Item 1. Business
References to “NorthStar Europe”, “we,” “us” or “our” refer to NorthStar Realty Europe Corp. and its subsidiaries unless the context specifically requires otherwise. References to “our Manager” refer to NorthStar Asset Management Group Inc., or NSAM, for the period prior to the completed tri-party merger with NorthStar Realty Finance Corp., or NorthStar Realty and Colony Capital, Inc., or Legacy Colony, pursuant to which the companies combined in an all-stock merger, or the Mergers, and Colony Capital, Inc., formerly known as Colony NorthStar, Inc. before June 25, 2018, for the period subsequent to the Mergers.
Overview
NorthStar Realty Europe Corp., a publicly-traded real estate investment trust, or REIT, (NYSE: NRE) is a European focused commercial real estate company with predominantly prime office properties in key cities within Germany, the United Kingdom and France. We commenced operations on November 1, 2015 following the spin-off by NorthStar Realty, of its European real estate business (excluding its European healthcare properties) into a separate publicly-traded company, NorthStar Realty Europe Corp., a Maryland corporation, or the Spin-off. Our objective is to provide our stockholders with stable and recurring cash flow supplemented by capital growth over time.
We are externally managed and advised by an affiliate of our Manager. Substantially all of our assets, directly or indirectly, are held by, and we conduct our operations, directly or indirectly, through NorthStar Realty Europe Limited Partnership, a Delaware limited partnership and our operating partnership, or our Operating Partnership. We have elected to be taxed and will continue to conduct our operations so as to continue to qualify as a REIT for U.S. federal income tax purposes.
Significant Developments
Amended and Restated Management Agreement
On November 7, 2018, we entered into Amendment No. 1, or the Amendment, to the amended and restated management agreement, or the Amended and Restated Management Agreement, dated November 9, 2017, with an affiliate of our Manager. The Amendment provides for the termination of the Amended and Restated Management Agreement upon the consummation of a change of control of NorthStar Europe or in connection with an internalization of management. The Amendment provides that upon the termination, we will be obligated to pay to our Manager a termination payment equal to (i) $70 million, minus (ii) the amount of any Incentive Fee (as defined in the Amended and Restated Management Agreement) paid pursuant to the Amended and Restated Management Agreement. As of December 31, 2018, the termination fee due to the Manager was
$64.6 million
. No Incentive Fee will be payable to our Manager for any period after the Termination Date.
Refer to Note 6 “Related Party Arrangements” in our accompanying consolidated financial statements included in Part II, Item 8 “Financial Statements and Supplementary Data” for a description of the terms of the Amendment and the Amended and Restated Management Agreement.
Strategic Review Committee
On November 7, 2018, we announced that the Strategic Review Committee of our board of directors has engaged financial and legal advisors to review strategic alternatives, including a potential sale of the Company or internalization of management.
Sales
In April 2018, we completed the sale of the Maastoren property, our largest non-core asset in the Netherlands, for approximately $193 million and received net equity proceeds of approximately $69 million after repayment of financing and transaction costs (based on the April 30, 2018 applicable exchange rate).
In September 2018, we completed the sale of an asset in Lisbon, Portugal for approximately $14 million and received net equity proceeds of approximately $14 million after transaction costs (based on the September 30, 2018 applicable exchange rate).
In December 2018, we completed the sale of Trianon Tower and received net equity proceeds of approximately $360 million, after repayment of mortgage financing and payment of transaction costs. Simultaneously with the completion of the closing, we prepaid and terminated the mortgage financing of $375 million, which included the prepayment penalties, secured by the Trianon Tower (based on the December 12, 2018 applicable exchange rate).
Additionally, in December 2018, we sold three assets in the United Kingdom for approximately $40 million and received net equity proceeds of approximately $23 million after repayment of financing and transaction costs (based on the December 21, 2018 applicable exchange rate).
Leasing
For the
year ended
December 31, 2018
, we signed new leases or lease extensions relating to 60,000 square meters. These leases included a nine year lease extension for 11,200 square meters with BNP Paribas S.A. on a property on Boulevard MacDonald, in
Paris, France, increasing the weighted average lease term of the asset by five years and a new 32,800 square meter lease on a property at Marly, in Greater Paris, France, increasing the asset’s occupancy from 45% to 100%. As a result, together with other leases signed during the year, portfolio occupancy increased from 81% as of
December 31, 2017
to 95% as of
December 31, 2018
.
Refinancing
In May 2018, we entered into a second amended and restated loan agreement related to the Trias Germany portfolio, which reduced the margin from 1.55% to 1.00%, extended the maturity date of the loan from December 2020 to June 2025 and eliminated certain covenants limited to portfolio concentration and required capital expenditures.
In August 2018, we amended and restated the loan agreement related to the Trias France portfolio, increasing the principal balance to $76 million, reducing the blended margin from 1.85% per annum to 1.65% per annum and extending the maturity by two years from April 8, 2020 to April 8, 2022.
Our Investments
Our primary business line is investing in European real estate. We are predominantly focused on real estate equity and preferred equity.
Real Estate Equity
Overview
Our real estate equity investment strategy is focused on European prime office properties located in key cities within Germany, the United Kingdom and France.
Our Portfolio
The following presents a summary of our portfolio as of
December 31, 2018
:
|
|
|
|
|
|
|
|
|
Portfolio by Geographic Location
|
|
|
December 31, 2018
(6)
|
December 31, 2017
(6)
|
Gross Book Value
(1)
|
$1.0 billion
|
|
|
Number of properties
(2)
|
18
|
Number of countries
|
3
|
Total square meters
(3)
|
205,884
|
Weighted average occupancy
|
95%
|
Weighted average occupancy - Office
|
94%
|
Weighted average lease term
|
6.2 years
|
In-place rental income:
(4)
|
|
Office portfolio
|
90%
|
Other
(5)
|
10%
|
_____________________________
|
|
(1)
|
Represents gross operating real estate and intangibles as of
December 31, 2018
and includes gross assets held-for-sale.
|
|
|
(2)
|
Includes four assets held-for-sale as of
December 31, 2018
, of which three were sold as of March 8, 2019.
|
|
|
(3)
|
Based on contractual rentable area, located in many key European markets, including Frankfurt, Hamburg, Berlin, London and Paris.
|
|
|
(4)
|
In-place rental income represents contractual rent adjusted for vacancies based on the rent roll as of
December 31, 2018
and is translated using foreign exchange rates as of
December 31, 2018
.
|
|
|
(5)
|
Other represents five assets including two retail in Germany, one industrial asset in France and two hotel (net lease) assets in Germany.
|
|
|
(6)
|
Based on rental income for 18 assets owned as of
December 31, 2018
.
|
The following table presents significant tenants in our portfolio, including assets held-for-sale as of December 31, 2018, based on in-place rental income as of
December 31, 2018
:
|
|
|
|
|
|
|
|
|
|
Significant tenants:
|
|
Asset (Location)
|
|
Square Meters
(1)
|
|
Percentage of In-Place Rental Income
|
|
Weighted Average Lease Term (in years)
|
BNP PARIBAS RE
|
|
Berges de Seine (Paris, France)
|
|
15,406
|
|
16.1%
|
|
1.1
|
BNP PARIBAS SA
|
|
Boulevard Macdonald (Paris, France)
|
|
11,210
|
|
9.2%
|
|
7.7
|
Invesco UK Limited
|
|
Portman Square (London, UK)
|
|
4,406
|
|
9.1%
|
|
8.7
|
Cushman & Wakefield LLP
|
|
Portman Square (London, UK)
|
|
5,150
|
|
8.4%
|
|
6.3
|
Morgan Lewis & Bockius LLP
|
|
Condor House (London, UK)
|
|
4,848
|
|
6.6%
|
|
7.0
|
PAREXEL International GmbH
|
|
Parexel (Berlin, Germany)
|
|
18,254
|
|
5.7%
|
|
15.5
|
Moelis & Co UK LLP
|
|
Condor House (London, UK)
|
|
3,366
|
|
4.5%
|
|
6.5
|
Bigpoint GmbH
|
|
Drehbahn (Hamburg, Germany)
|
|
11,916
|
|
4.5%
|
|
2.4
|
Globe Express
|
|
Marly (Paris, France)
|
|
32,790
|
|
3.2%
|
|
8.8
|
InterCityHotel GmbH
|
|
IC Hotel (Berlin, Germany)
|
|
8,457
|
|
2.8%
|
|
11.3
|
Total
|
|
|
|
115,803
|
|
70.1%
|
|
6.5
|
_____________________________
|
|
(1)
|
Based on contractual rentable area.
|
The following table presents gross book value, percentage of net operating income, or NOI, square meters and weighted average lease term concentration by country and type for our portfolio as of
December 31, 2018
(dollars in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Country
|
|
Number of Properties
|
|
Gross Book Value
(1)
|
|
Percentage of NOI
(2)
|
|
Square Meters
(3)
|
|
Weighted Average Lease Term (in years)
|
Office
|
|
|
|
|
|
|
|
|
|
|
Germany
(4)
|
|
7
|
|
$
|
236,901
|
|
|
24%
|
|
74,837
|
|
|
8.0
|
United Kingdom
|
|
2
|
|
353,010
|
|
|
35%
|
|
21,758
|
|
|
6.9
|
France
|
|
4
|
|
307,790
|
|
|
31%
|
|
32,059
|
|
|
3.9
|
Subtotal
|
|
13
|
|
897,701
|
|
|
90%
|
|
128,654
|
|
|
6.1
|
Other Property Types
|
|
|
|
|
|
|
|
|
|
|
France/Germany
(5)
|
|
5
|
|
89,149
|
|
|
10%
|
|
77,230
|
|
|
6.5
|
Total
|
|
18
|
|
$
|
986,850
|
|
|
100%
|
|
205,884
|
|
|
6.2
|
_____________________________
|
|
(1)
|
Represents gross operating real estate and intangibles as of
December 31, 2018
.
|
|
|
(2)
|
Based on annualized NOI, for the year ended
December 31, 2018
(refer to “Non-GAAP Financial Measures” for a description of this metric) for the 18 assets held as of December 31, 2018.
|
|
|
(3)
|
Based on contractual rentable area.
|
|
|
(4)
|
Includes one asset held for sale as of December 31, 2018.
|
|
|
(5)
|
Other represents five assets including two retail in Germany, one industrial asset in France and two hotel (net lease) assets in Germany. Includes three assets held of sale as of December 31, 2018.
|
Preferred Equity
In December 2018, in connection with the sale of Trianon Tower, we retained a $5.7 million (
€5 million
) equity interest in the form of preferred equity, with a 7% yield and five year maturity.
In May 2017, we partnered with a leading property developer in China to acquire a Class A office building in London United Kingdom with 22,557 square meters, 100% occupancy and a 5.2 year weighted average lease term to expiry. We invested approximately
$33.4 million
(
£26.2 million
) of preferred equity with a base yield of 8% plus equity participation rights.
Investing Strategy
We seek to provide our stockholders with a stable and recurring cash flow for distribution supplemented by capital growth over time. Our business is predominantly focused on prime office properties in key cities within Germany, the United Kingdom and France which are not only the largest economies in Europe, but are the most established, liquid and among the most stable office markets in Europe. We seek to utilize our established local networks to source suitable investment opportunities. We have a long term investment approach and expect to make equity investments, directly or indirectly through joint ventures.
Financing Strategy
We pursue a variety of financing arrangements such as mortgage notes and bank loans available from the commercial mortgage-backed securities market, finance companies and banks. However, we generally seek to limit our reliance on recourse borrowings. We target overall leverage of 40% to 50% over time, although there is no assurance that this will be the case. Borrowing levels for our investments may be dependent upon the nature of the investments and the related financing that is available.
Attractive long-term, non-recourse, non-mark-to-market, financing continues to be available in the European markets. We predominately use floating rate financing and we seek to mitigate the risk of interest rates rising through hedging arrangements including interest rate caps.
In addition, we may use corporate level financing such as credit facilities. In April 2017, we amended and restated our revolving credit facility, or Credit Facility, with a commitment of $35 million and with an initial two year term. The Credit Facility no longer contains a limitation on availability based on a borrowing base and the interest rate remains the same.
In March 2018, we amended the Credit Facility, increasing the size to $70 million and extending the term until April 2020 with one year extension option. The Credit Facility includes an accordion feature, providing for the ability to increase the facility to $105 million.
In May 2018, we entered into a second amendment and restatement loan agreement related to the Trias Germany portfolio with a principal balance of $87 million, which reduced the margin from
1.55%
to
1.00%
, extended the maturity date of the loan from December 2020 to June 2025 and eliminated certain covenants limited to portfolio concentration and required capital expenditures.
In August 2018, we amended and restated the loan agreement related to the Trias France portfolio, increasing the principal balance to $76 million, reducing the blended margin from 1.85% per annum to 1.65% per annum and extending the maturity by two years from April 8, 2020 to April 8, 2022.
Refer to Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources” for discussion of liquidity requirements and sources of capital resources.
Risk Management
Risk management is a significant component of our strategy to deliver consistent risk-adjusted returns to our stockholders. Given our need to maintain our qualification as a REIT for U.S. federal income tax purposes, we closely monitor our portfolio and actively seek to manage risks associated with, among other things, our assets, interest rates and foreign exchange rates. In addition, the audit committee of our board of directors, or the Board, in consultation with management, will periodically review our policies with respect to risk assessment and risk management, including key risks to which we are subject, such as credit risk, liquidity risk, financing risk, foreign currency risk and market risk, and the steps that management has taken to monitor and control such risks. The audit committee of the Board maintains oversight of financial reporting risk matters.
Underwriting
Prior to making any equity investments, our underwriting team, in conjunction with third-party providers, undertakes a rigorous asset-level due diligence process, involving intensive data collection and analysis, to seek to ensure that we understand fully the state of the market and the risk-reward profile of the asset. In addition, we evaluate material accounting, legal, financial and business matters in connection with such investment. These issues and risks are built into the valuation of an asset and ultimate pricing of an investment.
During the underwriting process, we review the following data, including, but not limited to: property financial data including historic and budgeted financial statements, liquidity and capital expenditure plans, property operating metrics (including occupancy, leasing activity, lease expirations, sales information, tenant credit review, tenant delinquency reports, operating expense efficiency and property management efficiency) and local real estate market conditions including vacancy rates, absorption, new supply, rent levels and comparable sale transactions, as applicable.
In addition to evaluating the merits of any proposed investment, we evaluate the diversification of our portfolio of assets. Prior to making a final investment decision, we determine whether a target asset will cause our portfolio of assets to be too heavily concentrated with, or cause too much exposure to, any one real estate sector, geographic region, source of cash flow such as tenants or borrowers, or other geopolitical issues. If we determine that a proposed investment presents excessive concentration risk, we may decide not to pursue an otherwise attractive investment.
Portfolio Management
Our Manager performs portfolio management services on our behalf. In addition, we rely on the services of local third-party service providers. The comprehensive portfolio management process includes day-to-day oversight by the portfolio management team, regular management meetings and a quarterly investment review process. These processes are designed to enable management to evaluate and proactively identify investment-specific matters and trends on a portfolio-wide basis. Nevertheless,
we cannot be certain that such review will identify all potential issues within our portfolio due to, among other things, adverse economic conditions or events adversely affecting specific investments; therefore, potential future losses may also stem from investments that are not identified during these investment reviews.
Our Manager uses many methods to actively manage our risks to seek to preserve income and capital, which includes our ability to manage our investments and our tenants in a manner that preserves cost and income and minimizes credit losses that could decrease income and portfolio value. Frequent re-underwriting, dialogue with tenants/property managers and regular inspections of our properties have proven to be an effective process for identifying issues early. Monitoring tenant creditworthiness is an important component of our portfolio management process, which may include, to the extent available, a review of financial statements and operating statistics, delinquencies, third party ratings and market data. During the quarterly portfolio review, or more frequently if necessary, investments may be put on highly-monitored status and identified for possible asset impairment based upon several factors, including missed or late contractual payments, tenant rating downgrades (where applicable) and other data that may indicate a potential issue in our ability to recover our invested capital from an investment.
We may need to make unplanned capital expenditures in connection with changes in laws and governmental regulations in relation to real estate. Where properties are being repositioned or refurbished, we may also be exposed to unforeseen changes in scope and timing of capital expenditures.
Given our need to maintain our qualification as a REIT for U.S. federal income tax purposes, and in order to maximize returns and manage portfolio risk, we may dispose of an asset earlier than anticipated or hold an asset longer than anticipated if we determine it to be appropriate depending upon prevailing market conditions or factors regarding a particular asset. We can provide no assurances, however, that we will be successful in identifying or managing all of the risks associated with acquiring, holding or disposing of a particular investment or that we will not realize losses on certain dispositions.
Interest Rate and Foreign Currency Hedging
Subject to maintaining our qualification as a REIT for U.S. federal income tax purposes, we may mitigate the risk of interest rate volatility through the use of hedging instruments, such as interest rate swap agreements and interest rate cap agreements. The goal of our interest rate management strategy is to minimize or eliminate the effects of interest rate changes on the value of our assets, to improve risk-adjusted returns and, where possible, to lock in, on a long-term basis, a favorable spread between the yield on our assets and the cost of financing such assets.
In addition, because we are exposed to foreign currency exchange rate fluctuations, we employ foreign currency risk management strategies, including the use of, among others, currency hedges, and matched currency financing.
We can provide no assurances, however, that our efforts to manage interest rate and foreign currency exchange rate volatility will successfully mitigate the risks of such volatility on our portfolio.
Regulation
We are subject, in certain circumstances, to supervision and regulation by international, federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing various requirements and restrictions, which, among other things:
• regulate our public disclosures, reporting obligations and capital raising activity;
• require compliance with applicable REIT rules;
• regulate credit granting activities;
• require disclosures to customers;
• govern secured transactions;
• set collection, taking title to collateral, repossession and claims-handling procedures and other trade practices;
• regulate land use and zoning;
• regulate the foreign ownership or management of real property or mortgages;
|
|
•
|
regulate the ability of foreign persons or corporations to remove profits earned from activities within the country to the person’s or corporation’s country of origin;
|
• regulate tax treatment and accounting standards; and
|
|
•
|
regulate use of derivative instruments and our ability to hedge our risks related to fluctuations in interest rates and exchange rates.
|
We qualified to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code, beginning with the year ended December 31, 2015 upon filing our initial U.S. federal income tax return. As a REIT, we must currently distribute, at a minimum, an amount equal to 90% of our taxable income. In addition, we must distribute 100% of our taxable income to avoid paying corporate U.S. federal income taxes. REITs are also subject to a number of organizational and operational requirements in order to elect and maintain REIT status. These requirements include specific share ownership tests and assets and gross income composition tests. If we fail to continue to qualify as a REIT in any taxable year, we will be subject to U.S. federal income tax (including any applicable alternative minimum tax) on our taxable income at regular corporate tax rates. Even if we qualify for taxation as a REIT, we may be subject to tax in foreign jurisdictions in which we operate or own property and state and local income taxes and to U.S. federal income tax and excise tax on our undistributed income.
We believe that we are not, and intend to conduct our operations so as not to become regulated as, an investment company under the Investment Company Act of 1940, as amended, or the Investment Company Act. We have relied, and intend to continue to rely on current interpretations of the staff of the U.S. Securities and Exchange Commission, or SEC, in an effort to continue to qualify for an exemption from registration under the Investment Company Act. For more information on the exemptions that we use refer to Item 1A. “Risk Factors - Risks Related to Regulatory Matters and Our REIT Tax Status.”
Real estate properties owned by us and the operations of such properties are subject to various international laws and regulations concerning the protection of the environment, including air and water quality, hazardous or toxic substances and health and safety. In addition, such properties are required to comply with applicable fire and safety regulations, building codes, legal or regulatory provisions regarding access to our properties for persons with disabilities and other land use regulations. For further information regarding environmental matters, refer to “Environmental Matters” below.
In addition, we currently own two hotels, leased to third-party operators, which are subject to various covenants, laws, ordinances and regulations, including regulations relating to common areas. We believe each of our hotels have the necessary permits and approvals to operate its business.
In the judgment of management, while we do incur significant expense complying with the various regulations to which we are subject, existing statutes and regulations have not had a material adverse effect on our business. However, it is not possible to forecast the nature of future legislation, regulations, judicial decisions, orders or interpretations, nor their impact upon our future business, financial condition and results of operations or prospects.
Environmental Matters
A wide variety of environmental and occupational health and safety laws and regulations affect our properties. These complex laws, and their enforcement, involve a myriad of regulations, many of which involve strict liability on the part of the potential offender. Some of these laws may directly impact us. Under various local environmental laws, ordinances and regulations, an owner of real property, such as us, may be liable for the costs of removal or remediation of hazardous or toxic substances at, under or disposed of in connection with such property, as well as other potential costs relating to hazardous or toxic substances (including government fines and damages for injuries to persons and adjacent property). The cost of any required remediation, removal, fines or personal or property damages and the owner’s liability therefore could exceed or impair the value of the property, and/or the assets of the owner. In addition, the presence of such substances, or the failure to properly dispose of or remediate such substances, may adversely affect the owner’s ability to sell or rent such property or to borrow using such property as collateral which, in turn, could reduce our revenues.
Selected Regulations Regarding our Operations in Germany, the United Kingdom and France
Our commercial real estate investments are subject to a variety of laws and regulations in Europe. If we fail to comply with any of these laws and regulations, we may be subject to civil liability, administrative orders, fines or even criminal sanctions. The following provides a brief overview of selected regulations that are applicable to our business operations in Germany, the United Kingdom and France, where a majority of our properties in terms of contribution to rental income are located.
Germany
Land-use Regulations, Building Regulations and Tenancy Law for Commercial Properties
Land-use Regulations.
There are several regulations regarding the use of land including German planning law and urban restructuring planning by communities.
Urban Restructuring Planning
. Communities may designate certain areas as restructuring areas and undertake comprehensive modernization efforts regarding the infrastructure in such areas. While this may improve the value of properties located in restructuring areas, being located in a restructuring area also imposes certain limitations on the affected properties (
e.g.
, the sale, encumbrance and leasing of such properties, as well as reconstruction and refurbishment measures, are generally subject to special consent by municipal authorities).
Building Regulations.
German building laws and regulations are quite comprehensive and address a number of issues, including, but not limited to, permissible types of buildings, building materials, proper workmanship, heating, fire safety, means of warning and escape in case of emergency, access and facilities for the fire department, hazardous and offensive substances, noise protection, ventilation and access and facilities for disabled people. Owners of erected buildings may be required to conduct alterations or improvements of the property if safety or health risks with respect to users of the building or the general public occur, including fire risks, traffic risks, risks of collapse and health risks from injurious building materials such as asbestos. To our knowledge, there are currently no official orders demanding any alterations to existing buildings owned by us.
Tenancy Law for Commercial Properties.
German tenancy laws for commercial properties generally provide landlords and tenants with far-reaching discretion in how they structure lease agreements and use general terms and conditions. Certain legal restrictions apply with regard to the strict written form requirements regarding the lease agreement and any addenda thereto, transfer of operating costs and maintenance costs, cosmetic repairs and final decorative repairs. Lease agreements with a term of more than one year must be executed in writing or are deemed to have been concluded for an indefinite period. As a consequence, and regardless of the contractually agreed lease term, such lease agreements can then be terminated by the lessor or the lessee at the end of one year turning over the leased property to the lessee at the earliest, and on the third working day of a calendar quarter to the end of the following calendar quarter thereafter. Subject to certain exceptions, operating costs of commercial tenancies may be apportioned to the tenants if the lease agreement stipulates explicitly and specifically which operating costs shall be borne by the tenant. Responsibility for maintenance and repair costs may be transferred to tenants, except for the full cost transfer of maintenance and repair costs for roof, structures and areas used by several tenants in general terms and conditions. Expenses for cosmetic repairs (
Schönheitsreparaturen
) may, in principle, be allocated to tenants, provided that the obligation to carry out ongoing cosmetic repairs is not combined with an undertaking to perform initial and/or final decorative repairs. German law considers standardized terms to be invalid if they are not clear and comprehensive or if they are disproportionate and provide an unreasonable disadvantage for the other party. For example, clauses allocating decorative repair costs and ancillary costs have been subject to extensive case law in Germany.
Regulation Relating to Environmental Damage and Contamination
The portion of our commercial real estate portfolio located in Germany is subject to various rules and regulations relating to the remediation of environmental damage and contamination.
Soil Contamination.
Pursuant to the German Federal Soil Protection Act (
Bundesbodenschutzgesetz
), the responsibility for residual pollution and harmful changes to soil, or Contamination, lies with, among others, the perpetrator of the Contamination, such perpetrator’s universal successor, the current owner of the property, the party in actual control of the property and, if the title was transferred after March 1999, the previous owner of the property if such owner knew or should have known about the Contamination, or the Liable Persons. The Liable Person that carried out the remediation work may claim indemnification on a pro rata basis from the other Liable Persons. Independently, from the aforementioned liability, civil law liability for Contaminations can arise from contractual warranty provisions or statutory law.
United Kingdom
For a discussion of the impact of regulations in the United Kingdom, refer to Item 1A. “Risk Factors — Risks Related to our Financing Strategy- “We are subject to risks associated with obtaining mortgage financing on our real estate, which could materially adversely affect our business, financial condition and results of operations and our ability to make distributions to our stockholders.”
France
Participation in Organismes de placement collectif immobilier
We hold participations in
Organismes de placement collectif immobilier
, or OPCIs, each of which takes the form of a
Société de Placement à Prépondérance Immobilière à Capital Variable
, or SPPICAV. These SPPICAVs and their management company, Swiss Life Reim (France), are authorized and supervised by the French Autorité des Marchés Financiers.
Commercial Lease Regulation
The contractual conditions applying to commercial lease periods, renewal, rent and rent indexation are heavily regulated. The minimum duration of commercial leases is nine years. We cannot terminate the lease before such period has expired, except in very specific cases (such as reconstructing or elevating an existing building or converting an existing building into a residential building (immeuble à usage principal d’habitation) through reconstruction, renovation or rehabilitation thereof). The tenant, on the other hand, has the power to terminate the lease at the end of every three-year period, subject to a six-month prior notice requirement. However, leases of premises to be used exclusively as office spaces may contain provisions restricting or excluding, such power of the tenant to terminate the lease.
The tenant has also a right of renewal of the lease at the end of its initial period and a right to a review of the rent every three years and, unless otherwise agreed by the parties, upon renewal of the lease. The rent variation is capped. In case of review, after a three-year period or in case of a renewal (unless otherwise agreed by the parties), the variation of the rent cannot exceed the
variation of the Commercial Rent Index (
indice trimestriel des loyers commerciaux
) or the Tertiary Activities Rent Index (
indice trimestriel des loyers des activités tertiaires
), which are published by the French National Institute of Statistics and Economic Studies (
Institut national de la statistique et des études économiques
), except in case of (i) a rent review after a three-year period where the rental value has considerably changed (
i.e.
, increase or decrease by more than 10%), (ii) a renewal of a lease where either the features of the premises, the use of the premises, the obligations of the parties under the lease or local marketing factors were significantly modified, (iii) a renewal of a lease, the initial duration of which exceeded nine years or the effective duration of which exceeded twelve years and (iv) certain variable rent leases (such as leases including sales-based or revenue-based rent clauses). In addition, a rent increase for a given year cannot exceed 10% of the rent paid during the previous year.
Moreover, the tenant has a right of first refusal if the leased premises are offered for sale.
The legal allocation of charges (rental expenses, related costs and taxes) between us and the tenant can be contractually determined. However, Articles L. 145-40-2 and R. 145-35 of the French
Code de commerce
, make it mandatory for the property owner in leases entered into or renewed, on or after November 5, 2014 to incur expenditures for major repairs, in particular those related dilapidated premises and those required to meet changing regulation.
Bankruptcy Law
In France, a safeguard proceeding (
sauvegarde
), judicial restructuring (
redressement judiciaire
) or judicial liquidation (
liquidation judiciaire
) procedure commencement order involving an insolvent tenant does not lead to the automatic termination of the lease. In such cases, we will not be able to get paid directly by the tenant and any due and unpaid rent as of the date of the commencement order will be subject to the rules applicable to the insolvency proceeding, which may have a substantial negative impact on our ability to be paid. Furthermore, the tenant, or the insolvency court-appointed receiver (
administrateur judiciaire or liquidateur judiciaire
) acting on behalf of the tenant, will have the choice to continue or terminate any unexpired lease. If the tenant chooses to continue an unexpired lease, but still fails to pay rent in connection with the occupancy after the issue of the commencement order, we cannot legally request the termination of the lease before the end of a three-month period from the date of issue of the commencement order.
Environmental Law
In France, our investments are subject to regulations regarding the accessibility of buildings to persons with disabilities, public health and the environment, covering a number of areas, including the ownership and use of classified facilities; the use, storage, and handling of hazardous materials in building construction; inspections for asbestos, lead, and termites; inspection of gas and electricity facilities; assessments of energy efficiency; and assessments of technological and natural risks.
Emerging Growth Company Status
We are an “emerging growth company,” as defined in the Jumpstart Our Business Act, or JOBS Act and we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies.” These exemptions include not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.
We have availed ourselves of some of the reduced regulatory and reporting requirements that are available to us as long as we qualify as an emerging growth company, except that we have irrevocably elected not to take advantage of the extension of time to comply with new or revised financial accounting standards available under Section 102(b) of the JOBS Act.
We will, in general, remain as an emerging growth company for up to five full fiscal years including December 31, 2015. We would cease to be an emerging growth company and, therefore, become ineligible to rely on the above exemptions, if we:
|
|
•
|
have more than
$1.07
billion in annual revenue in a fiscal year;
|
|
|
•
|
issue more than $1 billion of non-convertible debt during the preceding three-year period; or
|
|
|
•
|
become a “large accelerated filer” as defined in Exchange Act Rule 12b-2, which would occur at the end of the fiscal year after: (i) we have filed at least one annual report pursuant to the Exchange Act; (ii) we have been an SEC-reporting company for at least 12 months; and (iii) the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter.
|
Competition
We are subject to increased competition in seeking investments. We compete with many third parties engaged in real estate investment activities including publicly-traded REITs, insurance companies, commercial and investment banking firms, private equity funds, sovereign wealth funds and other investors. Some of these competitors, including other REITS and private real estate companies and funds, have substantially greater financial resources than we do. Such competitors may also enjoy significant competitive advantages that result from, among other things, a lower cost of capital and enhanced operating efficiencies.
Future competition from new market entrants may limit the number of suitable investment opportunities offered to us. It may also result in higher prices, lower yields and a narrower spread over our borrowing costs, making it more difficult for us to originate or acquire new investments on attractive terms.
Employees
We are externally managed by our Manager and do not have our own employees.
Available Information and Corporate Governance
We emphasize the importance of professional business conduct and ethics through our corporate governance initiatives. Our board of directors consists of a majority of independent directors; the audit, compensation and nominating and corporate governance committees of the board of directors are composed exclusively of independent directors. We have adopted corporate governance guidelines and a code of business conduct and ethics, which delineate our standards for our officers, directors and employees.
Our internet address is
www.nrecorp.com.
The information on our website is not incorporated by reference in this Annual Report on Form 10-K. We make available, free of charge through a link on our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, financial supplements, and amendments to such reports, if any, as filed or furnished with the SEC, as soon as reasonably practicable after such filing or furnishing. We also post corporate presentations on our website from time-to-time. Our website further contains our code of business conduct and ethics, code of ethics for senior financial officers, corporate governance guidelines and the charters of our audit committee, nominating and corporate governance committee and compensation committee of our board of directors. Within the time period required by the rules of the SEC and the NYSE we will post on our website any amendment to our code of business conduct and ethics and our code of ethics for senior financial officers as defined in the code. All of our reports, proxy and information statements filed with the SEC can also be obtained at the SEC’s website at
www.sec.gov
.
Item 1A. Risk Factors
The following risk factors and other information included in this Annual Report on Form 10-K should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us, which we currently deem immaterial or that generally apply to all businesses also may adversely impact our business. If any of the following risks occur, our business, financial condition, operating results, cash flow and liquidity could be materially adversely affected
.
Risks Related to Our Business
The commercial real estate industry has been and may continue to be adversely affected by economic conditions and geopolitical events in Europe, the United States and elsewhere.
Our business and operations are dependent on the commercial real estate industry generally, which in turn is dependent upon global economic conditions and geopolitical events in Europe, the United States and elsewhere. Concerns over global economic conditions, energy and commodity prices, geopolitical events, acts of war and terrorism, nuclear proliferation, inflation, deflation, rising interest rates, divergent central bank policy making, foreign exchange rates, the durability of the Euro as a currency, the availability and cost of credit, the sovereign debt crisis, the U.K. vote on June 23, 2016 to leave the European Union, or Brexit, the rise of protectionism and populism in the United States and Europe, and weak consumer confidence in many markets continue to contribute to increased economic uncertainty for the global economy. These factors, combined with the volatile prices of oil and declining business and consumer confidence in certain markets could precipitate an economic slowdown, as well as cause extreme volatility in security prices. Global economic and political headwinds, along with global market instability, the risk of maturing commercial real estate debt that may have difficulties being refinanced, and divergent central bank policy making, may continue to cause periodic volatility in the commercial real estate market for some time.
Adverse economic conditions in the commercial real estate industry, geopolitical events, acts of war or terrorism could harm our business and financial condition by, among other factors, reducing the value of our properties, limiting our access to debt and equity capital, impairing our ability to obtain new financing or refinance existing obligations and otherwise negatively impacting our operations.
Liquidity in the capital markets is essential to our business.
Liquidity is essential to our business. Our business may be adversely affected by disruptions in the debt and equity capital markets and institutional lending market, including a lack of access to capital or prohibitively high costs of obtaining or replacing capital, both within the United States and Europe. We depend on external financing to fund the growth of our business mainly because one of the requirements of the Internal Revenue Code for a REIT is that we distribute 90% of our taxable income to our stockholders, including taxable income where we do not receive corresponding cash. Our access to equity or debt financing depends on the willingness of third parties to make equity and debt investments in us. It also depends on conditions in the capital markets generally. Companies in the real estate industry, including us, are currently experiencing, and have at times historically experienced, limited availability of capital and new capital sources may not be available on acceptable terms. Our ability to raise capital could be impaired if the capital markets have a negative perception of our long-term or short-term financial prospects or the prospects for REITs and the commercial real estate market generally. Sufficient funding or capital may not be available to us in the future on terms that are acceptable to us. If we cannot obtain sufficient funding on acceptable terms, we will not be able to grow our business and may have difficulty maintaining liquidity and making distributions to our stockholders, which would have a negative impact on the market price of our common stock. For information about our available sources of funds, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources” in Item 7 of Part II of this Annual Report on Form 10-K and the notes to our consolidated financial statements in Item 8 of Part II of this Annual Report on Form 10-K.
We use significant leverage in connection with our investments, which increases the risk of loss associated with our investments and restricts our ability to engage in certain activities.
As of December 31, 2018 we had
$0.7 billion
of borrowings outstanding. We may also incur additional borrowings in the future to satisfy our capital and liquidity needs. Although the use of leverage may enhance returns and increase the number of investments that we can make, it may increase our risk of loss, impact our liquidity and restrict our ability to engage in certain activities. Our substantial borrowings, among other things, may:
|
|
•
|
require us to dedicate a large portion of our cash flow to pay principal and interest on our borrowings, which will reduce the availability of cash flow to fund working capital, capital expenditures and other business activities;
|
|
|
•
|
require us to maintain minimum unrestricted cash;
|
|
|
•
|
increase our vulnerability to general adverse economic and industry conditions;
|
|
|
•
|
require us to post additional reserves and other additional collateral to support our financing arrangements, which could reduce our liquidity and limit our ability to leverage our assets;
|
|
|
•
|
subject us to maintaining various debt, operating income, net worth, cash flow and other covenants and financial ratios;
|
|
|
•
|
limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;
|
|
|
•
|
restrict our operating policies and ability to make strategic acquisitions, dispositions or exploit business opportunities;
|
|
|
•
|
require us to maintain a borrowing base of assets;
|
|
|
•
|
place us at a competitive disadvantage compared to our competitors that have fewer borrowings;
|
|
|
•
|
put us in a position that necessitates raising equity capital at a time that is unfavorable to us and dilutive to our stockholders;
|
|
|
•
|
limit our ability to borrow additional funds (even when necessary to maintain adequate liquidity), dispose of assets or make distributions to our stockholders; and
|
|
|
•
|
increase our cost of capital.
|
If we fail to comply with the covenants in the instruments governing our borrowings or do not generate sufficient cash flow to service our borrowings, our liquidity may be materially and adversely affected. If we default or fail to meet certain coverage tests, we may be required to repay outstanding obligations, together with penalties, prior to the stated maturity, post additional collateral, sell assets to generate cash at inopportune times, subject our assets to foreclosure and/or require us to seek protection under bankruptcy laws.
The failure of any bank in which we deposit our funds or severe disruption in the financial markets could cause us to incur losses, reduce the amount of cash we have available to pay distributions and make additional investments.
We have deposited our cash and cash equivalents in multiple banking institutions in an attempt to minimize exposure to the failure of any one of these entities. However, limited amounts per depositor per insured bank are generally insured. At December 31, 2018, we had
$444.5 million
of cash and cash equivalents and restricted cash deposited transaction accounts at certain financial institutions exceeding these insured levels. If any of the banking institutions in which we have deposited funds ultimately fails, we may lose our deposits over the insured levels. The loss of our deposits could reduce the amount of cash we have available to distribute or invest. We further hold a portion of our cash in money market funds or bank money market accounts which are not insured. A severe decline in the financial markets could result in a loss on value of some or all of these holdings. In addition, during times of severe economic distress, money market funds have experienced intense redemption pressure and have had difficulty satisfying redemption requests. As such, we may not be able to access the cash in our money market funds if such event occurs. In each case, a disruption affecting the money markets where certain of our cash is held could cause us to incur losses, reduce the amount of cash we have available to pay distributions and make additional investments.
Continuing concerns regarding European debt, market perceptions concerning the instability and suitability of the Euro as a single currency, volatility and price movements in the rate of exchange between the U.S. dollar and the Euro could adversely affect our business, results of operations and financings.
Concerns persist regarding the debt burden of certain Euro Area countries and their potential inability to meet their future financial obligations, the overall stability of the Euro and the suitability of the Euro as a single currency, given the diverse economic and political circumstances in individual Euro Area countries, Brexit and volatility in the value of the Euro. These concerns could lead to the re-introduction of individual currencies in one or more Euro Area countries, or, in more extreme circumstances, the possible dissolution of the Euro currency entirely. Should the Euro dissolve entirely, the legal and contractual consequences for holders of Euro-denominated obligations would be uncertain. Such uncertainty would extend to, among other factors, whether obligations previously expressed to be owed and payable in Euros would be re-denominated in a new currency (with considerable uncertainty over the conversion rates), what laws would govern and which country’s courts would have jurisdiction. These potential developments, or market perceptions concerning these and related issues, could materially adversely affect the value of our Euro-denominated investments and obligations.
Furthermore, market concerns about economic growth in the Euro Area relative to the United States and speculation surrounding the potential impact on the Euro of a possible Greek or other country sovereign default and/or exit from the Euro Area as well as the resurgence of distress in certain Euro Area banking sectors, such as Italy, may continue to exert downward pressure on the rate of exchange between the U.S. dollar and the Euro, which may adversely affect our results of operations and our ability to obtain financing.
The U.K. vote to leave the European Union, or EU, could adversely impact our business, results of operations and financial condition.
In a June 2016 referendum, the United Kingdom voted to leave the EU. On March 29, 2017, the United Kingdom formally notified the European Council of its intention to leave the EU. Under Article 50(3) of the Treaty on the European Union (Article 50), the EU Treaties will cease to apply to the United Kingdom from the earlier of (i) the date of effectiveness of any withdrawal agreement between the European Union and the United Kingdom or (ii) two years after the notification of its intention to leave under Article 50, unless the European Council, in agreement with the United Kingdom, unanimously decides to extend this period or the United Kingdom revokes its Article 50 notice. The announcement of Brexit caused significant volatility in global stock markets and currency exchange rate fluctuations that resulted in the strengthening of the U.S. dollar against the U.K. Pound Sterling. On November 25, 2018, the EU and the U.K. government agreed to the terms of a withdrawal agreement that must be ratified by the U.K. and European parliaments ahead of the U.K.’s withdrawal on March 29, 2019. Failure to obtain parliamentary approval of an agreed withdrawal agreement would, absent a revocation of the United Kingdom’s notification to withdraw or some other delay, mean that the United Kingdom would leave the European Union on March 29, 2019, likely with no agreement (a so-called “hard Brexit”). Current discussions between the United Kingdom and the European Union may result in any number of outcomes including an extension or delay of the United Kingdom’s withdrawal from the European Union. The consequences for the economies of the European Union member states as a result of the United Kingdom’s withdrawal from the European Union are unknown and unpredictable, especially in the case of a hard Brexit. On January 15, 2019, the U.K. parliament rejected the withdrawal agreement. The implications of this rejection for Brexit are uncertain. The full impact of the Brexit vote depends on the terms of the U.K.’s withdrawal from the EU which have not yet been finalized. The announcement of Brexit caused significant volatility in global stock markets and currency exchange rate fluctuations that resulted in the strengthening of the U.S. dollar against the U.K. Pound Sterling. Strengthening of the U.S. dollar relative to the U.K. Pound Sterling may adversely affect our results of operations, in a number of ways, including:
|
|
•
|
All of the rent payments under our leases are denominated in Euro or U.K. Pound Sterling. A significant portion of our operating expenses and borrowings are also transacted in local currency. We report our results of operations and consolidated financial information in U.S. dollars. As a result, to the extent we are unable to fully hedge our exchange rate exposure, our results of operations as reported in U.S. dollars is impacted by fluctuations in the value of the local currencies in which we conduct our business.
|
|
|
•
|
While we seek to mitigate the risk of fluctuations in currency exchange rates by utilizing hedging strategies to reduce the impact of exchange rates fluctuations on our income, we do not employ any hedging techniques on our Euro or U.K. Pound Sterling denominated assets, which fully exposes our asset values to exchange rate risk.
|
The U.K.’s withdrawal from the EU could result in a regional economic, political and legal instability, which could depress the demand for European commercial real estate. The U.K. also could lose access to the European Economic Area single market and to the global trade deals negotiated by the EU on behalf of its members, depressing trade between the U.K. and other countries, which would negatively impact the demand for, and the value of, our properties located in the U.K. Additionally, we may face new regulations in the U.K. Compliance with any such regulations could be costly, negatively impacting our business, results of operations and financial condition. Further, the U.K.’s withdrawal from the EU could include changes to the U.K.’s border and immigration policy, which could negatively impact our Manager’s ability in the U.K. to recruit and retain employees to work in its U.K. based offices.
Risks Related to Our Manager
Our ability to achieve our investment objectives and to pay distributions to our stockholders depends in substantial part upon the performance of our Manager.
We rely upon our Manager to manage our day-to-day operations and our investments. Our ability to achieve our investment objectives and grow our business is dependent upon the performance of our Manager in the acquisition or disposition of investments, the determination of financing arrangements and the management of our investments and operation of our day-to-day activities under the supervision of, and subject to the policies and guidelines established by, our board of directors. As a result of our recent Amendment with our Manager to terminate our Amended and Restated Management Agreement, upon the consummation of a change of control of NorthStar Europe or in connection with an internalization of management, our Manager may be less incentivized to perform services obligated under the Amended and Restated Management Agreement, which could adversely affect our Manager’s performance during the remainder of the term. If our Manager performs poorly and as a result fails to manage our investments successfully, we may be unable to achieve our investment objectives or to pay distributions to our stockholders.
Any adverse changes in our Manager’s stock price, financial health, the public perception of our Manager or our relationship with our Manager could hinder our operating performance and adversely affect our financial condition and results of operations.
Because our Manager is a publicly-traded company, any negative reaction by the stock market reflected in the price of its securities or deterioration in the financial health or public perception of our Manager or any of its officers could result in an adverse effect on its ability to manage our portfolio, including acquiring or disposing of assets and obtaining financing from third parties on favorable terms or at all. Our Manager depends upon the management and other fees and reimbursement of costs that it receives from us and our Manager’s other managed companies in connection with the acquisition, management and sale of properties to conduct its operations. Any adverse changes in the financial condition of our Manager or our relationship with our Manager could hinder our Manager’s ability to successfully support our business, which could have a material adverse effect on our financial condition and results of operations.
Failure of our Manager to effectively perform its obligations to us, including under the management agreement, could have an adverse effect on our business and performance.
We have engaged our Manager to provide asset management and other services to us pursuant to a management agreement. Our ability to achieve our investment and business objectives and to make distributions to our stockholders depends in substantial part upon the performance of our Manager and its ability to provide us with asset management and other services. We are also dependent on other third party service providers to whom our Manager has delegated various responsibilities or engaged on our behalf. If for any reason our Manager or any other service provider is unable to perform such services at the level we require, our ability to terminate our Management Agreement earlier than the agreed termination date is limited. For example, even if we were able to terminate our management agreement with our Manager before the agreed termination date, alternate service providers may not be readily available on acceptable terms or at all and any internalization of these functions would take time to complete, which could adversely affect our performance and materially harm our ability to execute our business plan.
Our ability to terminate our management agreement with our Manager is limited and we may be required to pay our Manager a substantial termination fee in connection with a termination.
Pursuant to the terms of our Amendment, we will terminate upon the earlier of (i) the closing of an NRE Change of Control (as defined in the Asset Management Agreement) and (ii) the completion of an internalization of the management of our company within nine months of the later of (x) April 30, 2019, if on such date there is not in place a definitive agreement for an NRE Change of Control and (y) if on April 30, 2019 there is a definitive agreement for an NRE Change of Control, such date on which such agreement is terminated, if any, if no other definitive agreement for an NRE Change of Control is entered into within 30 days thereafter. Prior to this termination date the Management Agreement is only terminable by us for cause and we are unable to terminate our management agreement for any other reason, including if our Manager performs poorly or is unable to manage our company successfully. The term “cause” is limited to specific circumstances set forth in the management agreement. Termination for unsatisfactory financial performance does not constitute “cause” under our management agreement.
Our limited termination rights under the management agreement increases our risk that our Manager may not perform well and our business could suffer. This risk is heightened due to the near term termination date as agreed with our Manager. If our Manager’s performance as our Manager does not meet our or our stockholders’ expectations, and we are unable to terminate the management agreement at such time, the market price of our common stock could be adversely affected. For additional information relating to the terms of the management agreement please refer to Note 6 “Related Party Arrangements” in our accompanying consolidated financial statements included in Part II Item 8. “Financial Statements and Supplementary Data”.
Our incentive fee structure with our Manager could encourage our Manager to invest our assets in riskier investments.
Our Manager has the ability to earn incentive fees based on our total stockholder return exceeding a 10% cumulative annual hurdle rate, which may create an incentive for our Manager to invest in investments with higher yield potential, that are generally riskier or more speculative, or sell an investment prematurely for a gain, in an effort to increase our short-term net income and thereby increase our stock price and the incentive fees to which it is entitled. If our interests and those of our Manager are not aligned, the execution of our business plan and our results of operations could be adversely affected, which could materially and adversely affect the market price of our common stock and our ability to make distributions to our stockholders.
The provisions of our original management agreement were not determined on an arm’s length basis; therefore, we did not have the benefit of arm’s length negotiations of the type normally conducted between unrelated parties.
The provisions of our original management agreement entered into at the time of the
Spin-off were not determined on an arm’s length basis. As a result, the provisions of such agreement, including the amount of the management fees, were determined without the benefit of arm’s length negotiations of the type normally conducted between unrelated parties and may have been in excess of amounts that we would otherwise have paid to third parties for such services. Although our Amended and Restated Management Agreement and the Amendment thereto were negotiated and approved by an independent, special committee of our board of
directors and in consultation with financial advisors, it is possible that we would have been able to negotiate more favorable management agreement terms with an unaffiliated third party if we were not already subject to the original management agreement.
In addition to the management fees we pay to our Manager, we reimburse our Manager for costs and expenses incurred on our behalf, including certain indirect personnel and employment costs of our Manager, which costs and expenses may be substantial.
We pay our Manager substantial fees for the services it provides to us and we also have an obligation to reimburse our Manager for direct costs and expenses it may incur and pay on our behalf. Subject to certain limitations and quarterly maximums, we are also obligated to reimburse our Manager for certain indirect costs, including our Manager’s personnel and employment costs for employees of our Manager who provide services to us, which prior to January 1, 2018 were provided by unaffiliated third parties, services such as accounting and treasury services, plus an amount equal to 20% of such employees’ costs to cover reasonable overhead charges with respect to such personnel. The costs and expenses our Manager incurs on our behalf, including such compensatory costs incurred by our Manager and its affiliates, may be substantial and there are conflicts of interest that could arise when our Manager makes allocation determinations. In addition, we expect to issue annual equity awards to our Manager’s employees under the terms of our management agreement. Our Manager could allocate costs and expenses to us in excess of what we anticipate and such costs and expenses could have an adverse effect on our financial performance and ability to make distributions to our stockholders.
There are conflicts of interest in our relationship with our Manager that could result in decisions that are not in the best interests of our stockholders.
We are subject to conflicts of interest arising out of our relationship with our Manager, its affiliates, managed entities and strategic ventures. In particular, we expect to compete for investment opportunities directly with other companies and/or accounts that our Manager or its strategic or joint venture partners manage. Our Manager and certain of our Manager’s managed companies, along with companies, funds and vehicles that are subject to a strategic relationship between our Manager and its strategic or joint venture partners (which we refer to collectively as strategic vehicles), may have investment mandates and objectives that target the same investments as us.
In addition, our Manager may have additional managed companies or strategic vehicles that may compete directly with us for investment opportunities in the future. We adopted an investment allocation policy with our Manager that is intended to ensure that investments are allocated fairly and appropriately among us, our Manager, and our Manager’s other managed companies or strategic vehicles over time, but there is no assurance that our Manager will be successful in eliminating the conflicts arising from the allocation of investment opportunities. When determining the entity for which an investment opportunity would be the most suitable, the factors that our Manager may consider include, among other factors, the following:
|
|
•
|
investment objectives, dedicated mandates, strategy and criteria;
|
|
|
•
|
current and future cash requirements and of the investment and the managed company;
|
|
|
•
|
effect of the investment on the diversification of the portfolio, including by geography, size of investment, type of investment and risk of investment;
|
|
|
•
|
leverage policy and the availability of financing for the investment by each managed company;
|
|
|
•
|
anticipated cash flow of the investment to be acquired;
|
|
|
•
|
ramp-up or draw-down periods;
|
|
|
•
|
targeted distribution rates;
|
|
|
•
|
anticipated future pipeline of suitable investments;
|
|
|
•
|
the expected holding period of the investment and the remaining term of a managed company or strategic vehicle, if applicable;
|
|
|
•
|
legal, regulatory or tax considerations, including any conditions of an exemptive order;
|
|
|
•
|
affiliate and/or related party considerations; and
|
|
|
•
|
whether a managed company or strategic vehicle has other sources of investment opportunities.
|
A dedicated mandate may cause some managed companies or strategic vehicles to have priority over other managed companies or strategic vehicles with respect to certain investments. If, after consideration of the relevant factors, our Manager determines that an investment is equally suitable for us and one of its clients or strategic vehicles, the investment will be allocated among
each of the applicable entities, including us, on a rotating basis. Our Manager’s new managed companies or strategic vehicles, including us, will be initially added at the end of the rotation. If, after an investment has been allocated, a subsequent event or development, such as delays in structuring or closing on the investment, makes it, in the opinion of our Manager’s investment professionals, more appropriate for a different entity to fund the investment, our Manager may determine to place the investment with the more appropriate entity while still giving credit to the original allocation. In certain situations, our Manager may determine to allow more than one managed company or strategic vehicle to co-invest in a particular investment. Managed companies and strategic vehicles may have different allocation preferences. In addition, strategic vehicles may receive preference in the allocation of an investment opportunity that is initially presented to our Manager by the applicable strategic or joint venture partner. A dedicated mandate may cause a client to have priority over certain other clients with respect to investment opportunities.
Our Manager will allocate third-party acquisition costs incurred in connection with the selection, acquisition or origination of an investment to those managed companies or strategic vehicles that acquire or originate the investment. Such allocation will be made in accordance with each client’s allocation of the investment opportunity. If our Manager does not complete a proposed investment, it will allocate any third-party acquisition costs (Broken Deal Costs) incurred to date relating to the proposed investments, to those clients that would have acquired or originated the investment in accordance with the allocations set out in the applicable investment allocation. If our Manager does not complete an investment before making an investment allocation, it will allocate the Broken Deal Costs to the client or clients for which the investment opportunity was suitable. If there are multiple managed companies or strategic vehicles, such Broken Deal Costs will be allocated pro-rata.
There is no assurance this policy will remain in place during the entire period we are seeking investment opportunities. In addition, our Manager may sponsor additional managed companies or strategic vehicles in the future and, in connection with the creation of such managed companies or strategic vehicles, may revise these allocation procedures. The result of a revision to the allocation procedures may, among other things, be to increase the number of parties who have the right to participate in investment opportunities sourced by our Manager or us, thereby reducing the number of investment opportunities available to us.
In addition, under this policy, our Manager’s investment professionals may consider the investment objectives and anticipated pipeline of future investments of its managed companies or strategic vehicles. The decision of how any potential investment should be allocated among us and one of our Manager’s managed companies or strategic vehicles for which such investment may be suitable may, in many cases, be a matter of subjective judgment which will be made by our Manager. Pursuant to the investment allocation policy, our Manager may choose to allocate favorable investments to its other managed companies instead of to us. Our Manager’s investment allocation policy could produce unfavorable results for us that could harm our business.
Our Manager may encourage our use of third party service providers, including those in which our Manager owns an interest, for which we pay a fee. In addition, we may enter into principal transactions or cross transactions with our Manager’s other managed companies or strategic vehicles. In certain transactions our Manager may receive a fee from the managed company. There is no guaranty that any such transactions will be favorable to us. Because our interests and our Manager’s interests may not be aligned, we may face conflicts of interest that result in action or inaction that is detrimental to us.
Further, there are conflicts of interest that arise when our Manager makes expense allocation determinations, as well as in connection with any fees payable between us and our Manager. These fees and allocation determinations are sometimes based on estimates or judgments, which may not be correct and could result in our Manager’s failure to allocate and pay certain fees and costs to us appropriately.
There is a risk of investor influence over our company that may be adverse to our best interests and those of our other stockholders.
Our Manager owned approximately
11.3%
of the shares of our common stock, as of December 31, 2018. Pursuant to and subject to the terms of an ownership waiver and voting agreement that we provided our Manager at the time we entered into our amended and restated management agreement, we granted our Manager an ownership waiver allowing it to purchase up to 45% of the shares of our common stock; provided that to the extent our Manager owns more than 25% of our common stock (such shares owned by our Manager in excess of the 25% threshold, the “Excess Shares”), it will vote the Excess Shares in the same proportion that the remaining shares of the Company not owned by our Manager or its affiliates are voted. Moreover, so long as our Management Agreement is in effect, our Manager has the right to nominate one director to our Board.
Our Manager’s current ownership of our common stock and its ability to significantly increase its ownership stake, together with the composition of our board of directors and the terms of our management agreement, may have the effect of making some transactions more difficult without our Manager’s support and can also have the effect of making certain transactions more likely if they are supported by our Manager even if they are not supported by the majority of our other stockholders. The interests of our Manager or any of its affiliates could conflict with or differ from our interests or the interests of the other holders of our common stock. For example, the large ownership stake held by our Manager (which ownership stake can be increased substantially) could delay, defer or prevent a change of control of our company or impede a merger, takeover or other business combination that may otherwise be favorable for us and the other stockholders. Our Manager may also pursue acquisition opportunities for itself
that could have been complementary to our business, and as a result, those acquisition opportunities may not be available to us. We do not believe that the terms of the ownership waiver and voting agreement can fully protect against these risks.
To the extent that our Manager owns a substantial portion of our outstanding shares, it would be able to exert significant influence over us, including:
|
|
•
|
the composition of our Board (in addition to its existing rights to nominate a director under the terms of our management agreement);
|
|
|
•
|
direction and policies, including the appointment and removal of officers;
|
|
|
•
|
the determination of incentive compensation, which may affect our ability to retain key professionals of our Manager who provide services to the Company;
|
|
|
•
|
any determinations with respect to change of control of our company, including mergers, takeovers or other business combinations involving the Company;
|
|
|
•
|
our acquisition or disposition of assets;
|
|
|
•
|
our financing decisions and our capital raising activities;
|
|
|
•
|
the payment of dividends;
|
|
|
•
|
conduct in regulatory and legal proceedings; and
|
|
|
•
|
amendments to our charter and bylaws.
|
Our Manager’s professionals who perform services for us face competing demands relating to their time and conflicts of interests relating to performing services on our behalf, which may cause our operations to suffer.
We rely on our Manager’s professionals to perform services related to the operation of our business. Our Manager professionals performing services for us may also perform services for our Manager’s other managed companies or strategic vehicles. As a result of their interests in our Manager, other managed companies and the fact that they may engage in other business activities on behalf of others, these individuals may face conflicts of interest in allocating their time among us, our Manager and other managed companies or strategic vehicles and other business activities in which they are involved. In addition, certain management personnel performing services on behalf of our Manager own equity interests in our Manager or other managed companies or strategic vehicles and our Manager may grant additional equity interests in our Manager or other managed companies, or strategic vehicles to such persons in connection with their continued services. These conflicts of interest, as well as the loyalties of these individuals to other entities and investors, could result in action or inaction that is detrimental to our business, which could harm the implementation of our business strategy and our investment opportunities. If we do not successfully implement our business strategy, we may be unable to generate the cash needed to make distributions to our stockholders or to maintain or increase the value of our portfolio.
Further, at times when there are turbulent conditions in the real estate markets or distress in the credit markets or other times when we will need focused support and assistance from our Manager, our Manager’s other managed companies or strategic vehicles may likewise require greater focus and attention, placing our Manager’s resources in high demand. In such situations, we may not receive the level of support and assistance that we may receive if we were internally managed or if our Manager did not act as a manager for other entities.
Our executive officers are employees of our Manager and face conflicts of interest related to their positions and interests in our Manager, which could hinder our ability to implement our business strategy.
Our executive officers are employees of our Manager and provide services to us solely in such capacity pursuant to our Manager’s obligations to us under the management agreement. We do not have employment agreements with any of our executive officers; however we are required, in certain instances, pursuant to the terms of our Management Agreement with our Manager, to reimburse our Manager for up to 50% of any severance payments paid to Mr. Nia. If the management agreement with our Manager were to be terminated, we could lose the services of all our executive officers and our Manager investment professionals acting on our behalf. Furthermore, if any of our executive officers ceased to be employed by our Manager, such individual may also no longer serve as one of our executive officers. Our Manager is an independent contractor and controls the activities of its employees, including our executive officers. Our executive officers therefore owe duties to our Manager and its stockholders, which may from time-to-time conflict with the duties they owe to us and our stockholders. In addition, our executive officers may also own equity in our Manager or its other managed companies, or strategic vehicles. As a result, the loyalties of these individuals to other entities and investors could result in action or inaction that is detrimental to our business, which could harm the implementation of our business strategy and our investment opportunities.
Both our board of directors and our Manager’s board of directors have adopted, and will likely in the future adopt, certain incentive plans to create incentives that will allow us and our Manager to retain and attract the services of key professionals. These incentive
plans may be tied to the performance of our common stock or our Manager’s common stock and any decline in our stock price may result in us or our Manager being unable to motivate and retain our management and these other professionals. Our inability to motivate and retain these individuals could also harm our business and our prospects. Additionally, competition for experienced real estate professionals could require our Manager or us to pay higher wages and provide additional benefits to attract qualified employees, which could result in higher compensation expenses to us.
We may not realize the anticipated benefits of our Manager’s strategic partnerships and joint ventures.
Our Manager may enter into strategic partnerships and joint ventures to further its own interests or the interests of its managed companies, including us. Our Manager may not be able to realize the anticipated benefits of these strategic partnerships and joint ventures. These strategic partnerships and/or joint ventures may also subject our Manager and its managed companies, including us, to additional risks and uncertainties, as our Manager and its managed companies, including us, may be dependent upon, and subject to, liability, losses or reputational damage relating to systems, control and personnel that are not under our Manager’s control. In addition, where our Manager does not have a controlling interest, it may not be able to take actions that are in our best interests due to a lack of full control. Furthermore, to the extent that our Manager’s partners provide services to us, certain conflicts of interests may exist. Moreover, disagreements or disputes between our Manager and its partners could result in litigation, which could potentially distract our Manager from our business.
Our Manager manages our portfolio pursuant to investment guidelines and our board of directors does not approve each investment and financing decision made by our Manager unless required by our investment guidelines.
Our Manager is authorized to follow investment guidelines established by our board of directors. Our board of directors periodically reviews our investment guidelines and our investment portfolio but does not, and is not required to review all of our proposed investments, except in circumstances as set forth in our investment guidelines. Our board of directors may also make modifications to our investment guidelines from time to time as it deems appropriate. In addition, in conducting periodic reviews or modifying our investment guidelines, our board of directors may rely primarily on information provided to them by our Manager. Furthermore, transactions entered into by our Manager on our behalf may be costly, difficult or impossible to unwind by the time they are reviewed by our board of directors. Our Manager has flexibility within the parameters of our investment guidelines in determining the types and amounts of investments in which to invest on our behalf, including making investments that may result in returns that are substantially below expectations or result in losses, which could materially and adversely affect our business and results of operations, or may otherwise not be in the best interests of our stockholders.
Our Manager’s liability is limited under the management agreement and we have agreed to indemnify our Manager against all liabilities incurred in accordance with and pursuant to the management agreement.
We have entered into a management agreement with our Manager, which governs our relationship with our Manager. Our Manager maintains a fiduciary relationship with us. Under the terms of the management agreement, and subject to applicable law, our Manager, its directors, officers, employees, partners, managers, members, controlling persons, and any other person or entity affiliated with our Manager are not liable to us or our subsidiaries for acts taken or omitted to be taken in accordance with and pursuant to the management agreement, except those resulting from acts of gross negligence, willful misfeasance or bad faith in the performance of our Manager’s duties under the management agreement. In addition, subject to applicable law, we have agreed to indemnify our Manager and each of its directors, officers, employees, partners, managers, members, controlling persons and any other person or entity affiliated with our Manager from and against any claims or liabilities, including reasonable legal fees and other expenses reasonably incurred, arising out of or in connection with our Manager’s performance of its duties or obligations under the management agreement or otherwise as our manager, except where attributable to acts of gross negligence, willful misfeasance or bad faith in the performance of our Manager’s duties under the management agreement.
Our Manager is subject to extensive regulation as an investment adviser and/or fund manager, which could adversely affect its ability to manage our business.
Certain of our Manager’s affiliates, including our manager, are subject to regulation as investment advisers and/or fund managers by various regulatory authorities that are charged with protecting the interests of our Manager’s managed companies, including us. Instances of criminal activity and fraud by participants in the investment management industry and disclosures of trading and other abuses by participants in the financial services industry have led the U.S. government and regulators in foreign jurisdictions to consider increasing the rules and regulations governing, and oversight of, the financial system. This activity is expected to result in continued changes to the laws and regulations governing the investment management industry and more aggressive enforcement of the existing laws and regulations. Our Manager could be subject to civil liability, criminal liability, or sanction, including revocation of its registration as an investment adviser in the United States or in any foreign jurisdictions where it is registered, revocation of the licenses of its employees, censures, fines or temporary suspension or permanent bar from conducting business, if it is found to have violated any of these laws or regulations. Any such liability or sanction could adversely affect its ability to manage our business.
Our Manager must continually address conflicts between its interests and those of its managed companies, including us. In addition, the SEC and other regulators have increased their scrutiny of potential conflicts of interest. However, appropriately dealing with conflicts of interest is complex and difficult and if our Manager fails, or appears to fail, to deal appropriately with conflicts of interest, it could face litigation or regulatory proceedings or penalties, any of which could adversely affect its ability to manage our business.
Risks Related to Our Investments
A prolonged economic slowdown, a lengthy or severe recession or declining real estate values could harm our investments.
Our investments may be susceptible to economic slowdowns or recessions, which could lead to financial losses and a decrease in revenues, earnings and asset values. Any economic slowdown or recession, most particularly affecting the jurisdictions in which we own properties, in addition to other non-economic factors such as an excess supply of properties, could have a material negative impact on the values of our investments. Declining real estate values will reduce the value of our properties, as well as our ability to refinance our properties and use the value of our existing properties to support the purchase or investment in additional properties. Slower than expected economic growth pressured by a strained labor market, along with overall financial uncertainty, could result in lower occupancy rates and lower lease rates across many property types and may create obstacles for us to achieve our business plans. We may also be less able to pay principal and interest on our borrowings, which could cause us to lose title to properties securing our borrowings. Any of the foregoing could significantly harm our revenues, results of operations, financial condition, business prospects and our ability to make distributions to our stockholders.
We are subject to significant competition and we may not be able to compete successfully for investments.
We are subject to significant competition for attractive investment opportunities from other real estate investors, some of which have greater financial resources than us, including publicly-traded REITs, non-traded REITs, insurance companies, commercial and investment banking firms, private institutional funds, hedge funds, private equity funds, sovereign wealth funds and other investors. We may not be able to compete successfully for investments. In addition, the number of entities and the amount of funds competing for suitable investments may increase. If we pay higher prices for investments, our returns may be lower and the value of our investments may not increase or may decrease significantly below the amount we paid for such investments. If such events occur, we may experience lower returns on our investments.
While we are primarily focused on investing in office properties within Germany, the United Kingdom, and France, we have no established investment criteria limiting the particular country or region, industry concentration or investment type of our investments. If our investments are concentrated in a particular country or region or property type that experiences adverse economic conditions, our investments may lose value and we may experience losses.
Properties that we may acquire may be concentrated in a particular country or region or in a particular property type. These current and future investments carry the risks associated with significant regional or industry concentration. We have not established and do not plan to establish any investment criteria to limit our exposure to these risks for future investments. As a result, properties underlying our investments may be overly concentrated in certain countries or regions or industries and we may experience losses as a result. A worsening of economic conditions, a natural disaster or civil disruptions in a particular country or region in which our investments may be concentrated, or economic upheaval with respect to a particular property type, could have an adverse effect on our business, including impairing the value of our properties.
Approximately
90%
of our in-place rental income was generated from office properties, which increases the likelihood that exposure to the risks inherent in the office sector will become more material to our business and results of operations.
Our exposure to the risks inherent in the office sector may make us more vulnerable to a downturn or slowdown in the office sector. A downturn in the office industry could negatively affect our lessees’ ability to make lease payments to us and our ability to pay distributions to our stockholders. These adverse effects may be more pronounced than if our investments were more diversified.
We are subject to additional risks due to the international nature of our investments, which could adversely impact our business and results of operations.
All of our investments are located within Germany, the United Kingdom and France.
Our investments may be affected by factors peculiar to the laws of the jurisdiction in which the property is located and these laws may expose us to risks that are different from and/or in addition to those commonly found in the United States. We and our Manager may not be as familiar with the potential risks to our investments outside of the United States and we may incur losses as a result. These risks include:
|
|
•
|
governmental laws, rules and policies including laws relating to the foreign ownership of real property or mortgages and laws relating to the ability of foreign persons or corporations to remove profits earned from activities within the country to the person’s or corporation’s country of origin;
|
|
|
•
|
translation and transaction risks related to fluctuations in foreign currency exchange rates;
|
|
|
•
|
adverse market conditions caused by inflation, deflation or other changes in national or local political and economic conditions;
|
|
|
•
|
challenges of complying with a wide variety of foreign laws, including corporate governance, operations, taxes and litigation;
|
|
|
•
|
changes in relative interest rates;
|
|
|
•
|
changes in the availability, cost and terms of borrowings resulting from varying national economic policies;
|
|
|
•
|
changes in real estate and other tax rates, the tax treatment of transaction structures and other changes in operating expenses in a particular country where we have an investment;
|
|
|
•
|
our REIT tax status not being respected under foreign laws, in which case any income or gains from foreign sources be subject to foreign taxes and withholding taxes;
|
|
|
•
|
lack of uniform accounting standards (including availability of information in accordance with accounting principles generally accepted in the United States, or U.S. GAAP);
|
|
|
•
|
changes in land use and zoning laws;
|
|
|
•
|
more stringent environmental laws or changes in such laws;
|
|
|
•
|
changes in the social stability or other political, economic or diplomatic developments in or affecting a country where we have an investment;
|
|
|
•
|
changes in applicable laws and regulations in the United States that affect foreign operations; and
|
|
|
•
|
legal and logistical barriers to enforcing our contractual rights in other countries, including insolvency regimes, landlord/tenant rights and ability to take possession of collateral.
|
Each of these risks might adversely affect our performance and impair our ability to make distributions to our stockholders required to qualify and remain qualified as a REIT. In addition, there is generally less publicly available information about foreign companies and a lack of uniform financial accounting standards and practices (including the availability of information in accordance with U.S. GAAP) which could impair our ability to analyze transactions and receive timely and accurate financial information from tenants necessary to meet our reporting obligations to financial institutions or governmental or regulatory agencies.
Our business is also subject to extensive regulation by various non-U.S. regulators, including governments, central banks and other regulatory bodies, in the jurisdictions in which we make investments. In many countries, the laws and regulations applicable to the financial services and securities industries are uncertain and evolving and it may be difficult for us to determine the exact requirements of local laws in every market or manage our relationships with multiple regulators in various jurisdictions. Our inability to remain in compliance with local laws in a particular market and manage our relationships with regulators could have a significant and adverse effect not only on our businesses in that market but also on our reputation generally.
Our joint venture partners could take actions that decrease the value of an investment to us and lower our overall return.
We currently are party to and may in the future enter into joint ventures with third parties to make investments. We may also make investments in partnerships or other co-ownership arrangements or participations. Such investments may involve risks not otherwise present with other methods of investment, including, for example, the following risks:
|
|
•
|
our joint venture partner in an investment could become insolvent or bankrupt;
|
|
|
•
|
fraud or other misconduct by our joint venture partners;
|
|
|
•
|
we may share decision-making authority with our joint venture partner regarding certain major decisions affecting the ownership of the joint venture and the joint venture property, such as the sale of the property or the making of additional capital contributions for the benefit of the property, which may prevent us from taking actions that are opposed by our joint venture partner;
|
|
|
•
|
such joint venture partner may at any time have economic or business interests or goals that are or that become in conflict with our business interests or goals, including for example the operation of the properties owned by such joint venture;
|
|
|
•
|
such joint venture partner may be in a position to take action contrary to our instructions or requests or contrary to our policies or objectives;
|
|
|
•
|
our joint venture partners may be structured differently than us for tax purposes and this could create conflicts of interest and risk to our REIT status; and
|
|
|
•
|
the terms of our joint ventures could restrict our ability to sell or transfer our interest to a third party when we desire on advantageous terms, which could result in reduced liquidity.
|
Any of the above might subject us to liabilities and thus reduce our returns on our investment with that joint venture partner. In addition, disagreements or disputes between us and our joint venture partner could result in litigation, which could increase our expenses and potentially limit the time and effort our officers and directors are able to devote to our business.
Because real estate investments are relatively illiquid, we may not be able to vary our portfolio in response to changes in economic and other conditions, which may result in losses.
Real estate investments are relatively illiquid. A variety of factors could make it difficult for us to dispose of any of our investments on acceptable terms even if a disposition is in the best interests of our stockholders. We cannot predict whether we will be able to sell any property for the price or on the terms set by us or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a property. Certain properties may also be subject to transfer restrictions that materially restrict us from selling that property for a period of time or impose other restrictions, such as a limitation on the amount of financing that can be placed or repaid on that property. We may be required to expend cash to correct defects or to make improvements before a property can be sold, and we cannot assure you that we will have cash available to correct those defects or to make those improvements. Additionally, the Internal Revenue Code also places limits on our ability to sell certain properties held for fewer than two years.
We may also give our tenants a right of first refusal or similar options. As a result, our ability to sell investments in response to changes in economic and other conditions could be limited. To the extent we are unable to sell any property for its book value or at all, we may be required to take a non-cash impairment charge or loss on the sale, either of which would reduce our earnings. Limitations on our ability to respond to adverse changes in the performance of our properties may have a material adverse effect on our business, financial condition and results of operations and our ability to make distributions to our stockholders.
We are subject to risks, such as declining real estate values and operating performance, associated with future advance or capital expenditure obligations and our capital expenditure projections may prove inaccurate.
Future funding obligations subject us to significant risks such as that the property may have declined in value, projects to be completed with the additional funds may have cost overruns and the tenant may be unable to generate enough cash flow and execute its business plan, or sell or refinance the property, in order to repay our indebtedness. We may also need to fund capital expenditures and other significant expenses for our investments in excess of those projected at the time of our underwriting because of, among other reasons, inaccurate or incomplete technical advice from our advisors at the time of underwriting that results in greater than expected expenditures.
We could also determine that we need to fund more money than we originally anticipated in order to maximize the value of our investment even though there is no assurance additional funding would be the best course of action. Further, future funding obligations require us to maintain higher liquidity than we might otherwise maintain and these funding obligations could reduce the overall return on our investments. We could also find ourselves in a position with insufficient liquidity to fund future obligations, which could result in material losses.
We may obtain only limited warranties when we purchase a property, which increases the risk that we could lose some or all of our invested capital in the property or rental income from the property if losses are incurred that are not covered by the limited warranties, which, in turn, could materially adversely affect our business, financial condition and results from operations and our ability to make distributions to our stockholders.
The seller of a property often sells such property in an “as is” condition on a “where is” basis and “with all faults.” In addition, the related real estate purchase and sale agreements may contain only limited warranties, representations and indemnifications that will only survive for a limited period after the closing. Despite our efforts, we may fail to uncover all material risks during our diligence process. The purchase of properties with limited warranties increases the risk that we may lose some or all of our invested capital in the property, as well as the loss of rental income from that property if losses are incurred that are not covered by the limited warranties. If we experience losses that are not recoverable under the limited warranties provided by a seller, it may have a material adverse effect on our business, financial condition and results of operations and our ability to make distributions to our stockholders. In addition, we may be further limited in our ability to enforce against breaches of certain representations and warranties granted in the purchase and sale agreement beyond a very limited period of time or at all where a seller is in financial distress or where the seller of a property we purchase is a liquidating fund or funds after our purchase of the property.
We may be required to indemnify purchasers of our assets against certain liabilities and obligations, which may affect our returns on dispositions.
We may be required to enter into real estate purchase and sale agreements with warranties, representations and indemnifications, which may expose us to liabilities and obligations following dispositions of our assets. Despite our efforts, we may fail to identify all liabilities, which may materially impair the anticipated returns on any dispositions. Further, we may be forced to incur unexpected
significant expense in connection with such liabilities and obligations, which could have a material adverse effect on our business, financial condition and results of operations and our ability to make distributions to stockholders.
The price we pay for acquisitions of real property is based on our projections of market demand, occupancy and rental income, as well as on market factors, and our return on our investment may be lower than expected if any of our projections are inaccurate.
The price we pay for real property investments is based on our projections of market demand, occupancy levels, rental income, the costs of any development, redevelopment or renovation of property and other factors. In addition, increased competition in the real estate market may drive up prices for commercial real estate. If any of our projections are inaccurate or we overpay for investments and their value subsequently drops or fails to rise because of market factors, returns on our investment may be lower than expected and we could experience losses. This may be particularly pronounced during periods of market dislocation.
Our lease transactions may not result in market rates over time, which could have an adverse impact on our income and distributions to our stockholders.
We expect substantially all of our rental and escalation income to come from lease transactions, which may have longer terms than one year or renewal options that specify maximum rate increases. If we do not accurately judge the potential for increases in market rates, rental and escalation increases, the terms of our lease transactions may fail to result in fair market rates over time. Further, we may have no ability to terminate our lease transactions or adjust the rent to then-prevailing market rates. As a result, our income and distributions to our stockholders could be lower than they would otherwise be if we did not enter into lease agreements with longer terms or renewal options that specify maximum rates increase, which could have an adverse impact on our income and ability to make distributions to our stockholders.
We may enter into short term leases that are subject to heightened lease turnover risk or we may invest in single tenant properties or properties that are leased primarily to one tenant, which could negatively impact our ability to comply with financial covenants under our borrowings and could materially impact our income and distributions to our stockholders.
We may also enter into leases that are short term in nature and therefore subject to heightened lease turnover risk. Additionally, for single tenant properties or our properties that are primarily leased to one tenant, such as certain of our French properties lease expirations may impact our ability to comply with financial covenants under our borrowings. As a result, we could be subject to a sudden and material change in value of our portfolio and available cash flow from such investments in the event that these leases are not renewed or in the event that we are not able to comply with or obtain relief from our financial covenants under the borrowings related to, or cross-collateralized with, the properties that are subject to these leases.
We may not be able to relet or renew leases at our properties on favorable terms, or at all.
The ability to relet or renew leases underlying our properties may be negatively impacted by challenging economic conditions in general or challenging market conditions in a particular region or asset class. For example, upon expiration or earlier termination of leases for space located at our properties, the space may not be relet or, if relet, the terms of the renewal or reletting (including the cost of required renovations or concessions to tenants) may be less favorable than current lease terms. We may be receiving above market rental rates in certain instances at our properties, which may decrease upon renewal. Any such decrease could adversely impact our income and could harm our ability to service our debt and operate successfully. Weak economic conditions would likely reduce tenants’ ability to make rent payments in accordance with the contractual terms of their leases and could lead to early termination of leases. Furthermore, commercial space needs may contract, resulting in lower lease renewal rates and longer releasing periods when leases are not renewed. Any of these situations may result in extended periods where there is a significant decline in revenues or no revenues generated by a property. Additionally, to the extent that market rental rates are reduced, property-level cash flow would likely be negatively affected as existing leases renew at lower rates. If we are unable to relet or renew leases for all or substantially all of the space at these properties, if the rental rates upon such renewal or reletting are significantly lower than expected or if our reserves for these purposes prove inadequate, we will experience a reduction in net income and may be required to reduce or eliminate cash distributions to our stockholders.
Additionally, the open market lease review process in certain jurisdictions can be a lengthy one and often results in resolution through arbitration. While the agreed rent level generally applies retroactively to the lease review date, this can be a lengthy and costly process.
Many of our investments are dependent upon tenants successfully operating their businesses and their failure to do so could have a material adverse effect on our business, financial condition and results of operations and our ability to make distributions to our stockholders.
We depend on our tenants to manage their day-to-day business operations in a manner that generates revenues sufficient to allow them to meet their obligations to us, including their obligations to pay rent, maintain certain insurance coverage, pay real estate taxes and maintain the properties under their operational control in a manner that does not jeopardize their operating licenses or regulatory status. We may not be able to find suitable tenants to lease our properties, and the ability of our tenants to fulfill their
obligations to us may depend, in part, upon the overall profitability of their operations, including any other facilities, properties or businesses they may acquire or operate. The cash flow generated by the operation of our properties may not be sufficient for a tenant to meet its obligations to us. Tenants who are having trouble with their cash flow are more likely to expose our properties to liens and other risks to our investments. In addition, we may have trouble recovering from tenants who are insolvent or in financial distress. Our financial position could be weakened and our ability to fulfill our obligations under our real estate borrowings could be limited if our tenants are unable to meet their obligations to us or we fail to renew or extend our contractual relationship with any of our tenants. In addition, to the extent we seek to replace a tenant following a default we may incur substantial delays and expenses. Further, we may be required to fund certain expenses and obligations to preserve the value of our properties while they are being marketed to secure a new tenant. Once a suitable tenant is located, it may still take an extended period of time before the replacement tenant takes possession of the property. Any of these results could have a material adverse effect on our business, financial condition and results of operations and our ability to make distributions to our stockholders.
We may become responsible for unexpected capital improvements. To the extent such capital improvements are not undertaken, the ability of our tenants to manage our properties effectively and on favorable terms may be affected, which in turn could materially adversely affect our business, financial conditions and results of operations and our ability to make distributions to our stockholders.
We may be responsible under local law of certain jurisdictions in which we own property for unexpected capital improvements. In France, the legal distribution of charges between us and the tenant may be contractually set out. However, certain French law makes it mandatory for us, as owners of the real properties, for leases entered into or renewed on or after November 3, 2014, to incur expenditures for major repairs, in particular those related to the obsolescence of the properties and those required to meet changing regulations. French law may also force us to pay certain taxes. These expenditures, which cannot be contractually transferred to the tenant, could have a material adverse effect on our business if they exceed our expectations.
In addition, under German law, maintenance and modernization measures may be required to meet changing legal, environmental or market requirements (
e.g.
, with regard to health and safety requirements and fire protection). The costs associated with keeping properties up to market demand are borne primarily by the property owner. Lease agreements for commercial properties may also transfer responsibility for the maintenance and repair of leased properties to tenants. However, the costs of maintenance and repairs to the roof and structures and of areas located in the leased property used by several tenants may not be fully transferred to tenants by use of general terms and conditions and requires contractual limitation on the amount apportioned.
Furthermore, although tenants are generally responsible for capital improvement expenditures under typical net lease structures applicable in the United Kingdom, it is possible that a tenant may not be able to fulfill its obligations to keep a property in good operating condition. To the extent capital improvements are not undertaken or are deferred, occupancy rates and the amount of rental and reimbursement income generated by the property may decline, which would negatively impact the overall value of the affected property. We may be forced to incur unexpected significant expense to maintain our properties, even those that are subject to net leases. Any of these results could have a material adverse effect on our business, financial condition and results of operations and our ability to make distributions to our stockholders.
We could incur additional costs if the actual costs of maintaining or modernizing our properties exceed our estimates, if we are not permitted to raise rents in connection with maintenance and modernization measures, if hidden defects not covered by insurance or contractual warranties are discovered during the maintenance or modernization process or if additional spending is required. Any failure to undertake appropriate maintenance and modernization measures could adversely affect our rental income and entitle tenants to withhold or reduce rental payments or even to terminate existing lease agreements. If we incur substantial unplanned maintenance, repair and modernization costs or fail to undertake appropriate maintenance measures, this could have a material adverse effect on our business, net assets, financial condition, cash flows or results of operations.
We are party to commercial leases that are heavily regulated to protect the tenant and any future amendments to such regulation could increase our expenditures.
Commercial leases are heavily regulated in some countries in which we operate. In France, the contractual conditions applying to commercial leases duration, renewal, rent and rent indexation are considered matters of public order (
ordre public
), and as such are heavily regulated to protect the tenant. The minimum duration of a commercial lease is nine years. The tenant has the right to terminate the lease at the end of every three-year period, unless contractually agreed otherwise for leases of premises to be used exclusively as office space. The tenant also has a right of renewal of the lease at the end of its initial period.
In addition, the tenant has a right to a review of the rent every three years and, unless otherwise agreed by the parties, upon renewal of the lease. The rent variation, however, is capped. In case of a review after a three-year period, or in case of a renewal (unless otherwise agreed by the parties), the variation of the rent cannot exceed the variation of the Commercial Rent Index (
indice trimestriel des loyers commerciaux)
, or the Tertiary Activities Rent Index (
indice trimestriel des loyers des activités tertiaires)
,which are published by the French National Institute of Statistics and Economic Studies (
Institut national de la statistique et des études économiques
), except in case of (i) a rent review after a three-year period where the rental value has considerably changed (
i.e.
, increase or decrease by more than 10%), (ii) a renewal of a lease where either the features of the premises, the use of the premises,
the obligations of the parties under the lease or local marketing factors were significantly modified, (iii) a renewal of a lease, the initial duration of which exceeded nine years or the effective duration of which exceeded twelve years and (iv) certain variable rent leases (such as leases including sales-based or revenue-based rent clauses). In addition, a rent increase for a given year cannot exceed 10% of the rent paid during the previous year. Consequently, we cannot freely raise rents of ongoing leases in France.
Furthermore, changes in the content, interpretation or enforcement of these laws and regulations could compromise some of the practices adopted by us in managing our property holdings and increase our costs for operating, maintaining and renovating our property holdings and adversely affect the valuation of such property holdings. In particular, in 2014, changes to French law amended many provisions applicable to commercial leases in France, and more specifically:
|
|
•
|
replaced all references to the Construction Cost Index (indice national trimestriel mesurant le coût de la construction)with references to the Commercial Rent Index or the Tertiary Activities Rent Index in provisions of the French
Code de commerce
applicable to rent reviews and renewals of leases;
|
|
|
•
|
prohibited clauses restricting or excluding the tenant’s right to terminate the lease at the end of every three-year period, with the exception of leases of premises to be used exclusively as office space; and
|
|
|
•
|
imposed certain expenses, costs and taxes on the property owner.
|
In Germany, fixed-term lease agreements with a term exceeding one year can be terminated by the tenant prior to their contractually agreed expiration date if the tenant complies with certain formal requirements. These include the requirement that there would be a document that contains all the material terms of the lease agreement, including all attachments and addenda and the signatures of all parties thereto. While the details of the applicable formal requirements are assessed differently by various German courts, most courts agree that such requirements are, in principle, strict. If any of our lease agreements would not satisfy the strict written form requirements, the respective lease agreement could be deemed to have been concluded for an indefinite term. Consequently, such lease agreement could be terminated one year after handover of the respective property to the tenant at the earliest, and at the beginning of a calendar quarter to the end of the following calendar quarter, which may result in a significantly shorter term of the lease. As a result, some of our tenants might attempt to invoke alleged non-compliance with these formal requirements in order to procure an early termination of their lease agreements or a renegotiation of the terms of such lease agreements to our disadvantage.
Moreover, we rely on certain standardized contractual general terms and conditions in Germany. As a general rule, standardized terms are regarded to be invalid under German law if they are not clear and comprehensive or if they are disproportionate and provide an unreasonable disadvantage for the other party. It is impossible to fully avoid risks arising from the use of standardized contractual terms because of the frequency of changes that are made to the legal framework and particularly court decisions relating to general terms and conditions of business. Even in the case of contracts prepared with legal advice, problems of this nature cannot be fully prevented, either from the outset or in the future due to subsequent changes in the legal framework, particularly case law, making it impossible for us to avoid the ensuing legal disadvantages. Such developments could lead to claims being brought against us or us being forced to bear costs that we had expected to be borne by our tenants (e.g., decorative repair costs during the lease term and at lease-end, the allocation of ancillary costs).
Furthermore, our lease terms in Germany typically include an annual indexation that is linked to the consumer price index for Germany (
Verbraucherpreisindex für Deutschland
(
CPI
)), which is calculated monthly by the German Federal Statistical Office (
Statistisches Bundesamt
). In accordance with applicable German law, these clauses provide not only for upward adjustments but also for downward adjustments tied to changes in the CPI. Consequently, rental proceeds may decrease if the macroeconomic environment worsens and hence consumer prices decline. Furthermore, rent adjustments from indexation will generally only be triggered if certain thresholds of the CPI are met or exceeded, when compared to the index level at the beginning of the lease or the previous rent adjustment. Consequently, we cannot freely raise rents of ongoing leases in Germany.
Lease defaults, terminations or landlord-tenant disputes may reduce our income from our real estate investments.
The creditworthiness of our tenants in our real estate investments have been, or could become, negatively impacted as a result of challenging economic conditions or otherwise, which could result in their inability to meet the terms of their leases. Lease defaults or terminations by one or more tenants may reduce our revenues unless a default is cured or a suitable replacement tenant is found promptly. In addition, disputes may arise between the landlord and tenant that result in the tenant withholding rent payments, possibly for an extended period. These disputes may lead to litigation or other legal procedures to secure payment of the rent withheld or to evict the tenant. Upon a lease default, we may have limited remedies, be unable to accelerate lease payments or evict a defaulting tenant and have limited or no recourse against a guarantor. In addition, the legal process for evicting defaulting tenants may be lengthy and costly. Tenants as well as guarantors may have limited or no ability to satisfy any judgments we may obtain. We may also have duties to mitigate our losses and we may not be successful in that regard. Any of these situations may result in extended periods during which there is a significant decline in revenues or no revenues generated by a property. If this occurred, it could adversely affect our results of operations.
The bankruptcy, insolvency or financial deterioration of any of our tenants could significantly delay our ability to collect unpaid rents or require us to find new tenants.
Our financial position and our ability to make distributions to our stockholders may be adversely affected by financial difficulties experienced by any of our major tenants, including bankruptcy, insolvency or a general downturn in business, or the occurrence of any of our major tenants failing to renew or extend their lease.
We are exposed to the risk that our tenants may not be able to meet their obligations to us or other third parties, which may result in their bankruptcy or insolvency. Although some of our leases and loans permit us to evict a tenant, demand immediate repayment and pursue other remedies, bankruptcy laws afford certain rights to a party that has filed for bankruptcy or reorganization. A tenant in bankruptcy may be able to restrict our ability to collect unpaid rents or interest during the bankruptcy proceeding. Furthermore, dealing with a tenant bankruptcy or other default may divert management’s attention and cause us to incur substantial legal and other costs.
Bankruptcy laws vary across the different jurisdictions in Europe. In certain jurisdictions, a debtor or liquidator has the option to assume (continue) or reject (terminate) an unexpired lease. A debtor cannot choose to keep the beneficial provisions of a contract while rejecting the burdensome ones; the contract must be assumed (continued) or rejected (terminated) as a whole. In France, if the debtor chooses to continue an unexpired commercial lease, but still fails to pay rent in connection with the occupancy after the bankruptcy procedure commencement order, we cannot legally request the termination of the lease before the end of a three-month period from the date of issue of the order relating to the bankruptcy procedure commencement.
Our tenants’ forms of entities may cause special risks or hinder our recovery.
Most of our tenants in the real estate that we own are legal entities rather than individuals. The obligations these entities owe us are typically non-recourse so we can only look to our collateral, and at times, the assets of the entity may not be sufficient to recover our investment. As a result, our risk of loss may be greater than for leases with individuals. Unlike individuals involved in bankruptcies, these legal entities will generally not have personal assets and creditworthiness at stake. As a result, the default or bankruptcy of one of our tenants, or a general partner or managing member of that tenant, may impair our ability to enforce our rights and remedies under the terms of the lease agreement.
Compliance with fire and safety and other regulations may require us or our tenants to make unanticipated expenditures which could adversely affect our business, financial condition and results of operations and our ability to make distributions to our stockholders.
Our properties are required to comply with jurisdiction-specific fire and safety regulations, building codes and other land regulations and licensing or certification requirements as they may be adopted by governmental agencies and bodies from time-to-time. We may be required to incur substantial costs to comply with those requirements. Changes in labor and other laws could also negatively impact us and our tenants. For example, changes to labor-related statutes or regulations could significantly impact the cost of labor in the workforce, which would increase the costs faced by our tenants and increase their likelihood of default.
Environmental compliance costs and liabilities associated with our properties may materially impair the value of our investments and expose us to liability.
Under various international and local environmental laws, ordinances and regulations, a current or previous owner of real property, such as us, and our tenants, may be liable in certain circumstances for the costs of investigation, removal or remediation of, or related releases of, certain hazardous or toxic substances, including materials containing asbestos, at, under or disposed of in connection with such property, as well as certain other potential costs relating to hazardous or toxic substances, including government fines and damages for injuries to persons and adjacent property. In addition, some environmental laws create a lien on the contaminated site in favor of the government for damages and the costs it incurs in connection with the contamination. These laws often impose liability without regard to whether the owner knew of, or was responsible for, the presence or disposal of such substances and liability may be imposed on the owner in connection with the activities of a tenant at the property. The presence of contamination or the failure to remediate contamination may adversely affect our or our tenants’ ability to sell or lease real estate, or to borrow using the real estate as collateral, which, in turn, could reduce our revenues. We, or our tenants, as owner of a site, may be liable to third parties for damages and injuries resulting from environmental contamination emanating from the site. The cost of any required investigation, remediation, removal, fines or personal or property damages and our or our tenants’ liability could significantly exceed the value of the property without any limits.
The scope of the indemnification our tenants have agreed to provide us may be limited. For instance, some of our agreements with our tenants do not require them to indemnify us for environmental liabilities arising before the tenant took possession of the premises. Further, any such tenant may not be able to fulfill its indemnification obligations. If we were deemed liable for any such environmental liabilities and were unable to seek recovery against our tenant, our business, financial condition and results of operations could be materially and adversely affected.
We may make investments that involve property types and structures with which we have less familiarity, thereby increasing our risk of loss.
We may determine to invest in property types with which we have limited or no prior experience. When investing in property types with which we have limited or no prior experience, we may not be successful in our diligence and underwriting efforts. We may also be unsuccessful in preserving value if conditions deteriorate and we may expose ourselves to unknown substantial risks. Furthermore, these investments could require additional management time and attention relative to investments with which we are more familiar. All of these factors increase our risk of loss.
We may dispose of properties that no longer meet our strategic plans. If the proceeds of our dispositions are not what we expect, or if we cannot effectively and timely redeploy the proceeds from a disposal, there could be an adverse effect on our results of operations and our ability to make distributions to our stockholders.
We may dispose of properties that no longer meet our strategic plans. We then intend to use the proceeds generated from any potential disposition to acquire additional properties that meet the requirements of our strategic plans. We may not be able to dispose of properties for the amounts of proceeds we expect, or at all. In addition, if we are able to dispose of those properties, we may not be able to use the capital in a timely or more efficient manner. As such, we may not be able to adequately time any decrease in revenues from the sale of properties with a corresponding increase in revenues associated with the acquisition of new properties. The failure to dispose of properties, or to timely and more efficiently apply the proceeds from any disposition of properties to attractive acquisition opportunities could have an adverse effect on our results of operations and our ability to make distributions to our stockholders.
Uninsured losses relating to real estate and lender requirements to obtain insurance may reduce our returns.
There are types of losses relating to real estate, generally catastrophic in nature, such as losses due to wars, acts of terrorism, earthquakes, floods, hurricanes, pollution or environmental matters, for which we may not obtain insurance unless we are required to do so by our mortgage lenders. If any of our properties incurs a casualty loss that is not fully covered by insurance, the value of our assets will be reduced by any such uninsured loss. In addition, other than any reserves we may establish, we have no source of funding to repair or reconstruct any uninsured damaged property, and we cannot assure you that any such sources of funding will be available to us for such purposes in the future. Also, to the extent we must pay unexpectedly large amounts for uninsured losses, we could suffer reduced earnings that would result in less cash available for distribution to our stockholders. In cases where we are required by mortgage lenders to obtain casualty loss insurance for catastrophic events or terrorism, such insurance may not be available, or may not be available at a reasonable cost, which could inhibit our ability to finance or refinance our properties. Additionally, if we obtain such insurance, the costs associated with owning a property would increase and could have a material adverse effect on the net income from the property, and, thus, the cash available for distribution to our stockholders.
Risks Related to Our Financing Strategy
Changes in the method pursuant to which the benchmark rates are calculated and their potential discontinuance could adversely impact our business operations and financial results.
Our floating-rate funding and certain interest rate hedging transactions determine the applicable interest rate or payment amount by reference to a benchmark rate, such as the British pound sterling LIBOR (“GBP LIBOR”), EURIBOR (“Euro Interbank Offered Rate”), or U.S. dollar LIBOR (“USD LIBOR”). In the event any such benchmark rate or other referenced financial metric is significantly changed, replaced or discontinued, or ceases to be recognized as an acceptable market benchmark rate or financial metric, there may be uncertainty or differences in the calculation of the applicable interest rate or payment amount depending on the terms of the governing instrument, and there may be significant work required to transition to any new benchmark rate or other financial metric.
In July 2017, the Chief Executive of the U.K. Financial Conduct Authority (“FCA”) announced that the FCA intends to stop persuading or compelling banks to submit rates for the calculation of GBP LIBOR after 2021. This announcement indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021. The Bank of England and FCA in 2015 established the Working Group on Sterling Risk-Free Reference Rates (the “RFRWG”) to develop alternative risk-free rates, and in April 2017, the RFRWG has identified the Sterling Overnight Index Average (“SONIA”) as its recommended alternative to GBP LIBOR for use in new British pound sterling credit facilities, derivatives and other financial instruments.
Similarly, in the United States, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York in 2014 convened the Alternative Reference Rates Committee (“ARRC”) in order to identify best practices for alternative reference rates, identify best practices for contract robustness, develop an adoption plan, and create an implementation plan with metrics of success and a timeline. In June 2017, the ARRC identified the Secured Overnight Financing Rate (“SOFR”) as its recommended alternative to USD LIBOR for use in certain new U.S. credit facilities, dollar derivatives and other financial instruments.
In the case of EURIBOR, the relevant regulatory authorities called for the development of alternative interest rate benchmarks in line with the requirements imposed by the EU Benchmark Regulation (“BMR”) and imposed the authorization deadline of January
1, 2020. Currently, the European Central Bank and the European Money Markets Institute are working on reforming EURIBOR as BMR-compliant Hybrid EURIBOR as well as developing a new risk-free rate - ESTER - which may replace EURIBOR altogether.
Despite progress made to date by regulators and industry participants to prepare for the anticipated discontinuation of benchmark rates, especially GBP LIBOR, EURIBOR, and/or USD LIBOR, significant uncertainties still remain. Such uncertainties relate to, for example, whether the EURIBOR, GBP LIBOR, USD LIBOR and other similar benchmarks would continue to be viewed as acceptable market benchmark rates, what rate or rates may become accepted and endorsed by regulators as alternatives to GBP LIBOR, EURIBOR, and/or USD LIBOR, how any replacement would be implemented across the industry, and the effect of any changes in industry views or movement to alternative benchmarks would have on the markets for GBP LIBOR, EURIBOR, and/or USD LIBOR-linked financial instruments.
The discontinuation of a benchmark rate or other financial metric, changes in a benchmark rate or other financial metric, or changes in market perceptions of the acceptability of a benchmark rate or other financial metric, including GBP LIBOR, EURIBOR, and/or USD LIBOR, could, among other things result in increased interest payments, changes to our risk exposures, or require renegotiation of previous transactions. In addition, any such discontinuation or changes, whether actual or anticipated, could result in market volatility, adverse tax or accounting effects, increased compliance, legal and operational costs, and risks associated with contract negotiations.
We may not be able to access financing sources on attractive terms, if at all, which could adversely affect our ability to execute our business plan.
We use a variety of financing sources, including mortgage notes, credit facilities and other term borrowings, as well as preferred equity. For example, as of March 8, 2019, we had $0.7 billion of borrowings outstanding.
Our ability to effectively execute our financing strategy depends on various conditions in the financing markets that are beyond our control, including liquidity and credit spreads. While we seek non-recourse long-term financing, such financing may not be available to us on favorable terms or at all. If our strategy is not viable, we will have to find alternative forms of financing for our assets, which may include more restrictive recourse borrowings and borrowings with higher debt service that limit our ability to engage in certain transactions and reduce our cash available for distribution to stockholders. If alternative financing is not available on favorable terms, or at all, we may have to liquidate assets at unfavorable prices to pay off such financing. Our return on our investments and distributions to stockholders may be reduced to the extent that changes in market conditions cause the cost of our financing to increase relative to the earnings that we can derive from the assets we acquire or originate.
Substantially all of our borrowings are floating rate and fluctuations in interest rates may cause losses.
Substantially all of our existing borrowings bear, and future borrowing may bear, interest at variable rates. As market interest rates increase, the interest rate on our variable rate borrowings will increase and will create higher debt service requirements, which would adversely affect our cash flow and could adversely impact our results of operations. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political conditions and other factors beyond our control. While we may enter into agreements limiting our exposure to higher debt service requirements, any such agreements may not offer complete protection from this risk.
Our interest rate risk sensitive assets, liabilities and related derivatives are generally held for non-trading purposes. Based on our current portfolio, a hypothetical 100 basis point increase to the interest rate caps in the applicable benchmark (EURIBOR and GBP LIBOR) applied to our floating-rate liabilities and related derivatives would result in an increase in net interest expense of approximately
$4.2 million
.
In a period of rising interest rates, our interest expense could increase while the income we earn on our investments would not change, which would adversely affect our profitability.
Our operating results depend in large part on differences between the income from our investments less our operating costs, reduced by any credit losses and financing costs. Income from our investments may respond more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may influence our net income. Increases in these rates may decrease our net income. Interest rate fluctuations resulting in our interest expense exceeding the income from our investments could result in losses for us and may limit our ability to make distributions to our stockholders. In addition, if we need to repay existing borrowings during periods of rising interest rates, we could be required to liquidate one or more of our investments at times that may not permit realization of the maximum return on those investments, which would adversely affect our profitability.
Our Credit Facility permits us to make significant borrowings, which restrict our ability to engage in certain activities and could require that we generate significant cash flow or access the capital markets to satisfy the payment and other obligations.
We may in the future make significant borrowings under our Credit Facility. We could also obtain additional facilities or increase our line of credit on our existing facility in the future. Our Credit Facility contains various affirmative and negative covenants,
including, among other things, limitations on debt, liens and restricted payments, as well as financial covenants. Compliance with these covenants restrict our ability to engage in certain transactions, which could materially adversely affect our financial condition.
In addition, any future borrowings under our Credit Facility may exceed our cash on hand and/or our cash flows from operating activities. Our ability to meet the payment and other obligations under our Credit Facility depends on our ability to generate sufficient cash flow or access capital markets in the future. Our ability to generate cash flow or access capital markets, to some extent, is subject to general economic, financial, competitive, legislative and regulatory factors, as well as other factors that are beyond our control. We cannot assure you that our business will generate cash flow from operations, or that future borrowings will be available to us, in amounts sufficient to enable us to meet our payment obligations under our Credit Facility. If we are not able to generate sufficient cash flow to service our Credit Facility or other borrowing obligations, we may need to refinance or restructure our borrowings, reduce or delay capital investments, or seek to raise additional capital. There is no assurance we will be able to do any of the foregoing on favorable terms or at all. If we are unable to implement one or more of these alternatives, we may not be able to meet our payment obligations under our Credit Facility, which could materially and adversely affect our liquidity.
We may not be able to borrow under our Credit facility.
Our borrowings may restrict our ability to incur additional indebtedness, such as under our Credit Facility, which includes financial maintenance covenants and non-financial covenants. Breach of any such covenants would block additional borrowings under the facility. Our inability to borrow additional amounts could delay or prevent us from acquiring, financing, and completing desirable investments and could negatively affect our liquidity, which could materially and adversely affect our business. Inability to borrow could also prevent us from making distributions to our stockholders.
We are subject to risks associated with obtaining mortgage financing on our real estate, which could materially adversely affect our business, financial condition and results of operations and our ability to make distributions to our stockholders.
As of December 31, 2018, our real estate portfolio had $0.7 billion of total mortgage financing. Financing for new real estate investments and our maturing borrowings may be provided by credit facilities, private or public debt offerings, assumption of secured borrowings, mortgage financing on a portion of our owned portfolio or through joint ventures. We are subject to risks normally associated with financing, including the risks that our cash flow is insufficient to make timely payments of interest or principal, that we may be unable to refinance existing borrowings or support collateral obligations and that the terms of refinancing may not be as favorable as the terms of existing borrowing. If we are unable to refinance or extend principal payments due at maturity or pay them with proceeds from other capital transactions or the sale of the underlying property, our cash flow may not be sufficient in all years to make distributions to our stockholders and to repay all maturing borrowings. This may entitle secured creditors to exercise their rights under their credit documentation which may include an acceleration of their claims and a foreclosure of security. The rights of secured creditors will be jurisdiction specific, but in the United Kingdom, for example, this may include the appointment of a receiver pursuant to the Law of Property Act 1925 or under the terms of the security document who, in the latter case, will be entitled to take possession and control of the relevant secured properties subject to the mortgage and to exercise a power of sale of a property in order discharge the secured indebtedness. This creates a risk that the proceeds will be insufficient to provide us with any equity in those properties. Alternatively, certain secured creditors may have the right to appoint an administrator with respect to the property investments held by a company incorporated in the United Kingdom. An administrator is an officer of the court who will take possession, custody and control of the relevant company’s assets and undertakings and is able to exercise legislative powers that include a power of sale. The appointment of an administrator may similarly create a risk that the proceeds of realization of our assets in an administration will be insufficient to provide us with any equity in those properties or surplus proceeds.
Furthermore, if prevailing interest rates or other factors at the time of refinancing result in higher interest rates upon refinancing, the interest expense relating to that refinanced borrowing would increase, which could reduce our profitability and the amount of distributions we are able to pay to our stockholders. Moreover, additional financing increases the amount of our leverage, which could negatively affect our ability to obtain additional financing in the future or make us more vulnerable in a downturn in our results of operations or the economy generally.
Hedging against interest rate and currency exposure may adversely affect our earnings, limit our gains or result in losses, which could adversely affect cash available for distribution to our stockholders.
We have and may in the future enter into interest rate swap, cap or floor agreements or pursue other interest rate or currency hedging strategies. Our hedging activity will vary in scope based on interest rate levels, the type of investments held and other changing market conditions. Interest rate and/or currency hedging may fail to protect or could adversely affect us because, among other things:
|
|
•
|
interest rate and/or currency hedging can be expensive, particularly during periods of rising and volatile interest rates;
|
|
|
•
|
available interest rate and/or currency hedging may not correspond directly with the risk for which protection is sought;
|
|
|
•
|
the duration of the hedge may not match the duration of the related liability or investment;
|
|
|
•
|
our hedging opportunities may be limited by the treatment of income from hedging transactions under the rules determining REIT qualification;
|
|
|
•
|
the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction;
|
|
|
•
|
the counterparties with which we trade may cease making markets and quoting prices in such instruments, which may render us unable to enter into an offsetting transaction with respect to an open position;
|
|
|
•
|
the party owing money in the hedging transaction may default on its obligation to pay; and
|
|
|
•
|
we may purchase a hedge that turns out not to be necessary,
i.e.
, a hedge that is out of the money.
|
Any hedging activity we engage in may adversely affect our earnings, which could adversely affect cash available for distribution to our stockholders. Therefore, while we may enter into such transactions to seek to reduce interest rate and/or currency risks, unanticipated changes in interest rates or exchange rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in a hedging strategy and price movements in the portfolio positions being hedged or liabilities being hedged may vary materially. Moreover, for a variety of reasons, we may not be able to establish a perfect correlation between hedging instruments and the investments being hedged. Any such imperfect correlation may prevent us from achieving the intended hedge and expose us to risk of loss. We may also be exposed to liquidity issues as a result of margin calls or settlement of derivative hedges.
Hedging instruments often are not traded on regulated exchanges, guaranteed by an exchange or its clearinghouse or regulated by any foreign or U.S. governmental authorities and involve risks and costs.
The cost of using hedging instruments increases as the period covered by the instrument lengthens and during periods of rising and volatile interest rates and change in foreign currency exchange rates. We may increase our hedging activity and thus increase our hedging costs during periods when interest rates are volatile or rising or foreign currency exchange rates are unfavorable and hedging costs have increased. In addition, hedging instruments involve risk since they often are not traded on regulated exchanges, not guaranteed by an exchange or its clearing house, or are less regulated by foreign or U.S. governmental authorities than exchange traded instruments. Consequently, there are no regulatory or statutory requirements with respect to recordkeeping, financial responsibility or segregation of customer funds and positions. Furthermore, the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty with whom we may enter into a hedging transaction will most likely result in a default. Default by a party with whom we may enter into a hedging transaction may result in the loss of unrealized profits and force us to cover our resale commitments, if any, at the then current market price. It may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot assure you that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.
Refer to the below risk factor “- Risks Related to Regulatory Matters and Our REIT Tax Status” - The direct or indirect effects of the continuing implementation and enforcements by regulations of the Dodd-Frank Act, originally enacted in July 2010 for the purpose of stabilizing or reforming the financial markets, may have an adverse effect on our interest rate hedging activities for a discussion of how the Dodd-Frank Wall Street Reform Act, or the Dodd-Frank Act, may affect the use of hedging instruments.
Risks Related to Our Company
We may be subject to the actions of activist stockholders.
We may be the subject of increased activity by activist stockholders as stockholder activism generally is increasing. Responding to stockholder activism can be costly and time-consuming, create conflicts with our manager, disrupt our operations and divert the attention of our manager from executing our business plan. Activist campaigns can create perceived uncertainties as to our future direction, strategy or leadership and may result in the loss of potential business opportunities, harm our ability to attract new investors, tenants/operators/managers and joint venture partners and cause our stock price to experience periods of volatility or stagnation. Moreover, if individuals are elected to our board of directors with a specific agenda, even though less than a majority, our ability to effectively and timely implement our current initiatives and execute on our long-term strategy may be adversely affected.
The process undertaken by the Strategic Review Committee of our board of directors to review strategic alternatives, which may include a sale of the Company, could have an adverse impact on our business
.
On November 7, 2018, we announced that the Strategic Review Committee of our board of directors has engaged financial and legal advisors to review strategic alternatives, including considering a potential sale of the Company. We have incurred and will continue to incur substantial expenses in connection with exploring these strategic initiatives, and the review process will be time consuming and may disrupt our business operations. In addition, the strategic review process has diverted management attention and resources from the operation of our business and may therefore result in an adverse effect on our business and operations, including exposing us to potential litigation in connection with this process or any resulting transaction. In addition, there can be no assurance that the exploration of the corporate strategic initiatives will result in the sale of the Company or any of the Company’s assets.
The termination payment that we are obligated to pay our Manager under the Amendment will reduce the proceeds to our stockholders in the event of a sale of the Company
.
On November 7, 2018, we entered into the Amendment with our Manager providing for the termination of the Management Agreement upon a sale of the Company, or upon the internalization of the management of the Company. In connection with such termination, we will be obligated to make a termination payment to our Manager of $70 million, minus the amount of the incentive fees paid to the Manager under the Amendment (the “Termination Payment”). As a result, the amount of proceeds that stockholders would otherwise have received upon a sale of the Company will be reduced by the amount of the Termination Payment.
If we internalize our management rather than a sale of the Company, our ability to conduct our business may be adversely affected
.
Under the terms of the Amendment, if there is no definitive agreement in place to sell the Company by April 30, 2019, we are obligated to begin the process of internalizing management of the Company. We currently rely on persons employed by our Manager and its affiliates to manage our day-to-day operations. If we were to effect an internalization of our management, we may not be able to retain all of the employees of our Manager that currently assist in the management of the Company and who are most familiar with our business and operations. We may also have difficulty integrating these management functions as a stand-alone entity and we may fail to properly obtain the appropriate mix of personnel and capital needed to operate as a stand-alone entity, which could adversely affect our business.
In addition, while we would no longer bear the costs of the various fees and expenses we are currently obligated to pay our Manager under the Amendment, if we internalize our management we would incur general and administrative costs, including legal, accounting, SEC reporting and compliance and other expenses related to corporate governance, as well compensation and benefits costs of our officers and other employees, and such costs and expenses may be higher than the amount we currently pay our Manager. Any such increases in costs and expenses, along with the Termination Payment we would be obligated to pay to our Manager, could result in decreases to our net income and CAD (as defined below).
Distributions paid from sources other than our cash flows from operations will result in us having fewer funds available for the acquisition of properties and other real estate-related investments, which may adversely affect our ability to fund future distributions with cash flows from operations and may adversely affect a stockholder
’
s overall return.
We may pay distributions from sources other than from our cash flows from operations. Until we acquire additional properties or other real estate-related investments, we may not generate sufficient cash flows from operations to pay distributions. Our inability to acquire additional properties or other real estate-related investments may result in a lower return on a stockholder’s investment.
Failure of NorthStar Realty, a subsidiary of Colony Capital, to effectively perform its obligations to us could have an adverse effect on our business and performance.
In connection with the Spin-off, we entered into a separation agreement and various other agreements with NorthStar Realty. These agreements govern our relationship with NorthStar Realty and generally provide that all liabilities and obligations attributable to periods prior to the Spin-off. We and NorthStar Realty agreed to provide each other with indemnities with respect to liabilities arising out of the period after the Spin-off. We rely on NorthStar Realty to perform its obligations under these agreements. Following the Mergers, NorthStar Realty is a subsidiary of our Manager. Any such failure could lead to a decline or other adverse effects to our operating results and could harm our ability to execute our business plan.
We rely on our Manager for the performance of our information technology functions and our Manager’s failure to implement effective information and cyber security policies, procedures and capabilities could disrupt our business and harm our results of operations.
All of our information technology functions and data are maintained on our Manager’s systems and therefore we are dependent on the effectiveness of our Manager’s information and cyber security policies, procedures and capabilities to protect its computer and telecommunications systems and our data that resides on or is transmitted through them. An externally caused information security incident, such as a hacker attack, virus, worm, or natural disaster or an internally caused issue, such as failure to control
access to sensitive systems, could materially interrupt business operations or cause disclosure or modification of sensitive or confidential information and could result in material financial loss, loss of competitive position, regulatory actions, breach of contracts, reputational harm or legal liability. Such security incidents also could result in a violation of applicable U.S. and international privacy and other laws, and subject us to litigation and governmental investigations and proceedings, any of which could result in our exposure to material civil or criminal liability. For example, the EU adopted a new regulation that became effective in May 2018, called the General Data Protection Regulation (“GDPR”), which requires companies to meet new requirements regarding the handling of personal data, including its use, protection and the ability of persons whose data is stored to correct or delete such data about themselves. Failure to meet GDPR requirements could result in penalties of up to 4% of worldwide revenue. Our reputation could also be adversely impacted if we fail, or are perceived to have failed, to properly respond to these incidents. Such failure to properly respond could also result in similar exposure to liability. In addition, our Manager is dependent on information technology systems provided by other parties upon which it does not have control thus the performance of such systems may be affected due to failures or other information security events originating at suppliers or vendors (so called “fourth party risk”). We and our Manager may not be able to effectively monitor or mitigate fourth-party risk.
We may continue to grow our business through acquisitions, which entails substantial risk.
We may continue growing our business through acquisitions. Such acquisitions entail substantial risk. During our due diligence of such acquisitions, we may not uncover all relevant liabilities and we may have limited, if any, recourse against the sellers. We may also incur significant transaction and integration costs in connection with such acquisitions. Further, we may not successfully integrate the investments that we acquire into our business and operations, which could have a material adverse effect on our financial results and condition.
We believe cash available for distribution, or CAD and NOI, each a non-GAAP measure, provide meaningful indicators of our operating performance, however, CAD and NOI should not be considered as an alternative to net income (loss) determined in accordance with U.S. GAAP as indicators of operating performance.
Our management uses CAD and NOI, each a non-GAAP measure, to evaluate our profitability and our board of directors considers CAD and NOI in determining our quarterly cash distributions.
We believe that CAD is useful because it adjusts net income (loss) for a variety of non-cash items. We calculate CAD by subtracting from or adding to net income (loss) attributable to common stockholders, noncontrolling interests and the following items: depreciation and amortization items, including straight-line rental income or expense (excluding amortization of rent free periods), amortization of above/below market leases, amortization of deferred financing costs, amortization of discount on financings and other and equity-based compensation; other gain (loss), net (excluding any realized gain (loss) on the settlement on foreign currency derivatives); gain on sales, net; impairment on depreciable property; extinguishment of debt; acquisition gains or losses; transaction costs; foreign currency gains (losses) related to sales; goodwill impairment following the sale of operating real estate and other intangible assets; the incentive fee relating to the Amended and Restated Management Agreement; and one-time events pursuant to changes in U.S. GAAP and certain other non-recurring items. These items, if applicable, include any adjustments for unconsolidated ventures. The definition of CAD may be adjusted from time to time for our reporting purposes in our discretion, acting through our audit committee or otherwise.
We believe NOI is a useful metric of the operating performance of our real estate portfolio in the aggregate. Portfolio results and performance metrics represent 100% for all consolidated investments. NOI represents total property and related revenues, adjusted for: (i) amortization of above/below market leases; (ii) straight line rent (except with respect to rent free period); (iii) other items such as adjustments related to joint ventures and non-recurring bad debt expense and less property operating expenses.
However, the usefulness of NOI is limited because it excludes general and administrative costs, interest expense, transaction costs, depreciation and amortization expense, gains on sales, net and other items under U.S. GAAP and capital expenditures and leasing costs, all of which may be significant economic costs. NOI may fail to capture significant trends in these components of U.S. GAAP net income (loss) which further limits its usefulness.
CAD and NOI should not be considered as an alternative to net income (loss), determined in accordance with U.S. GAAP, as indicators of operating performance. In addition, our methodology for calculating CAD and NOI involves subjective judgment and discretion and may differ from the methodologies used by other comparable companies, including other REITs, when calculating the same or similar supplemental financial measures and may not be comparable with these companies. For example, our calculation of CAD per share will not take into account any potential dilution from any restricted stock units subject to performance metrics not yet achieved.
We believe that disclosing EPRA NAV, a non-GAAP measure used by other European real estate companies, helps investors compare our balance sheet to other European real estate companies; however, EPRA NAV should not be considered as an alternative to net assets determined in accordance with U.S. GAAP as a measure of our asset values.
As our entire portfolio is based in Europe, our management calculates European Public Real Estate Association net asset value, or EPRA NAV, a non-GAAP measure, to compare our balance sheet to other European real estate companies and believes that
disclosing EPRA NAV provides investors with a meaningful measure of our net asset value. Our calculation of EPRA NAV is derived from our U.S. GAAP balance sheet with adjustments reflecting our interpretation of EPRA’s best practices recommendations. Accordingly, our calculation of EPRA NAV may be different from how other European real estate companies calculate EPRA NAV, which utilize International Financial Reporting Standards (“IFRS”) to prepare their balance sheet. EPRA NAV makes adjustments to net assets as determined in accordance with U.S. GAAP in order to provide our stockholders a measure of fair value of our assets and liabilities with a long-term investment strategy. This performance measure excludes assets and liabilities that are not expected to materialize in normal circumstances. EPRA NAV includes the revaluation of investment properties and excludes the fair value of financial instruments that we intend to hold to maturity, deferred tax and goodwill that resulted from deferred tax. All other assets, including real property and investments reported at cost are adjusted to fair value based upon an independent third party valuation conducted in December and June of each year. This measure should not be considered as an alternative to measuring our net assets in accordance with U.S. GAAP.
The use of estimates and valuations may be different from actual results, which could have a material effect on our consolidated financial statements.
We make various estimates that affect reported amounts and disclosures. Broadly, those estimates are used in measuring the fair value of our assets, establishing provision for losses and potential litigation liability. Market volatility may make it difficult to determine the fair value for certain of our assets and liabilities. Subsequent valuations, in light of factors then prevailing, may result in significant changes in the values of these assets in future periods. In addition, at the time of any sales and settlements of these assets and liabilities, the price we ultimately realize will depend on the demand and liquidity in the market at that time for that particular type of asset and may be materially lower than our estimate of their current fair value. Estimates are based on available information and judgment. In addition, the value of the assets in our portfolio may differ from our estimates. Therefore, actual values and results could differ from our estimates and that difference could have a material adverse effect on our consolidated financial statements.
Our distribution policy is subject to change.
Our board of directors determines an appropriate distribution on our common stock based upon numerous factors, including REIT qualification requirements, the amount of cash flow generated from operations, availability of existing cash balances, borrowing capacity under existing credit agreements, access to cash in the capital markets and other financing sources, our view of our ability to realize gains in the future through appreciation in the value of our investments, general economic conditions and economic conditions that more specifically impact our business or prospects. Our board of directors expects to review changes to our distribution on a quarterly basis and distribution levels are subject to adjustment based upon any one or more of the risk factors set forth in this Annual Report on Form 10-K, as well as other factors that our board of directors may, from time-to-time, deem relevant to consider when determining an appropriate distribution on our common stock.
We may not be able to make distributions in the future.
Our ability to generate income and to make distributions to our stockholders may be adversely affected by the risks described in this Annual Report on Form 10-K and any document we file with the SEC. All distributions are made at the discretion of our board of directors, subject to applicable law, and depend on our earnings, our financial condition, maintenance of our REIT qualification and such other factors as our board of directors may deem relevant from time-to-time. We may not be able to make distributions in the future or we may have to reduce our distribution rate.
There can be no assurance that we will continue to repurchase our common stock or that we will repurchase stock at favorable prices.
Our board of directors has approved a stock repurchase program and may approve additional repurchase programs in the future. The amount and timing of stock repurchases are subject to capital availability and our determination that stock repurchases are in the best interest of our stockholders and are in compliance with all respective laws and our agreements applicable to the repurchase of stock. Our ability to repurchase stock will depend upon, among other factors, our cash balances and potential future capital requirements, our results of operations, financial condition and other factors beyond our control that we may deem relevant. A reduction in, or the completion or expiration of, our stock repurchase program could have a negative effect on our stock price. We can provide no assurance that we will repurchase stock at favorable prices, if at all. Further, stock repurchases result in increased leverage, which increases the risk of loss associated with our business.
Our ability to make distributions is limited by the requirements of Maryland law.
Our ability to make distributions on our common stock is limited by the laws of Maryland. Under applicable Maryland law, a Maryland corporation generally may not make a distribution if, after giving effect to the distribution, the corporation would not be able to pay its liabilities as the liabilities become due in the usual course of business, or generally if the corporation’s total assets would be less than the sum of its total liabilities plus, unless the corporation’s charter provides otherwise, the amount that would be needed if the corporation were dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution
of the stockholders whose preferential rights are superior to those receiving the distribution. We may not make a distribution on our common stock unless permitted by Maryland law.
We may change our investment strategy without stockholder consent and make riskier investments.
We may change our investment strategy at any time without the consent of our stockholders, which could result in us making investments that are different from and possibly riskier than our existing investments. A change in our investment strategy may increase our exposure to interest rate and commercial real estate market fluctuations.
Stockholders have limited control over changes in our policies and operations, which increases the uncertainty and risks they face as stockholders.
Our board of directors exclusively determines our indebtedness, capitalization, dividends, acquisitions of investments, and other major policies, including our policies regarding growth, REIT qualification and distributions. Our board of directors may amend or revise these and other policies without a vote of the stockholders. We may change our investment policies without stockholder notice or consent, which could result in investments that are different than, or in different proportion than, those described in this Annual Report on Form 10-K. Under the Maryland General Corporation Law, or MGCL, and our charter, stockholders have a right to vote only on limited matters. Our board of directors’ broad discretion in setting policies and our stockholders’ inability to exert control over those policies increases the uncertainty and risks stockholders face.
Certain provisions of Maryland law may limit the ability of a third-party to acquire control of us, which could depress our stock price.
Certain provisions of the MGCL may have the effect of inhibiting a third-party from acquiring us or of impeding a change of control under circumstances that otherwise could provide our stockholders with the opportunity to realize a premium over the then-prevailing market price of such shares, including:
|
|
•
|
“business combination”
provisions that, subject to limitations, prohibit certain business combinations between an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our outstanding shares of voting stock or an affiliate or associate of the corporation who, at any time within the two-year period immediately prior to the date in question, was the beneficial owner of 10% or more of the voting power of the then outstanding stock of the corporation) or an affiliate of any interested stockholder and us for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter imposes two super-majority stockholder voting requirements on these combinations; and
|
|
|
•
|
“control share”
provisions that provide that holders of “control shares” of our company defined as voting shares of stock that, if aggregated with all other shares of stock owned or controlled by the acquirer or in respect of which the acquirer is able to exercise or direct the exercise of voting power (except solely by virtue of a revocable proxy), would entitle the acquirer to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of issued and outstanding “control shares,” subject to certain exceptions) have no voting rights except to the extent approved by stockholders by the affirmative vote of at least two-thirds of all of the votes entitled to be cast on the matter, excluding all interested shares.
|
Pursuant to the Maryland Business Combination Act, our board of directors will exempt any business combinations between us and any person, provided that any such business combination is first approved by our board of directors (including a majority of our directors who are not affiliates or associates of such person). Additionally, our board of directors has exempted any business combinations between us and our Manager, any of its affiliates or any of their sponsored or other managed companies. Consequently, the five-year prohibition and the super-majority vote requirements do not apply to business combinations between us and any of them. As a result, such parties may be able to enter into business combinations with us that may not be in the best interest of stockholders, without compliance with the supermajority vote requirements and the other provisions in the statute. Our bylaws contain a provision exempting from the Maryland Control Share Acquisition Act any and all acquisitions by any person of shares of our stock. There can be no assurance that these resolutions or exemptions will not be amended or eliminated at any time in the future.
Our authorized but unissued common and preferred stock and other provisions of our charter and bylaws may prevent a change in our control.
Our charter authorizes us to issue additional authorized but unissued shares of our common stock or preferred stock and authorizes a majority of our entire board of directors, without stockholder approval, to amend our charter to increase or decrease the aggregate number of shares of stock or the number of shares of stock of any class or series that we have the authority to issue. In addition, our board of directors may classify or reclassify any unissued shares of our common stock or preferred stock and may set the preferences, conversions or other rights, voting powers and other terms of the classified or reclassified shares. Our board of directors could establish a series of common stock or preferred stock that could delay or prevent a transaction or a change in control that might involve a premium price for the common stock or otherwise be in the best interest of stockholders.
Our charter and bylaws contains other provisions that may delay or prevent a transaction or a change in control that might involve a premium price for shares of our common stock or otherwise be in the best interest of our stockholders.
Maryland law also allows a corporation with a class of equity securities registered under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and at least three independent directors to elect to be subject, by provision in its charter or bylaws or a resolution of its board of directors and notwithstanding any contrary provision in its charter or bylaws, to a classified board, unless its charter prohibits such an election. Our charter contains a provision prohibiting such an election to classify our board of directors under this provision of Maryland law. This may make us more vulnerable to a change in control. If stockholders voted to amend this charter provision and to classify our board of directors, the staggered terms of our directors could reduce the possibility of a tender offer or an attempt at a change in control even though a tender offer or change in control might be in the best interests of stockholders.
Risks Related to Regulatory Matters and Our REIT Tax Status
We are subject to substantial regulation, numerous contractual obligations and extensive internal policies and failure to comply with these matters could have a material adverse effect on our business, financial condition and results of operations.
We and our subsidiaries are subject to substantial regulation, numerous contractual obligations and extensive internal policies. Given our organizational structure, we are subject to regulation by the SEC, NYSE, Internal Revenue Service, or IRS, and other international, federal, state and local governmental bodies and agencies. These regulations are extensive, complex and require substantial management time and attention. If we fail to comply with any of the regulations that apply to our business, we could be subjected to extensive investigations as well as substantial penalties and our business and operations could be materially adversely affected. Our lack of compliance with applicable law could result in among other penalties, our ineligibility to contract with and receive revenue from the federal government or other governmental authorities and agencies. We also have numerous contractual obligations that we must adhere to on a continuous basis to operate our business, the default of which could have a material adverse effect on our business and financial condition. We established internal policies designed to ensure that we manage our business in accordance with applicable law and regulation and in accordance with our contractual obligations. While we designed policies to appropriately operate our business, these internal policies may not be effective in all regards and, further, if we fail to comply with our internal policies, we could be subjected to additional risk and liability.
The direct or indirect effects of the continuing implementation and enforcement by regulators of the Dodd-Frank Act, originally enacted in July 2010 for the purpose of stabilizing or reforming the financial markets, may have an adverse effect on our interest rate hedging activities.
In July 2010, the Dodd-Frank Act became law in the United States. Title VII of the Dodd-Frank Act provided for significantly increased regulation of and restrictions on derivatives markets and transactions that could affect our interest rate hedging or other risk management activities, including: (i) regulatory reporting for swaps; (ii) mandated clearing through central counterparties and execution through regulated exchanges or electronic facilities for certain swaps; and (iii) margin and collateral requirements for certain uncleared swaps. The U.S. Commodity Futures Trading Commission has finalized the majority of the requirements that are to take effect, such as swap reporting, the mandatory clearing of certain interest rate swaps and credit default swaps and the mandatory trading of certain swaps on swap execution facilities or exchanges. The full potential impact of the Dodd-Frank Act on our interest rate hedging activities has been in part mitigated by our ability in some instances to rely on exemptions from certain requirements that are available for swaps used for commercial hedging activities (including exemptions from the exchange trading, mandatory clearing and margin requirements). Nonetheless, our counterparties typically cannot rely on these exemptions for their broader business, and this can result in increased costs or lower liquidity for their customers, thus potentially limiting our ability to hedge. In addition, regulators continue to implement and/or revise other Dodd-Frank Act rules and regulations, and market practices related to the implementation of Dodd-Frank Act requirements in practice continue to develop, and thus the requirements of Title VII may affect our ability to enter into hedging or other risk management transactions, may increase our costs in entering into such transactions and may result in us entering into such transactions on less favorable terms than prior to effectiveness of the Dodd-Frank Act and the rules promulgated thereunder. The occurrence of any of the foregoing events may have an adverse effect on our business.
If we are deemed an investment company under the Investment Company Act, our business would be subject to applicable restrictions under the Investment Company Act, which could make it impracticable for us to continue our business as contemplated and would have a material adverse impact on the market price of our common stock.
We do not believe that we are an “investment company” under the Investment Company Act because we are not, and we do not hold ourselves out, as being engaged primarily in the business of investing, reinvesting or trading in securities, and thus we do not fall within the definition of investment company provided in Section 3(a)(1)(A) of the Investment Company Act. Instead, we are in the business of commercial real estate. In addition, we satisfy the 40% test provided in Section 3(a)(1)(C) of the Investment Company Act. This test, described in more detail under “Business-Regulation-Policies Related to the Investment Company Act” below, provides that issuers that own or propose to acquire investment securities having a value exceeding 40% of the value of the issuer’s total assets are investment companies. Because of the nature of our assets, we do not expect to own investment
securities. Instead, we own commercial real estate through our wholly-owned and majority-owned subsidiaries. Thus, we seek to conduct our operations so that we will not be deemed an investment company under the Investment Company Act. If we were to be deemed an investment company, however, either because of SEC interpretation changes or otherwise, we could, among other things, be required either: (i) to substantially change the manner in which we conduct our operations to avoid being required to register as an investment company; or (ii) to register as an investment company, either of which could have an adverse effect on us and the market price of our common stock. If we are required to register as an investment company under the Investment Company Act, we would become subject to substantial regulation with respect to our capital structure (including our ability to use leverage), management, operations, transactions with affiliated persons (as defined in the Investment Company Act), portfolio composition, including restrictions with respect to diversification and industry concentration and other matters.
Failure to qualify as a REIT, or failure to remain qualified as a REIT, would cause us to be taxed as a regular corporation, which would substantially reduce funds available for distributions to our stockholders.
We believe that our organization and method of operation have enabled us to meet the requirements for qualification and taxation as a REIT commencing with our taxable year ended December 31, 2015, and we intend to continue to operate in a manner so as to continue to qualify as a REIT. However, we cannot assure you that we will remain qualified as a REIT. Our qualification and taxation as a REIT will depend upon our ability to meet on a continuing basis, through actual annual operating results, certain qualification tests set forth in the U.S. federal tax laws. Accordingly, no assurance can be given that our actual results of operations for any particular taxable year will satisfy such requirements.
If we fail to qualify as a REIT in any taxable year, we will face serious tax consequences that will substantially reduce the funds available for distributions to our stockholders because:
|
|
•
|
we would not be allowed a deduction for dividends paid to stockholders in computing our taxable income and would be subject to U.S. federal income tax at regular corporate rates;
|
|
|
•
|
we could be subject to the U.S. federal alternative minimum tax and possibly increased state and local taxes; and
|
|
|
•
|
unless we are entitled to relief under certain U.S. federal income tax laws, we could not re-elect REIT status until the fifth calendar year after the year in which we failed to qualify as a REIT.
|
In addition, if we fail to qualify as a REIT, we will no longer be required to make distributions. As a result of all these factors, our failure to qualify as a REIT could impair our ability to expand our business and raise capital, and it could adversely affect the value of our common stock.
If NorthStar Realty, a subsidiary of Colony Capital, failed to qualify as a REIT in its 2015 taxable year, we would be prevented from electing to qualify as a REIT.
We believe that from the time of our formation until the date of our separation from NorthStar Realty, we were treated as a “qualified REIT subsidiary” of NorthStar Realty. Under applicable Treasury regulations, if NorthStar Realty failed to qualify as a REIT in its 2015 taxable year, unless NorthStar Realty’s failure was subject to relief under U.S. federal income tax laws, we would be prevented from electing to qualify as a REIT prior to the fifth calendar year following the year in which NorthStar Realty failed to qualify.
Complying with REIT requirements may force us to borrow funds to make distributions to our stockholders or otherwise depend on external sources of capital to fund such distributions.
To qualify as a REIT, we are required to distribute annually at least 90% of our taxable income, subject to certain adjustments, to stockholders. To the extent that we satisfy the distribution requirement, but distribute less than 100% of our taxable income, we will be subject to U.S. federal corporate income tax on our undistributed taxable income. In addition, we may elect to retain and pay income tax on our net long-term capital gain. In that case, a stockholder would be taxed on its proportionate share of our undistributed long-term gain and would receive a credit or refund for its proportionate share of the tax we paid. A stockholder, including a tax-exempt or foreign stockholder, would have to file a U.S. federal income tax return to claim that credit or refund. Furthermore, we will be subject to a 4% nondeductible excise tax if the actual amount that we distribute to stockholders in a calendar year is less than a minimum amount specified under U.S. federal tax laws. We anticipate that distributions generally will be taxable as ordinary income, although a portion of such distributions may be designated by us as long-term capital gain to the extent attributable to capital gain income recognized by us, or may constitute a return of capital to the extent that such distribution exceeds our earnings and profits as determined for tax purposes.
From time-to-time, we may generate taxable income greater than our net income (loss) for U.S. GAAP, due to among other things, amortization of capitalized purchase premiums, fair value adjustments and reserves. In addition, our taxable income may be greater than our cash flow available for distribution to stockholders as a result of, among other things, repurchases of our outstanding debt at a discount and investments in assets that generate taxable income in advance of the corresponding cash flow from the assets (for example, if a borrower defers the payment of interest in cash pursuant to a contractual right or otherwise).
If we do not have other funds available in the situations described in the preceding paragraph, we could be required to borrow funds on unfavorable terms, sell investments at disadvantageous prices or find another alternative source of funds to make distributions sufficient to enable us to distribute enough of our taxable income to satisfy the REIT distribution requirement and to avoid corporate income tax and the 4% excise tax in a particular year. These alternatives could increase our costs or reduce our equity.
Because of the distribution requirement, it is unlikely that we will be able to fund all future capital needs, including capital needs in connection with investments, from cash retained from operations. As a result, to fund future capital needs, we likely will have to rely on third-party sources of capital, including both debt and equity financing, which may or may not be available on favorable terms or at all. Our access to third‑party sources of capital will depend upon a number of factors, including the market’s perception of our growth potential and our current and potential future earnings and cash distributions and the market price of our stock.
We could fail to qualify as a REIT and/or pay additional taxes if the IRS recharacterizes the structure of certain of our European investments.
We have funded our equity in certain of our European investments through the use of instruments that we believe will be treated as equity for U.S. federal income tax purposes. If the IRS disagreed with such characterization and was successful in recharacterizing the nature of our investments in European jurisdictions, we could fail to satisfy one or more of the asset and gross income tests applicable to REITs. Additionally, if the IRS recharacterized the nature of our investments and we were to take action to prevent such REIT test failures, the actions we would take could expose us to increased taxes both internationally and in the United States.
We could be subject to increased taxes if the tax authorities in various European jurisdictions were to modify tax rules and regulations on which we have relied in structuring our European investments.
We comply with local tax rules, regulations, tax authority rulings and international tax treaties in structuring our investments. Should changes occur to these rules, regulations, rulings or treaties, the amount of taxes we pay with respect to our investments may increase.
If, in order to meet the REIT distribution requirement, we must repatriate cash from various European jurisdictions at a higher level than planned, we could be subject to additional taxes in such European jurisdictions.
As discussed above, we comply with local tax rules, regulations, tax authority rulings and international tax treaties in structuring our investments. Our tax treatment under such rules, regulations, rulings and treaties may be dependent, in part, on the timing, amount and level of ownership from which we repatriate cash from European jurisdictions. If, in order to meet the REIT distribution requirement, we must repatriate cash from those jurisdictions at certain times and in certain amounts we could be subject to additional taxes in such European jurisdictions.
Even if we qualify as a REIT, we may be subject to tax (including foreign taxes for which we will not be permitted to pass-through any foreign tax credit to our stockholders), which would reduce the amount of cash available for distribution to our stockholders.
Even if we qualify as a REIT, we may be subject to foreign, U.S. federal, state and local taxes, including alternative minimum taxes and foreign, state or local income, franchise, property and transfer taxes. For example, we intend to make investments solely in real properties located outside the United States through foreign entities. Such entities may be subject to local income and property taxes in the jurisdiction in which they are organized or where their assets are located. In addition, in certain circumstances, we may be subject to non-U.S. withholding tax on repatriation of earnings from such non-U.S. entities. To the extent we are required to pay any such taxes we will not be able to pass through to our stockholders any foreign tax credit with respect to our payment of any such taxes.
To the extent we distribute less than 100% of our taxable income, we will be subject to U.S. federal corporate income tax on our undistributed income and will incur a 4% non-deductible excise tax on the amount, if any, by which our distributions in any calendar year are less than a minimum amount specified under the Internal Revenue Code. In addition, we could in certain circumstances be required to pay an excise or penalty tax, which could be significant in amount, in order to utilize one or more relief provisions under the Internal Revenue Code to maintain qualification for taxation as a REIT. Furthermore, we may hold some of our assets through taxable REIT subsidiaries, or TRSs. Any TRS or other taxable corporation in which we own an interest could be subject to U.S. federal, state and local income taxes at regular corporate rates if such entities are formed as domestic entities or generate income from U.S. sources or activities connected with the United States, and also will be subject to any applicable foreign taxes. Any of these taxes would decrease the amount available for distribution to our stockholders.
Complying with REIT requirements may cause us to forego otherwise attractive opportunities or liquidate otherwise attractive investments.
To qualify as a REIT for U.S. federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to stockholders and the ownership of our stock. As discussed above, we may be required to make distributions to stockholders at disadvantageous times or when we
do not have funds readily available for distribution. Additionally, we may be unable to pursue investments that would be otherwise attractive to us in order to satisfy the source of income requirements for qualifying as a REIT.
We must also ensure that, at the end of each calendar quarter, at least 75% of the value of our assets consists of cash, cash items, government securities and qualified real estate assets, including certain mortgage loans and mortgage-backed securities, personal property leased in connection with the real property to the extent the rents attributable to such property are treated as “rents from real property,” and debt instruments issued by “publicly offered REITs” (i.e. REITs that are required to file annual and periodic reports with the SEC under the Exchange Act). The remainder of our investment in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our assets can consist of the securities of any one issuer (other than government securities and qualified real estate assets) and no more than 20% (25% for taxable years beginning on or before December 31, 2017) of the value of our total securities can be represented by securities of one or more TRSs. Lastly, no more than 25% of the value of our total securities can be represented by debt instruments of “publicly offered REITs” to the extent such debt instruments are not secured by real property or interests in real property.
If we fail to comply with these requirements at the end of any calendar quarter, we must correct such failure within 30 days after the end of the calendar quarter to avoid losing our REIT status and suffering adverse tax consequences, unless certain relief provisions apply. As a result, compliance with the REIT requirements may hinder our ability to operate solely on the basis of profit maximization and may require us to liquidate investments from our portfolio, or refrain from making, otherwise attractive investments. These actions could have the effect of reducing our income and amounts available for distribution to stockholders.
Complying with REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Internal Revenue Code may limit our ability to hedge the risks inherent to our operations. Under current law: (i) any transaction entered into in the normal course of our trade or business primarily to manage the risk of interest rate or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, to acquire or carry real estate assets; (ii) any transaction entered into primarily to manage the risk of currency fluctuations with respect to any item of income or gain that would be qualifying income under the 75% or 95% gross income test (or any property which generates such income or gain); and (iii) any transaction entered into to “offset” a transaction described in clause (i) or (ii) if a portion of the hedged indebtedness is extinguished, or the related property is disposed of, will not constitute gross income for purposes of the 75% and 95% income requirements applicable to REITs. Beginning with our 2016 and subsequent taxable years, any transaction entered into in the normal course of our trade or business primarily to manage interest rate risk or price changes with respect to any previous hedging transaction with respect to which the related borrowing or obligation has been extinguished will also not constitute gross income for purposes of the 75% and 95% income requirements applicable to REITs. We are required to clearly identify any such hedging transaction before the close of the day on which it was acquired, originated or entered into and to satisfy other identification requirements in order to be treated as a qualified hedging transaction. In addition, any income from certain other qualified hedging transactions would generally not constitute gross income for purposes of both the 75% and 95% income tests. However, we may be required to limit the use of hedging techniques that might otherwise be advantageous, which could result in greater risks associated with interest rate or other changes than we would otherwise incur. We intend to structure any hedging transactions in a manner that does not jeopardize our qualification as a REIT.
Currency fluctuations could adversely impact our ability to satisfy the REIT requirements.
Substantially all of our operating income and expense is denominated in currencies where our assets are located and our Operating Partnership pays distributions in foreign currencies or U.S. dollars. Accordingly, our Operating Partnership holds various foreign currencies at any given time and may enter into foreign currency hedging transactions. The U.S. federal income tax rules regarding foreign currency transactions could adversely impact our compliance with the REIT requirements. For example, changes in the U.S. dollar value of the currencies of our operations will impact the determination of our gross income from such operations for U.S. federal income tax purposes. Variations in such currency values could therefore adversely affect our ability to satisfy the REIT gross income tests. In addition, foreign currency held by our Operating Partnership could adversely affect our ability to satisfy the REIT asset tests to the extent our Operating Partnership holds foreign currency on its balance sheet other than its functional currency or otherwise holds any foreign currency that is not held in the normal course of the activities of our Operating Partnership which give rise to qualifying income under the 95% or 75% gross income tests or are directly related to acquiring or holding qualifying assets under the 75% asset test.
If any of our activities do not comply with the applicable REIT requirements, the U.S. federal income tax rules applicable to foreign currencies could magnify the adverse impact of such activities on our REIT compliance. For example, if we receive a distribution from our Operating Partnership that is attributable to operations within a particular foreign jurisdiction, we could recognize foreign currency gain or loss based on the fluctuation in the U.S. dollar value of the local currency of such jurisdiction between the time that the underlying income was recognized and the time of such distribution. Provided that the segment of our Operating Partnership’s business to which such distribution is attributable satisfies certain of the REIT income and asset tests on
a standalone basis, any foreign currency gain resulting from such distribution will be excluded for purposes of the REIT gross income tests. However, if such segment did not satisfy the applicable REIT income and asset tests on a standalone basis, any currency gain resulting from such distribution may be non-qualifying income for purposes of the REIT gross income tests, which would adversely affect our ability to satisfy such tests. As another example, foreign currency gain attributable to our holding of certain obligations, including currency hedges of such obligations, will be excluded for purposes of the 95% gross income test, but not the 75% gross income test. However, if such gains are attributable to cash awaiting distribution or reinvestment, such gains may be non-qualifying income under the 75% and 95% gross income tests. Furthermore, the impact of currency fluctuations on our compliance with the REIT requirements could be difficult to predict.
The U.S. federal income tax rules regarding foreign currency transactions are complex, in certain respects uncertain, and limited authority is available regarding the application of such rules. As a result, there can be no assurance that the IRS will not challenge the manner in which we apply such rules to our operations. Any successful challenge could increase the amount which we are required to distribute to our stockholders in order to qualify as a REIT or otherwise adversely impact our compliance with the REIT requirements.
Liquidation of assets may jeopardize our REIT qualification.
To qualify as a REIT, we must comply with requirements regarding our assets and our sources of income. If we are compelled to liquidate our investments to satisfy our obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% prohibited transaction tax on any resulting gain if we sell assets that are treated as dealer property or inventory.
Legislative or regulatory tax changes could adversely affect us or our stockholders.
The present U.S. federal income tax treatment of REITs may be modified, possibly with retroactive effect, by legislative, judicial or administrative action at any time, which could affect the U.S. federal income tax treatment of an investment in us. The REIT rules are constantly under review by persons involved in the legislative process and by the IRS and the U.S. Treasury Department which may result in statutory changes as well as revisions to regulations and interpretations. Changes to the U.S. federal tax laws and interpretations thereof could adversely affect an investment in our common stock.
On December 22, 2017, the Tax Cuts and Jobs Act was signed into law. The Tax Cuts and Jobs Act made significant changes to the U.S. federal income tax rules governing the taxation of individuals and corporations, generally effective for taxable years beginning after December 31, 2017. In addition to reducing corporate and non-corporate tax rates, the Tax Cuts and Jobs Act eliminated or restricted various deductions. Most of the changes applicable to individuals are temporary and apply only to taxable years beginning after December 31, 2017 and before January 1, 2026. The Tax Cuts and Jobs Act made numerous large and small changes to tax rules that do not affect REITs directly, but may affect our stockholders and may indirectly affect us.
While the changes in the Tax Cuts and Jobs Act generally are favorable with respect to REITs, the extensive changes to the non-REIT provisions of the Internal Revenue Code may have unanticipated impacts on us or our stockholders. The individual and collective impact of these changes on REITs and their stockholders remain uncertain in some respects and their full impact may not become evident for some period of time. Investors are urged to consult their tax advisors with respect to the Tax Cuts and Jobs Act and any other legislative, regulatory or administrative developments and proposals and their potential effect on an investment in our common stock.
We may be subject to the REIT prohibited transactions tax as a result of executing on our capital recycling plan, which could result in a significant U.S. federal income tax liability to us.
We have disposed of certain non-strategic assets in conjunction with our capital recycling plan. A REIT will incur a 100% tax on the net income from prohibited transactions. Generally, a prohibited transaction includes a sale or disposition of property held primarily for sale to customers in the ordinary course of a trade or business. While we believe that any dispositions of our assets pursuant to our capital recycling plan should not be treated as prohibited transactions, and although we intend to conduct our operations so that we will not be treated as holding our properties for sale, whether a particular sale will be treated as a prohibited transaction depends on the underlying facts and circumstances and we have not sought and do not intend to seek, a ruling from the IRS on that issue. Accordingly, we cannot assure you that the IRS would not successfully assert a contrary position with respect to our dispositions. If all or a significant portion of our dispositions were treated as prohibited transactions, we would incur a significant U.S. federal income tax liability, which could have a material adverse effect on our results of operations.
We may distribute our common stock in a taxable distribution, in which case stockholders may sell shares of our common stock to pay tax on such distributions, placing downward pressure on the market price of our common stock.
We may make taxable distributions that are payable in cash and our common stock. The IRS has issued Revenue Procedure 2017-45 authorizing elective cash/stock dividends to be made by publicly offered REITs (e.g., REITs that are required to file annual and periodic reports with the SEC under the Exchange Act). Pursuant to Revenue Procedure 2017-45, effective for distributions declared on or after August 11, 2017, the IRS will treat the distribution of stock pursuant to an elective cash/stock dividend as a distribution
of property under Section 301 of the Internal Revenue Code (e.g., a dividend), as long as at least 20% of the total dividend is available in cash and certain other parameters detailed in the Revenue Procedure are satisfied. If we made a taxable distribution payable in cash and our common stock, taxable stockholders receiving such distributions will be required to include the full amount of the distribution, which is treated as ordinary income to the extent of our current and accumulated earnings and profits, as determined for U.S. federal income tax purposes. As a result, stockholders may be required to pay income tax with respect to such distributions in excess of the cash distributions received. If a U.S. stockholder sells our common stock that it receives as a distribution in order to pay this tax, the sales proceeds may be less than the amount recorded in earnings with respect to the distribution, depending on the market price of our common stock at the time of the sale. Furthermore, with respect to certain non-U.S. stockholders, we may be required to withhold U.S. federal income tax with respect to such distributions, including in respect of all or a portion of such distribution that is payable in our common stock. If we made a taxable distribution payable in cash and our common stock and a significant number of stockholders determine to sell shares of our common stock in order to pay taxes owed on distributions, it may put downward pressure on the trading price of our common stock.
The stock ownership restrictions of the Internal Revenue Code for REITs and the 9.8% stock ownership limit in our charter may inhibit market activity in our stock and restrict our business combination opportunities.
To qualify as a REIT, five or fewer individuals, as defined in the Internal Revenue Code, may not own, actually or constructively, more than 50% in value of our issued and outstanding stock at any time during the last half of a taxable year. Attribution rules in the Internal Revenue Code determine if any individual or entity actually or constructively owns our stock under this requirement. Additionally, at least 100 persons must beneficially own our stock during at least 335 days of a taxable year. To help insure that we meet these tests, our charter restricts the acquisition and ownership of shares of our stock.
Our charter, with certain exceptions, authorizes our directors to take such actions as are necessary and desirable to preserve our qualification as a REIT. Unless exempted by our board of directors, no person, including entities, may own more than 9.8% in value of the aggregate of the outstanding shares of our stock or more than 9.8% in value or number (whichever is more restrictive) of the aggregate of the outstanding shares of our common stock. The board may not grant an exemption from these restrictions to any proposed transferee whose ownership in excess of 9.8% of the value of our common stock outstanding would result in the termination of our status as a REIT. Despite these restrictions, it is possible that there will be five or fewer individuals who own more than 50% in value of our outstanding shares, which could cause us to fail to continue to qualify as a REIT. These restrictions on transferability and ownership will not apply, however, if our board of directors determines that it is no longer in our best interest to continue to qualify as a REIT.
These ownership limits could delay or prevent a transaction or a change in control that might involve a premium price for our common stock or otherwise be in the best interest of the stockholders.
REIT distribution requirements could adversely affect our ability to execute our business plan.
We generally must distribute annually at least 90% of our REIT taxable income (which is determined without regard to the dividends paid deduction or net capital gain for this purpose) in order to continue to qualify as a REIT. We have made and intend to continue to make distributions to stockholders to comply with the REIT requirements of the Internal Revenue Code and to avoid corporate income tax and the 4% excise tax. We may be required to make distributions to stockholders at times when it would be more advantageous to reinvest cash in our business or when we do not have funds readily available for distribution. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.
Distributions paid by REITs are generally taxed at a higher rate than other corporate distributions.
The maximum tax rate for “qualified dividends” paid by corporations to individuals is 20%. Beginning in 2018, under the Tax Cuts and Jobs Act, distributions paid by REITs generally benefit from a 20% deduction, resulting in a maximum federal income tax rate of 29.6%, rather than the preferential 20% rate applicable to qualified dividends. Additionally, without further legislative action, the 20% deduction applicable to REIT dividends will expire on January 1, 2026. The more favorable rates applicable to regular corporate distributions, combined with reduced corporate tax rates provided by the Tax Cuts and Jobs Act, could cause potential investors who are individuals to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay qualified distributions, which could adversely affect the value of the stock of REITs, including our common stock.
Non-U.S. stockholders will generally be subject to withholding tax with respect to our dividends.
Non-U.S. stockholders will generally be subject to U.S. federal withholding tax on dividends received from us at a 30% rate, subject to reduction under an applicable treaty or a statutory exemption under the Internal Revenue Code. Although such withholding taxes may be creditable in such non-U.S. stockholder’s resident jurisdiction, for many such non-U.S. stockholders, investment in a REIT that invests principally in non-U.S. real property may trigger additional tax costs compared to a direct investment in such assets which would generally not subject such non-U.S. stockholders to U.S. federal withholding taxes.
Changes to our corporate structure may result in an additional tax burden.
We may undergo changes to our corporate structure involving, among other things, the direct or indirect transfer of legal or beneficial title to real estate. These transactions may results in unforeseen adverse tax consequences that may have detrimental effects on our business, net assets, financial condition, cash flow and results of operations.
Risks Related to Ownership of Our Common Stock
The market price and trading volume of our common stock may be volatile.
The market price of our common stock could fluctuate significantly for many reasons, including in response to the risk factors listed in this Annual Report on Form 10-K or for reasons unrelated to our specific performance, such as investor perceptions, reports by industry analysts or negative developments with respect to our affiliates, as well as third parties. Our common stock could also be volatile as a result of speculation or general economic and industry conditions.
The reduced disclosure requirements applicable to us as an “emerging growth company” may make our common stock less attractive to investors.
We are an “emerging growth company” as defined in the JOBS Act, and we may avail ourselves of certain exemptions from various reporting requirements of public companies that are not “emerging growth companies,” including, but not limited to, an exemption from complying with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, as amended, or the Sarbanes-Oxley Act, and, like smaller reporting companies, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirement of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We may remain an emerging growth company for up to five full fiscal years following the Spin-off. We would cease to be an emerging growth company, and, therefore, become ineligible to rely on the above exemptions, if we have more than $1 billion in annual revenue in a fiscal year, if we issue more than $1 billion of non-convertible debt over a three-year period or on the date that we become a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act which would occur at the end of the fiscal year after: (i) we have filed at least one annual report; (ii) we have been an SEC-reporting company for at least 12 months; and (iii) the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter. We cannot predict if investors will find our common stock less attractive because we may rely on these exemptions.
If some investors find our common stock less attractive as a result of the exemptions available to us as an emerging growth company, there may be a less active trading market for our common stock (assuming a market ever develops) and our value may be more volatile than that of an otherwise comparable company that does not avail itself of the same or similar exemptions.
If, we are unable to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act or our internal control over financial reporting is not effective, the reliability of our financial statements may be questioned and our stock price may suffer.
Section 404 of the Sarbanes-Oxley Act requires any company subject to the reporting requirements of the U.S. securities laws to do a comprehensive evaluation of its and its consolidated subsidiaries’ internal controls over financial reporting. To comply with this statute, we will be required, following the loss of our status as an emerging growth company to document and test our internal controls procedures. The rules governing the standards that must be met for management to assess our internal controls over financial reporting are complex and require significant documentation, testing and possible remediation to meet the detailed standards under the rules. During the course of its testing, our management may identify material weaknesses or deficiencies which may not be remedied in time to meet the deadline imposed by the Sarbanes-Oxley Act. If our management cannot favorably assess the effectiveness of our internal controls over financial reporting or our auditors identify material weaknesses in our internal controls, investor confidence in our financial results may weaken and our stock price may suffer.
Our bylaws designate the Circuit Court for Baltimore City, Maryland or, if that court does not have jurisdiction, the United States District Court for the District of Maryland, Baltimore Division, as the sole and exclusive forum for certain types of actions and proceedings that may be initiated by our stockholders, which could limit our stockholders’ ability to bring a claim in a judicial forum that the stockholders believe is a more favorable judicial forum for disputes with us or our directors, officers, manager or agents.
Our bylaws currently provide that, unless we consent in writing to the selection of an alternative forum, the Circuit Court for Baltimore City, Maryland, or if that court does not have jurisdiction, the United States District Court for the District of Maryland, Baltimore Division, will be the sole and exclusive forum for: (i) any derivative action or proceeding brought on our behalf; (ii) any action asserting a claim for breach of a duty owed by any director, officer, manager, agent or employee of ours to us or our stockholders; (iii) any action asserting a claim against us or any director, officer, manager, agent or employee of ours arising pursuant to the MGCL, our charter or bylaws brought by or on behalf of a stockholder; or (iv) any action asserting a claim against us or any director, officer, manager, agent or employee of ours that is governed by the internal affairs doctrine. This choice of forum provision may limit a stockholder’s ability to bring a claim in a judicial forum that the stockholder believes is favorable
for disputes with us or our directors, officers, manager or agents, which may discourage lawsuits against us and our directors, officers, manager or agents.