds in our 2005 and 2006 CDOs that have a fair value of $37.9 million as of June 30, 2012.

These bonds could be sold in the market exchange to further increase our cash balance. But in the meantime, we receive interest income and principal where applicable on these bonds and compliance with overcollateralization test does not affect the payment on these senior most outstanding bonds.

On our consolidated statement of operations, this interest income is eliminated in the consolidation and like other transactions between our business units appears more like a transfer of cash from restricted cash in our CDOs to unrestricted cash rather than appearing as a true revenue stream that

it is. We have no liabilities on our corporate balance sheet, other than the accrued dividend payable on our preferred stock, which we have accrued now for 15 quarters. And we'll continue to accrue until we have enough requirement to make such distribution to maintain our REIT status or until the new business strategy achieves sustainable cash flows in order to restart dividend payments to shareholders.

For the second quarter of 2012, management general administrative expense was approximately $13.9 million as compared to $6.7 million in the prior quarter. Of the increase, $2.3 million is related to the write-off of cost related to the conclusion of the Board of Directors' strategic review process, which commenced at the establishment of a Special Committee of the board in June of last year and concluded with the announcement of a new business strategy during this quarter.

In addition to that, there was a onetime non-cash accounting charge of $600,000 related to a change in vesting of certain existing restricted stock awards done primarily as an employee retention measure in light of the uncertainty that existed during the period that the strategic process was ongoing.

Finally, the remainder of the increase in MG&A was attributable to higher legal and enforcement costs and servicing advances related to assets within our company's CDOs. These costs and advances are expensed on our consolidated financial statements. However, they are repayable by our CDOs over time as matters with respect to the underlying investment and the CDOs are resolved. When repayment occurs, the repayment appears again as a transfer of cash from restricted cash in our CDOs to unrestricted cash at corporate. Repayment of such advances to the CDO does not appear as revenue nor does it reduce MG&A expense in future periods. As of June 30, 2012, approximately $8.3 million is owed to the company from our CDOs.

So our headline figures in our press release this morning for the quarter with respect to FFO of negative $18.6 million or negative $0.37 per diluted common share as compared to FFO of negative $13.8 million or negative $0.27 per diluted common share in the prior quarter. We also reported GAAP net loss to common stockholders of $21.5 million or $0.42 per diluted common share for the second quarter as compared to a GAAP net loss to common stockholders of $2.1 million or $0.04 per diluted share for the prior quarter.

For the second quarter of 2012, however, our focus remained on increasing the company's liquidity. We ended the second quarter of 2012 with unrestricted corporate cash of approximately $192.6 million as compared to the $186.3 million of liquidity reported in the prior quarter. And today, with CDO distributions received to date, we have just under $200 million of cash.

Additionally, as described earlier, we hold CDO bonds that are available for reissuance and those bonds have a fair value of approximately $37.9 million as of June 30, 2012. And finally, we have -- we are owed that $8.3 million from our CDOs for loan enforcement costs and servicing advances described earlier. Our liquidity position provides a good base for the company's new business direction that Gordon described earlier. Gordon?

Gordon F. DuGan

Thank you, John. With that, we'd like to turn it over to Q&A and we'd love to take questions from shareholders.

Question-and-Answer Session


[Operator Instructions] And our first question is from Matthew Renaud from Renaud & Company.

Matthew Renaud

Appreciate you holding the conference call, it's a breath of fresh air as you can imagine. You've done a very nice job in your presentation today in answering most of my questions. Couple of specific ones. I noticed in the June filing, I think it was June 13, Michael Kavourias now has an incentive to sell CDO assets. Is this part of the plan? Is this something that's ongoing? Is this for all CDO assets?

Gordon F. DuGan

Well, I'll answer that in 2 parts, and Jon, you can chime in as well. This is Gordon DuGan. Number one, Michael is -- his incentive plan is very much related to his ongoing employment with the company. He's a key guy, so we wanted to keep him tied down. In terms of the CDO -- sale of CDO assets in general, we haven't made a determination of whether or not to sell those assets, I think as we mentioned, they cause a lot of confusion on our financial statements. And that part we don't like. On the other hand, they are a valuable -- these management contracts are valuable. We manage roughly $2 billion in total assets within those CDOs. So there's nothing to read at this point into either Michael's retention package or -- we haven't made any determination with respect to the CDOs at this point.

Matthew Renaud

Okay, a quick sub question to that before my other -- because this was in June, were you involved, Gordon, in restructuring Michael's contract?

Gordon F. DuGan

I was not. The board -- that was primarily, as I understand it, handled by the board.

Matthew Renaud

Okay, second question. I realized at the corporate level, you're still receiving cash from the senior CDO bonds you own. But does it make sense that their rate of return will be considerably higher if that money was also used and moderately levered up as you mentioned earlier in net lease properties?

Gordon F. DuGan

Yes, absolutely. I think that's right. If we didn't have the cash balance we had, there would, as Jon said, it would make a great deal of sense to sell those securities and invest them into real estate. So for us, we consider it an investable asset even though it's currently in the form of securities rather than in the form of cash. We just want to work our way -- we like those securities too, so we just want to work our way through the cash first because we get, unfortunately, as everyone in the call knows, a lower return on cash than anything.

Matthew Renaud

Sure. And one last one and I'll jump back in the queue. Is it possible at the corporate level to use these CDO bonds that you have to help with the overcollateralization and interest coverage test for CDO 6 or 5?

Jon W. Clark

Matt, this is Jon Clark. Those particular CDO bonds are the highest classes of the CDO bonds, and those are not the ones that you would want to use to try and regain overcollateralization tests. You get much more bang from the buck by going out and buying subordinate bonds than you would by trying to extinguish the senior-most bonds. And we have essentially no subordinate bond in inventory at the moment.

Matthew Renaud

Okay. I'm trying to get my arms around that. It just seems like the cash flow that we would be losing for having those pass tests might be a fair exchange for the amount of money in their fair value today?

Gordon F. DuGan



Our next question is from Joe Di Scala from Carmel Capital Partners.

Joseph Di Scala

So you guys incurred about $12 million in G&A during the quarter. I know that you have this cost reduction initiative in place, but what is the right run rate today?

Gordon F. DuGan

Joe, I would defer that to the operational review that -- where we'll be able to break that down with some more specificity. The question is a complicated one in part because there's a lot of stuff running through that G&A that needs to be broken down. And some of that G&A is offset with directly tied revenue, so it's a question that if that business line continues, there's revenue for the G&A if we were to -- no longer be in that business line and somebody else were to be in that business line, then obviously the revenue and the G&A would both go away at the same time. Jon, I don't know if you have anything you want to add to that?

Jon W. Clark

No, Joe, the only thing I would add is that historically, our MG&A has been rather volatile, and it's primarily because of the CDOs and primarily because accounting rules generally require that you expense costs leading up to a foreclosure or workout. And so these costs tend to be unpredictable and tend to hit when we need to work on troubled loans. So I think if you look at our history, we do have periods where our MG&A is up and sharply down in the very next quarter.

Gordon F. DuGan

And I would just add to that, that one of the surprising things for me coming in new is the correct accounting treatment, but it's almost counterintuitive that the advances -- as special servicer and when there's a loan workout within the CDOs, to the extent we put money in, whether it's, let's say, it's the carrying costs for the property, legal enforcement costs, what have you. Let's say we put $1 million in as special servicer. That $1 million runs through our MG&A as an expense. What it really is, is an advance, if you will. And that advance within the CDO is very senior in the capital structure, and so is in all likelihood completely money good as an advance. So it almost becomes -- it almost moves from the opposite of what Jon was saying earlier. It moves from unrestricted cash to restricted cash on our balance sheet. But it runs through the income statement as G&A. And I, in my own mind, don't view that as real G&A because it's really an advance to the CDO that we will get back from the CDO plus interest because those advances are very senior in the CDO structure. So that's one of the pieces that is somewhat counterintuitive. That's not all of the G&A, of course, but those types of expenses running through it are part of the complication of Gramercy as it is today.

Joseph Di Scala

Okay, that makes sense. And then lastly, how is the property operating expense split between the KBS portfolio and your legacy properties and also how much does it cost you to manage the CDOs?

Jon W. Clark

Joe, I don't know if I really want to get into specifics on how much is directly related to the KBS contract as far as revenues and expenses. In part, since you can identify one particular contract, there are other people that are in this business and that would put us at a slight competitive disadvantage. The real estate that we own is not really substantial. And substantially, all of the costs are related to managing those properties for KBS. And then as far as direct costs related to the CDOs, I think that's something that really we should present to you as part of the investor presentation that we do in September. On Page 2 of the press release, we've done the best we could trying to segregate costs by business unit, but I will tell you that there are many people here that are shared among multiple business units. And it was just a little bit too onerous to go through a process to try and allocate percentages to people. But we'll make a measure to be able to do that with the September presentation.


The next question is from Colin Wilson Murphy from Bowery Investment.

Colin Wilson Murphy

I have 2 quick questions. The first one is what's your current unlevered hurdle rate when underwriting net new lease real estate?

Gordon F. DuGan

Well, I'll answer that by giving a range because it really -- it will depend on credit quality, lease term, asset quality. But our typical expectation will be cap rates in the 7% to 8% range on an unlevered basis. That would be our -- that is where we expect sort of the sweet spot.

Colin Wilson Murphy

Okay. And the second question is, Gordon, it's always nice to see management purchase equity in the open market. In addition to owning common equity, were you given the opportunity to buy preferred shares?

Gordon F. DuGan

I was not. I wasn't given the opportunity. I didn't think about that, so I just -- it wasn't a discussion. But I bought common, yes.

Okay, I think -- well, again, thank you, all, for joining us today. It's been some time since we've had a call. This will be a regular earnings call going forward. And we appreciate your time this afternoon and plan to have more time together as we go forward. So with that, I'll turn it back to the operator to close out our call.


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

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