Item 1A. RISK FACTORS
An investment in our shares of common stock involves risks. Investors should specifically consider the following material risks in addition to the other information contained in this Form 10-K. The occurrence of any of the following risks might cause an investor to lose a significant part of their investment. The risks and uncertainties discussed below are not the only ones we face, but do represent those risks and uncertainties that we believe are most significant to our business, operating results, financial condition, prospects and forward-looking statements.
Risks Related to Our Organizational Structure
We have a limited operating history, we have limited experience operating as a REIT and there is no assurance that we will achieve our investment objectives.
We are a recently formed entity with a limited operating history and may not be able to achieve our investment objectives. As of the date of this Form 10-K, we have made limited investments in real estate debt. We cannot assure investors that the past experiences of affiliates of the Advisor or the Sub-Advisor will be sufficient to allow us to successfully achieve our investment objectives. As a result, an investment in our shares may entail more risk than the shares of common stock of a REIT with a substantial operating history.
The Sub-Advisor, subject to the oversight of the Advisor, manages our portfolio pursuant to very broad investment guidelines and generally is not required to seek the approval of our board of directors for each investment, financing or asset allocation decision made by it, which may result in our making riskier investments and which could adversely affect our results of operations and financial condition.
The Advisor is responsible for the overall management of our activities and the Sub-Advisor is responsible for the day-to-day management of our investments. The Sub-Advisor is primarily responsible for analyzing, conducting due diligence on, and selecting prospective investments. Our board of directors approved very broad investment guidelines that delegate to the Sub-Advisor, subject to the oversight of the Advisor, the authority to execute acquisitions and dispositions of real estate debt on our behalf, in each case so long as such investments are consistent with the Sub-Advisory Agreement, our investment guidelines and our charter. The Sub-Advisor will implement on our behalf the strategies and discretionary approaches it believes from time to time may be best suited to prevailing market conditions in furtherance of that purpose, subject to the limitations under our investment guidelines and our charter. There can be no assurance that the Sub-Advisor will be successful in implementing any particular strategy or discretionary approach to our investment activities. Our board of directors reviews our investment guidelines on an annual basis (or more often as it deems appropriate) and reviews our investment portfolio periodically. The prior approval of our board of directors will be required only for the acquisition or disposition of assets that are not in accordance with our investment guidelines. In addition, in conducting periodic reviews, our directors rely primarily on information provided to them by the Advisor and the Sub-Advisor. Furthermore, transactions entered into on our behalf by the Sub-Advisor may be , or to unwind when they are subsequently reviewed by our board of directors.
There is no public trading market for our shares; therefore, an investor’s ability to dispose of their shares will likely be limited to repurchase by us. If an investor does sell their shares to us, such investor may receive less than the price they paid.
There is no current public trading market for our shares, and we do not expect that such a market will ever develop. Therefore, repurchase of shares by us will likely be the only way for an investor to dispose of their shares. We expect to repurchase shares at a price equal to the transaction price of the class of shares being repurchased on the date of repurchase (which will generally be equal to our prior month’s NAV per share) and not based on the price at which an investor initially purchased their shares. As a result, such investor may receive less than the price they paid for their shares when they sell them to us pursuant to our share repurchase plan.
An investor’s ability to have their shares repurchased through our share repurchase plan is limited. We may choose to repurchase fewer shares than have been requested to be repurchased, in our discretion at any time, and the number of shares we may repurchase is subject to volume limitations. Further, our board of directors may modify, suspend, or terminate our share repurchase plan if it deems such action to be in our best interest and the best interest of our stockholders.
We may choose to repurchase fewer shares than have been requested in any particular quarter to be repurchased under our share repurchase plan, or none at all, in our discretion at any time. We may repurchase fewer shares than have been requested to be repurchased due to lack of readily available funds because of adverse market conditions beyond our control, the need to maintain liquidity for our operations or because we have determined that investing in real estate debt or other illiquid investments is a better use of our capital than repurchasing our shares. In addition, the aggregate NAV of total repurchases is limited to no more than 2.5% of our aggregate NAV per calendar quarter (based on the aggregate NAV as of the last date of the month immediately prior to the repurchase date) and to no more than 10% of our aggregate NAV per year (based on the average aggregate NAV as of the end of each of our trailing four quarters). Additionally, shares that have not been outstanding for at least one year, as further described in our share repurchase plan, will not be repurchased, provided that such minimum holding requirement and the pro rata repurchase requirement may be waived by us in the case of documented death, qualifying disability, or bankruptcy of a stockholder or other exigent circumstances, as further described in our share repurchase plan. Further, our board of directors may amend, or our share repurchase plan or waive any of its specific conditions if it deems such action to be in our interests. If the total amount of all shares requested to be repurchased in any given quarter is not repurchased, funds will be allocated pro rata based on the total number of shares being repurchased without regard to class and subject to the volume and the order of priority described in our share repurchase plan. All repurchase requests must be resubmitted after the start of the next quarter, or upon the recommencement of our share repurchase plan, as applicable.
Our assets will primarily consist of real estate debt that cannot generally be readily liquidated without impacting our ability to realize full value upon their disposition. Therefore, we may not always have a sufficient amount of cash to immediately satisfy repurchase requests. Should repurchase requests, in our judgment, place an undue burden on our liquidity, adversely affect our operations or risk having an adverse impact on us as a whole, or should we otherwise determine that investing our liquid assets in real estate debt or other illiquid investments rather than repurchasing our shares is in our best interests as a whole, then we may choose to repurchase fewer shares than have been requested to be repurchased, or none at all. Because we are not required to authorize the recommencement of our share repurchase plan within any specified period of time, we may effectively terminate our share repurchase plan by suspending it indefinitely. As a result, an investor’s ability to have their shares repurchased by us may be limited and at times an investor may not be to their investment.
Our shares will not be listed on an exchange or quoted through a national quotation system for the foreseeable future, if ever. Therefore, an investor will have limited liquidity and may not receive a full return of their invested capital if they sell their shares.
Our shares are illiquid assets for which there is not expected to be any secondary market, nor is it expected that any will develop in the future. An investor’s ability to transfer their shares is limited. In an effort to provide our stockholders with liquidity in respect of their investment in our shares, we have adopted a share repurchase plan whereby, subject to certain limitations, stockholders may request on a quarterly basis that we repurchase all or any portion of their shares. However, we are not obligated to repurchase any shares and may choose to repurchase only some, or even none, of our shares that have been requested to be repurchased in any particular quarter in our discretion. If an investor is able to sell their shares, they may only be able to sell them at a substantial discount for the price they paid. Investor suitability standards imposed by certain states may also make it more difficult to sell such shares to someone in those states. Our shares should be purchased as a long-term investment only.
Economic events that may cause our stockholders to request that we repurchase their shares may materially adversely affect our cash flow and our results of operations and financial condition.
Economic events affecting the U.S. economy, such as the general negative performance of the real estate sector, could cause our stockholders to seek to sell their shares to us pursuant to our share repurchase plan at a time when such events are adversely affecting the performance of our assets. Even if we decide to satisfy all resulting repurchase requests, our cash flow could be materially adversely affected. In addition, if we determine to sell assets to satisfy repurchase requests, we may not be able to realize the return on such assets that we may have been able to achieve had we sold at a more favorable time, and our results of operations and financial condition, including, without limitation, breadth of our portfolio by asset type and location, could be materially adversely affected.
We face risks associated with the deployment of our capital.
In light of the continuous nature of our private offering in relation to our investment strategy and the need to be able to deploy potentially large amounts of capital quickly to capitalize on potential investment opportunities, if we have difficulty identifying and purchasing suitable assets on attractive terms, there could be a delay between the time we receive net proceeds from the sale of our shares in our private offering and the time we invest the net proceeds. We may also from time to time hold cash pending deployment into investments or have less than our targeted leverage, which cash or shortfall in target leverage may at times be significant, particularly at times when we are receiving high amounts of offering proceeds and/or times when there are few attractive investment opportunities. Such cash may be held in an account for the benefit of our stockholders that may be invested in money market accounts or other similar temporary investments, each of which are subject to management fees.
In the event we are unable to find suitable investments such cash may be maintained for longer periods which would be dilutive to overall investment returns. This could cause a substantial delay in the time it takes for an investor’s investment to realize its full potential return and could adversely affect our ability to pay regular distributions of cash flow from operations to investors. It is not anticipated that the temporary investment of such cash into money market accounts or other similar temporary investments pending deployment into investments will generate significant interest, and investors should understand that such low interest payments on the temporarily invested cash may adversely affect overall returns. In the event we fail to timely invest the net proceeds of sales of our common stock or do not deploy sufficient capital to meet our targeted leverage percentage, our results of operations and financial condition may be adversely affected.
The amount and source of distributions we may make to our stockholders are uncertain, and we may be unable to generate sufficient cash flows from our operations to make distributions to our stockholders at any time in the future.
Our ability to make distributions to our stockholders may be adversely affected by a number of factors, including the risk factors described in this Form 10-K. We may not generate sufficient income to make distributions to our stockholders. Our board of directors (or a committee of our board of directors) will make determinations regarding distributions based upon, among other factors, our financial performance, debt service obligations, debt covenants, REIT qualification and tax requirements and capital expenditure requirements. Among the factors that could impair our ability to make distributions to our stockholders are:
the limited size of our portfolio in the early stages of our development;
our inability to invest the proceeds from sales of our shares on a timely basis in income-producing assets;
high levels of repurchase requests under our share repurchase plan for a prolonged period of time, which could lead to the disposition of investments to generate liquidity to satisfy repurchase requests.
our inability to realize attractive risk-adjusted returns on our investments;
high levels of expenses or reduced revenues that reduce our cash flow or non-cash earnings; and
defaults in our investment portfolio or decreases in the value of our investments.
As a result, we may not be able to make distributions to our stockholders at any time in the future, and the level of any distributions we do make to our stockholders may not increase or even be maintained over time, any of which could materially and adversely affect the value of an investor’s investment.
We may pay distributions from sources other than our cash flow from operations, including, without limitation, from borrowings or the sale of or repayment under our assets, expense support from the Advisor and the Sub-Advisor, or proceeds from our private offering, and we have no limits on the amounts we may pay from such sources.
We may not generate sufficient cash flow from operations to fully fund distributions to stockholders, particularly during the early stages of our operation. Therefore, particularly in the earlier part of our private offering, we may fund distributions to our stockholders from sources other than cash flow from operations, including, without limitation, from borrowings, offering proceeds, expense support from the Advisor and the Sub-Advisor, or the sale of or repayment under our assets. We may also fund our distributions with proceeds from our private offering. The extent to which we pay distributions from sources other than cash flow from operations will depend on various factors, including how quickly we invest the proceeds from our private offering and the performance of our real estate debt portfolio. Funding distributions from borrowings or the sale of or repayment under our assets will result in us having less funds available to acquire real estate debt or other real estate-related investments. As a result, the return an investor realizes on their investment may be reduced. Doing so may also negatively impact our ability to generate cash flows. Likewise, funding distributions from the sale of additional securities may impact the NAV of shares and the value of an investor’s investment. We may be required to continue to fund our regular distributions from a combination of some of these sources if our investments fail to perform, if expenses are than our revenues or due to numerous other factors. We have not established a limit on the amount of our distributions that may be paid from any of these sources.
To the extent we borrow funds to pay distributions, we would incur borrowing costs and these borrowings would require a future repayment. The use of these sources for distributions and the ultimate repayment of any liabilities incurred could adversely impact our ability to pay distributions in future periods, decrease our NAV, decrease the amount of cash we have available for operations and new investments and adversely impact the value of an investor’s investment. There is no guarantee any of our operating expenses will be deferred and neither the Advisor nor the Sub-Advisor is under any obligation to receive future fees or distributions in our shares and may elect to receive such amounts in cash.
Purchases and repurchases of our shares are not made based on the current NAV per share.
Generally, our offering price per share with respect to our shares and the price at which we make repurchases of our shares will equal the NAV per share of the applicable class as of the last calendar day of the month immediately prior to the purchase date or the repurchase date, respectively, plus, in the case of our offering price, applicable upfront selling commissions and Managing Dealer fees. The NAV per share, if calculated as of the date on which an investor makes their subscription request or repurchase request, may be significantly different than the transaction price such investor pays or the repurchase price an investor receives. Certain of our investments or liabilities are subject to high levels of volatility from time to time and could change in value significantly between the end of the prior month as of which our NAV is determined and the date that an investor acquires or we repurchase our shares; however, the prior month’s NAV per share will generally continue to be used as the transaction price per share and repurchase price per share. In exceptional circumstances, we may in our sole discretion, but are not obligated to, offer and repurchase shares at a different price that we believe reflects the NAV per share of such stock more appropriately than the prior month’s NAV per share, including by updating a previously disclosed transaction price, in cases where we believe there has been a material change ( or ) to our NAV per share since the end of the prior month and we believe an updated price is appropriate. In such cases, the transaction price and the repurchase price will not equal our NAV per share as of any time.
Valuations of our assets are estimates of fair value and may not necessarily correspond to realizable value.
Our board of directors, including a majority of our independent directors, has adopted a valuation policy that contains a comprehensive set of guidelines to be used in connection with estimating the values of our assets and liabilities for purposes of our NAV calculation. The Advisor will initially determine the fair value of our assets in accordance with our valuation policy based on the recommendation of the Sub-Advisor and with the assistance of one of our independent valuation advisors. Recommendations are then presented to the audit committee and the ultimate determination of the fair value of our assets for which market quotations are not readily available will be made by our audit committee. Our board of directors has also delegated the calculation of our NAV to the Advisor, as the administrator (the “Administrator”); however, our board of directors is ultimately responsible for the determination of our NAV. Because these fair value calculations involve significant professional judgment in the application of both observable and unobservable attributes, the calculated fair value of our assets may differ from their actual realizable value or future fair value. Additionally, the Advisor and Sub-Advisor may, in their discretion, consider material market data and other information that becomes available after the end of the applicable month in valuing our assets and liabilities and calculating the valuation of our assets for a particular month. Under our valuation policy, certain assets will be valued based on the Sub-Advisor’s proprietary pricing models. For more information regarding our valuation process, see “ Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities—Calculation and Valuation of Net Asset Value. ”
Within the parameters of our valuation policy, the valuation methodologies used to value our investments will involve subjective judgments and projections and may not be accurate. Valuation methodologies will also involve assumptions and opinions about future events, which may or may not turn out to be correct. Valuations of our investments will be only estimates of fair value. Ultimate realization of the value of an asset depends to a great extent on economic, market and other conditions beyond our control and the control of the Advisor, the Sub-Advisor, and our independent valuation advisors. Further, valuations do not necessarily represent the price at which an asset would sell, since market prices of assets can only be determined by negotiation between a willing buyer and seller. As such, the carrying value of an asset may not reflect the price at which the asset could be sold in the market, and the difference between carrying value and the ultimate sales price could be material. In addition, accurate valuations are more difficult to obtain in times of low transaction volume because there are fewer market transactions that can be considered in the context of the valuation. There will be no retroactive adjustment in the valuation of such assets, the offering price of our shares, the price we paid to repurchase our shares or NAV-based fees we paid to the Advisor, the Sub-Advisor and CNL Securities Corp. (the “Managing Dealer”) to the extent such valuations prove to not accurately reflect the realizable value of our assets. Because the price an investor will pay for our shares in our private offering, and the price at which an investor’s shares may be repurchased by us pursuant to our share repurchase plan are generally based on our prior month’s NAV per share, an investor may pay more than realizable value or receive less than realizable value for such investor’s investment.
Our NAV per share amounts may change materially if the valuations of our assets materially change from prior valuations.
In connection with the monthly NAV process, the valuations of our assets will be conducted monthly. When these valuations are considered by the Advisor and the Sub-Advisor for purposes of valuing the relevant asset, there may be a material change in our NAV per share amounts for each class of our shares from those previously reported. These changes in an asset’s value may be as a result of asset-specific events or as a result of more general changes to real estate values resulting from local, national or global economic changes. We will not retroactively adjust the NAV per share of each class reported for the previous month. Therefore, because a new monthly valuation may differ materially from the prior valuation, the adjustment to take into consideration the new valuation may cause the NAV per share for each class of our shares to increase or decrease.
It may be difficult to reflect, fully and accurately, material events that may impact our monthly NAV.
The determination of our monthly NAV per share will be based in part on monthly valuations of our real estate debt and other securities for which market prices are not readily available reviewed by our independent valuation advisors, each in accordance with valuation policy approved by our board of directors. As a result, our published NAV per share in any given month may not fully reflect any or all changes in value that may have occurred since the most recent valuation. The Advisor and Sub-Advisor will review valuation reports and monitor our real estate debt, and are responsible for notifying the independent valuation advisors of the occurrence of any market-driven event they believe may cause a material valuation change in the real estate debt valuation, but it may be difficult to reflect fully and accurately rapidly changing market conditions or material events that may impact the value of our real estate debt or liabilities between valuations, or to obtain complete information regarding any such events in a timely manner. As a result, the NAV per share may not reflect a material event until such time as sufficient information is available and analyzed, and the financial impact is fully evaluated, such that our NAV may be appropriately adjusted in accordance with our valuation policy. Depending on the circumstance, the resulting potential disparity in our NAV may be in favor or to the detriment of either stockholders whose shares are repurchased, or existing stockholders.
NAV calculations are not governed by governmental or independent securities, financial or accounting rules or standards.
The method for calculating our NAV, including the components used in calculating our NAV, will not be prescribed by rules of the SEC or any other regulatory agency. Further, there are no accounting rules or standards that prescribe which components should be used in calculating NAV, and our NAV is not audited by our independent registered public accounting firm. The components and methodology used in calculating our NAV may differ from those used by other companies now or in the future. The monthly NAV for each class of shares will be based on the fair values of our investments, the addition of any other assets (such as cash on hand), and the deduction of any liabilities (including allocated or accrued management fees, total return incentive fees and the deduction of any distribution and stockholder servicing fees specifically applicable to such class of shares). We accrue estimated income and expenses on a monthly basis based on our budgets, projections and analyses. As soon as practicable, and on an ongoing basis, we adjust the income and expenses we have allocated or estimated for that month to reflect the income and expenses actually earned and incurred. These NAV and our underlying valuations may differ from liquidation values that could be realized in the event that we were forced to sell our assets. Additionally, errors may occur in calculating our NAV, which could impact the price at which we sell and repurchase our shares and the amount of the Advisor’s and the Sub-Advisor’s management fee and total return incentive fee. You should carefully review the disclosure of our valuation policy and how NAV will be calculated under “Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters—Calculation and Valuation of Net Asset Value.”
If we are unable to raise substantial funds, we will be limited in the number and type of investments we make, and the value of an investor’s investment in us will be more dependent on the performance of any of the specific assets we acquire.
Our private offering is being made on a “best efforts” basis, which means that the Managing Dealer is only required to use its best efforts to sell our shares and has no firm commitment or obligation to purchase any shares. As a result, the amount of proceeds we raise in our private offering, or other offerings or otherwise may be substantially less than the amount we would need to achieve a broader portfolio of investments. If we are unable to raise substantial funds, we will make fewer investments, resulting in less breadth in terms of the type, number, geography and size of investments that we make. In that case, the likelihood that any single asset’s or market’s performance would adversely affect our profitability will increase. There is a greater risk that investors will lose money in their investment if we have less breadth in our portfolio. Further, we will have certain fixed operating expenses, including expenses of being a public reporting company, regardless of whether we are able to raise substantial funds. Our to raise substantial funds would increase our fixed operating expenses as a percentage of gross income, reducing our net income and limiting our ability to make distributions. The of our private offering, and correspondingly our ability to implement our business strategy, is dependent upon the ability of the Managing Dealer to establish and maintain relationships with a network of licensed securities broker-dealers and other intermediaries to sell our shares. If the Managing Dealer to perform, we may not be to raise adequate proceeds through our private offering to implement our investment strategy. If we are in implementing our investment strategy, an investor could all or a part of their investment.
Our board of directors has, and may in the future, adopt certain measures under Maryland law without stockholder approval that may have the effect of making it less likely that a stockholder would receive a “control premium” for his, her or its shares.
Corporations organized under Maryland law with a class of registered securities and at least three independent directors are permitted to elect to be subject, by a charter or bylaw provision or a board of directors resolution and notwithstanding any contrary charter or bylaw provision, to any or all of five provisions:
staggering the board of directors into three classes;
requiring a two-thirds vote of stockholders to remove directors;
providing that only the board of directors can fix the size of the board;
by providing that all vacancies on the board, regardless of how the vacancy was created, may be filled only the affirmative vote of a majority of the remaining directors in office and for the remainder of the full term of the class of directors in which the vacancy occurred; and
providing for a majority requirement for the calling of a stockholder-requested special meeting of stockholders.
These provisions may discourage an extraordinary transaction, such as a merger, tender offer or sale of all or substantially all of our assets, all of which might provide a premium price for stockholders’ shares. In our charter, we have elected pursuant to Subtitle 8 that vacancies on our board of directors be filled only by the remaining directors and for the remainder of the full term of the directorship in which the vacancy occurred. Through other provisions in our charter and bylaws, we vest in our board of directors the exclusive power to fix the number of directorships, provided that the number is not less than three. We have not elected to be subject to all of the provisions described above.
Further, under the Maryland Business Combination Act, we may not engage in any merger or other business combination with an “interested stockholder” (which is defined as (1) any person who beneficially owns, directly or indirectly, 10% or more of the voting power of our outstanding voting stock and (2) an affiliate or associate of ours who, at any time within the two-year period prior to the date in question, was the beneficial owner, directly or indirectly, of 10% or more of the voting power of our then-outstanding stock) or any affiliate of that interested stockholder for a period of five years after the most recent date on which the interested stockholder became an interested stockholder. A person is not an interested stockholder if our board of directors approved in advance the transaction by which such person would otherwise have become an interested stockholder. In approving a transaction, our board of directors may provide that its approval is subject to compliance, at or after the time of approval, with any terms or conditions determined by our board of directors. After the five-year period ends, any merger or other business combination with the interested stockholder or any affiliate of the interested stockholder must be recommended by our board of directors and approved by the affirmative vote of at least:
80% of all votes entitled to be cast by holders of outstanding shares of our voting stock; and
two-thirds of all of the votes entitled to be cast by holders of outstanding shares of our voting stock other than those shares owned or held by the interested stockholder with whom or with whose affiliate the business combination is to be effected or held by an affiliate or associate of the interested stockholder unless, among other things, our stockholders receive a minimum payment for their common stock equal to the highest price paid by the interested stockholder for its shares.
The statute permits various exemptions from its provisions, including business combinations that are exempted by our board of directors prior to the time the interested stockholder becomes an interested stockholder. Our board of directors has adopted a resolution exempting any business combination involving us and any person, including CNL, Balbec, the Managing Dealer, the Advisor and the Sub-Advisor, from the provisions of this law, provided that such business combination is first approved by our board of directors.
Our charter permits our board of directors to issue preferred stock on terms that may be senior to the rights of the holders of our shares or discourage a third party from acquiring us.
Our board of directors is permitted, subject to certain restrictions set forth in our charter, to authorize the issuance of shares of preferred stock without stockholder approval. Further, our board of directors may classify or reclassify any unissued shares of common or preferred stock into other classes or series of stock and establish the preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends and other distributions, qualifications, and terms or conditions of redemption of the stock and may amend our charter from time to time to increase or decrease the aggregate number of shares of stock or the number of shares of any class or series of stock that we have authority to issue without stockholder approval. Thus, our board of directors could authorize us to issue shares of preferred stock with terms and conditions that could be senior to the rights of the holders of our shares or have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction such as a merger, tender offer or sale of all or substantially all of our assets, that might provide a premium price for holders of our shares.
Maryland law limits, in some cases, the ability of a third party to vote shares acquired in a “control share acquisition.”
The Maryland Control Share Acquisition Act provides that “control shares” of a Maryland corporation acquired in a “control share acquisition” have no voting rights except to the extent approved by stockholders by a vote of two-thirds of the votes entitled to be cast on the matter. Shares of stock owned by the acquirer, by officers or by employees who are directors of the corporation, are excluded from shares entitled to vote on the matter. “Control shares” are voting shares of stock which, if aggregated with all other shares of stock owned by the acquirer or in respect of which the acquirer can exercise or direct the exercise of voting power (except solely by virtue of a revocable proxy), would entitle the acquirer to exercise voting power in electing directors within specified ranges of voting power. Control shares do not include shares the acquiring person is then entitled to vote as a result of having previously obtained stockholder approval. A “control share acquisition” means the acquisition of issued and outstanding control shares. The control share acquisition statute does not apply: (1) to shares acquired in a merger, consolidation or share exchange if the Maryland corporation is a party to the transaction; or (2) to acquisitions approved or exempted by the charter or bylaws of the Maryland corporation. Our bylaws contain a provision exempting from the Control Share Acquisition Act any and all acquisitions of our stock by any person. There can be no assurance that this provision will not be amended or eliminated at any time in the future.
Maryland law and our organizational documents limit our rights and the rights of our stockholders to recover claims against our directors and officers, which could reduce an investor’s and our recovery against them if they cause us to incur losses.
Maryland law provides that a director will not have any liability as a director so long as he or she performs his or her duties in accordance with the applicable standard of conduct. In addition, as permitted by Maryland law, our charter provide that no director or officer shall be liable to us or our stockholders for monetary damages unless the director or officer (1) actually received an improper benefit or profit in money, property or services or (2) was actively and deliberately dishonest as established by a final judgment as material to the cause of action. Moreover, our charter requires us to indemnify and advance expenses to our directors and officers for losses they may incur by reason of their service in those capacities unless their act or omission was material to the matter giving rise to the proceeding and was committed in bad faith or was the result of active and deliberate dishonesty, and they actually received an personal in money, property or services or, in the case of any proceeding, they had reasonable cause to believe the act or was . Further, we intend to enter into separate indemnification agreements with each of our officers and directors. Notwithstanding the above, our charter provides that we may not indemnify a director, the Advisors or any of our or the Advisors’ affiliates for any liability or by any of them, or hold any of them harmless for any or liability by us, unless such person has determined, in faith, that the course of conduct that caused the or liability was in our interests, such person was acting on our behalf or performing services for us, the liability or was not the result of or by any of our non-independent directors, the Advisors or any of our or the Advisors’ affiliates (or gross or willful by any of our independent directors), and the indemnification or agreement to hold harmless is recoverable only out of our net assets and not from the stockholders. Nevertheless, an investor and we may have more limited rights our directors or officers than might otherwise exist under common law, which could reduce an investor’s and our recovery from these persons if they act in a manner that causes us to incur . In addition, we are obligated to fund the defense costs incurred by these persons in some cases.
Our charter contains stock ownership limits, which may delay or prevent a change of control.
In order for us to qualify as a REIT for each taxable year, no more than 50% in value of our outstanding capital stock may be owned, directly or indirectly, by five or fewer individuals during the last half of any calendar year, and at least 100 persons must beneficially own our capital stock during at least 335 days of a taxable year of 12 months, or during a proportionate portion of a shorter taxable year. “Individuals” for this purpose include natural persons, private foundations, some employee benefit plans and trusts and some charitable trusts. To assist us in complying with these limitations, among other purposes, our charter generally prohibits any person from directly or indirectly owning more than 9.8% in value or number of shares, whichever is more restrictive, of the outstanding shares of our capital stock or more than 9.8% in value or number of shares, whichever is more restrictive, of the outstanding shares of our common stock. These ownership limitations could also have the effect of discouraging a takeover or other transaction in which holders of our common stock might receive a premium for their shares over the then prevailing market price or which holders might believe to be otherwise in their best interests.
Our charter’s constructive ownership rules are complex and may cause the outstanding shares owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result, the acquisition of less than 9.8% of the outstanding shares, determined as described in the preceding paragraph, by an individual or entity could cause that individual or entity to own constructively in excess of 9.8% of the outstanding shares and thus violate the share ownership limits. Our charter also provides that any attempt to own or transfer shares of our common stock or preferred stock (if and when issued) in excess of the stock ownership limits without the consent of our board of directors or in a manner that would cause us to be “closely held” under Section 856(h) of the Internal Revenue Code (without regard to whether our shares are held during the last half of a taxable year) will result in our shares being deemed to be transferred to a trustee for a charitable trust or, if the transfer to the charitable trust is not automatically effective to prevent a violation of the share ownership limits or the restrictions on ownership and transfer of our stock, any such transfer of such shares being null and void. These ownership rules may , or prevent a transaction or a change of control that might involve a premium price for our common stock or that our stockholders otherwise believe to be in their interest.
An investor’s percentage ownership interest in us will be diluted if we issue additional shares.
Holders of our shares will not have pre-emptive rights to any shares we issue in the future. Our charter authorizes us to issue a total of 1,100,000,000 shares of capital stock, of which 1,000,000,000 shares are classified as common stock, of which 200,000,000 shares are classified as Class T shares, 200,000,000 shares are classified as Class D shares, 250,000,000 shares are classified as Class I shares, 200,000,000 shares are classified as Class A shares, 100,000,000 are classified as Class FA shares, and 50,000,000 shares are classified as Class E shares and 100,000,000 shares are classified as preferred stock. In addition, our board of directors may amend our charter from time to time to increase or decrease the aggregate number of authorized shares of capital stock or the number of authorized shares of capital stock of any class or series without stockholder approval. After an investor purchases our shares in our private offering, our board of directors may elect, without stockholder approval, to: (1) sell additional shares in our private or future private or public offerings; (2) issue shares upon the exercise of the options we may grant to our directors or future employees; (3) issue shares to the Advisor, the Sub-Advisor or their respective successors or assigns, in payment of an outstanding obligation to pay fees for services rendered to us; or (4) issue equity incentive compensation to certain employees of affiliated service providers or to third parties as satisfaction of obligations under incentive compensation arrangements. To the extent we issue additional shares after an investor’s purchase in our private offering, such investor’s percentage ownership interest in us will be diluted.
We are not required to comply with certain reporting requirements, including those relating to auditor’s attestation reports on the effectiveness of our system of internal control over financial reporting, accounting standards and disclosure about our executive compensation, that apply to other public companies.
The JOBS Act contains provisions that, among other things, relax certain reporting requirements for emerging growth companies, including certain requirements relating to accounting standards and compensation disclosure. We are classified as an emerging growth company. For as long as we are an emerging growth company, which may be up to five full fiscal years, unlike other public companies, we are not required to (1) provide an auditor’s attestation report on the effectiveness of our system of internal control over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act, (2) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer, (3) comply with any new audit rules adopted by the PCAOB after April 5, 2012 unless the SEC determines otherwise, (4) provide certain disclosure regarding executive compensation required of larger public companies or (5) hold stockholder advisory votes on executive compensation.
In addition, we are a “smaller reporting company,” as such term is defined in the Exchange Act. As a smaller reporting company, we are also eligible to take advantage of certain exemptions from various reporting and disclosure requirements that are applicable to public companies that are not smaller reporting companies. To the extent that we continue to qualify as a smaller reporting company after we cease to qualify as an emerging growth company, certain of the exemptions available to us as an emerging growth company may continue to be available to us as a smaller reporting company, including: (1) scaled executive compensation disclosures and (2) the requirement to provide only two years of audited financial statements, instead of three years.
Once we are no longer an emerging growth company or a smaller reporting company, so long as shares of our common stock are not traded on a securities exchange, we will be deemed to be a “non-accelerated filer” under the Exchange Act, and as a non-accelerated filer, we will be exempt from compliance with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act. In addition, so long as we are externally managed by the Advisor and we do not directly compensate our executive officers, or reimburse the Advisor or its affiliates for salaries, bonuses, benefits and severance payments for persons who also serve as one of our executive officers or as an executive officer of the Advisor, we do not have any executive compensation, making the exemptions listed in (4) and (5) above generally inapplicable.
We cannot predict if investors will find our common stock less attractive because we choose to rely on any of the exemptions discussed above.
As noted above, under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards that have different effective dates for public and private companies until such time as those standards apply to private companies. We have elected to take advantage of this extended transition period. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates for such new or revised standards. We may elect to comply with public company effective dates at any time, and such election would be irrevocable pursuant to Section 107(b) of the JOBS Act.
An investor’s investment return may be reduced if we are required to register as an investment company under the Investment Company Act.
We intend to continue to conduct our operations so that we are not an investment company under the Investment Company Act. However, there can be no assurance that we and our subsidiaries will be able to successfully avoid operating as an investment company.
A change in the value of any of our assets could negatively affect our ability to maintain our exemption from registration under the Investment Company Act. To maintain compliance with the applicable exemption under the Investment Company Act, we may be unable to sell assets we would otherwise want to sell and may need to sell assets we would otherwise wish to retain. In addition, we may have to acquire additional assets that we might not otherwise have acquired or may have to forego opportunities to acquire assets that we would otherwise want to acquire and would be important to our investment strategy.
If we were required to register as an investment company, we would become subject to substantial regulation with respect to our capital structure (including our ability to use borrowings), management, operations, transactions with affiliated persons (as defined in the Investment Company Act), and portfolio composition, including disclosure requirements and restrictions with respect to diversification and industry concentration, and other matters. Compliance with the Investment Company Act would, accordingly, limit our ability to make certain investments and require us to significantly restructure our business plan, which could materially adversely affect our NAV and our ability to pay distributions to our stockholders.
We depend on the Advisors to develop appropriate systems and procedures to control operational risk.
Operational risks arising from mistakes made in the confirmation or settlement of transactions, from transactions not being properly booked, evaluated or accounted for or other similar disruption in our operations may cause us to suffer financial losses, the disruption of our business, liability to third parties, regulatory intervention or damage to our reputation. We will depend on the Advisors and their respective affiliates to develop the appropriate systems and procedures to control operational risk. We rely heavily on our financial, accounting and other data processing systems. The ability of our systems to accommodate transactions could also constrain our ability to properly manage our portfolio. The liability of the Advisors for losses incurred due to the occurrence of any such errors may be limited.
We are subject to the risk that our intended investment transactions may not be effected in a timely and efficient manner due to various circumstances, including, without limitation, systems failure or human error. As a result, we could be unable to achieve the market position selected by the Advisors or might incur a loss in liquidating our positions. Since some of the markets in which we may effect transactions are over-the-counter or interdealer markets, the participants in such markets are typically not subject to credit evaluation or regulatory oversight comparable to that which members of exchange-based markets are subject. We are also exposed to the risk that a counterparty will not settle a transaction in accordance with its terms and conditions, thereby causing us to suffer a loss.
Compliance with the SEC’s Regulation Best Interest by participating broker-dealers may negatively impact our ability to raise capital in our private offering, or other offerings, which could harm our ability to achieve our investment objectives .
Broker-dealers are required to comply with Regulation Best Interest, which, among other requirements, establishes a new standard of conduct for broker-dealers and their associated persons when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. The continued impact of Regulation Best Interest on participating broker-dealers cannot be determined at this time, and it may negatively impact whether participating broker-dealers and their associated persons recommend our private offering to certain retail customers or the amount of shares which are recommended to such customers. In particular, under SEC guidance concerning Regulation Best Interest, a broker-dealer recommending an investment in our shares should consider a number of factors, including but not limited to cost and complexity of the investment and reasonably available alternatives in determining whether there is a reasonable basis for the recommendation. Broker-dealers may recommend a more costly or complex product as long as they have a reasonable basis to believe it is in the best interest of a particular retail customer. However, if broker-dealers instead choose alternatives to our shares, many of which likely exist, our ability to raise capital will be affected. If Regulation Interest reduces our ability to raise capital in our private offering, or other offerings, it may our ability to our objectives.
We could be negatively impacted by cybersecurity attacks.
We, and our businesses, as well as the Advisor and the Sub-Advisor, may use a variety of information technology systems in the ordinary course of business, which are potentially vulnerable to unauthorized access, computer viruses and cyber-attacks, including cyber-attacks to our information technology infrastructure and attempts by others to gain access to our proprietary or sensitive information, and ranging from individual attempts to advanced persistent threats. The risk of such a security breach or disruption has generally increased as the number, intensity and sophistication of attempted attacks and intrusions from around the world have increased and will likely continue to increase in the future. The procedures and controls we use to monitor these threats and mitigate our exposure may not be sufficient to prevent cybersecurity incidents. The results of these incidents could include disrupted operations, misstated or financial data, theft of trade secrets or other intellectual property, liability for disclosure of confidential customer, supplier or employee information, increased costs arising from the implementation of additional security protective measures, regulatory enforcement and reputational , which could materially affect our financial condition, business and results of operations. These risks require continuous and likely increasing attention and other resources from us to, among other actions, identify and quantify these risks, upgrade and expand our technologies, systems and processes to address them and provide periodic training to assist associated persons of the Advisors in detecting phishing, malware and other schemes. Such attention time and other resources from other activities and there is no assurance that our efforts will be . Additionally, the cost of maintaining and such systems and processes, procedures and internal controls may increase from its current level. Potential sources for , or of our information technology systems include, without , computer viruses, security , human , cyber-attacks, natural and in design. Additionally, due to the size and nature of our company, we rely on third-party service providers for many aspects of our business. Although we conduct due diligence on the cybersecurity of our third-party vendors, there can provide no assurance that the networks and systems that our third-party vendors have established or use will be . Even if we, the Advisor or the Sub-Advisor are not targeted directly, cyber-attacks on the U.S. and foreign governments, financial markets, financial institutions, or other businesses, including vendors, software creators, cybersecurity service providers, and other third parties with whom we, the Advisor or the Sub-Advisor do business, may occur, and such events could our normal business operations and networks in the future.
We may change our investment and operational policies without stockholder consent.
We may change our investment and operational policies, including our policies with respect to investments, operations, indebtedness, capitalization and distributions, at any time without the consent of our stockholders, which could result in our making investments that are different from, and possibly riskier or more highly leveraged than, the types of investments described in this Form 10-K. Our board of directors also approved very broad investment policy guidelines with which we must comply and which can be changed by our board of directors. These guidelines provide the Advisor and the Sub-Advisor with broad discretion. A change in our investment strategy may, among other things, increase our exposure to real estate market fluctuations, default risk and interest rate risk, all of which could materially affect our results of operations and financial condition.
General Risks Related to Our Investments
Investments in real estate debt are subject to risks including various creditor risks and early redemption features which may materially adversely affect our results of operations and financial condition.
The real estate debt in which we may invest may not be fully protected by financial covenants or limitations upon additional indebtedness, may be illiquid or have limited liquidity, and may not be rated by a credit rating agency. Real estate debt is also subject to other creditor risks, including (i) the possible invalidation of an investment transaction as a “fraudulent conveyance” under relevant creditors’ rights laws, (ii) so-called lender liability claims by the issuer of the obligation and (iii) environmental liabilities that may arise with respect to collateral securing the obligations. Our investments may be subject to early redemption features, refinancing options, pre-payment options or similar provisions which, in each case, could result in the issuer repaying the principal on an obligation held by us earlier than expected, resulting in a lower return to us than anticipated or reinvesting in a new obligation at a lower return to us.
Prepayment rates may adversely affect the value of our portfolio.
Prepayment rates may adversely affect the value of our portfolio. Prepayment rates on our investments, where contractually permitted, are influenced by changes in current interest rates, significant improvement in the performance of underlying real estate assets and a variety of economic, geographic and other factors beyond our control. Consequently, prepayment rates cannot be predicted with certainty and no strategy can completely insulate us from increases in such rates. The conditional prepayment rate (“CPR”) is a method of expressing the prepayment rate for a mortgage pool that assumes that a constant fraction of the remaining principal is prepaid each month or year. An increase in prepayment rates, as measured by the CPR, will typically accelerate the amortization of our securitized portfolio of loans, thereby reducing the yield or interest income earned on such assets.
In periods of declining interest rates, prepayments on investments generally increase and the proceeds of prepayments received during these periods may be reinvested by us in comparable assets at reduced yields. In addition, the market value of investments subject to prepayment may, because of the risk of prepayment, benefit less than other fixed-income securities from declining interest rates. Conversely, in periods of rising interest rates, prepayments on investments, where contractually permitted, generally decrease, in which case we would not have the prepayment proceeds available to invest in comparable assets at higher yields. Under certain interest rates and prepayment scenarios, we may fail to recoup fully our cost of certain investments.
Our investments in RMBS may result in losses stemming from prepayments on the underlying asset and changes in interest rates.
We intend to purchase mortgage loans and bundle such assets and issue securities backed by such assets, including re-performing and performing mortgage loans. Investing in, issuing or holding structured finance securities backed by mortgage loans may entail a variety of unique risks. Among other risks, structured finance securities backed by mortgage loans may be subject to prepayment risks, credit risks, liquidity risks, interest rate risks, operations risks, structural risks and legal risks.
RMBS in general are subject to particular risks because they have yield and maturity characteristics corresponding to their underlying assets. Unlike traditional debt securities, which may pay a fixed rate of interest until maturity when the entire principal amount comes due, payments on certain RMBS include both interest and a partial payment of principal. This partial payment of principal may be comprised of a scheduled principal payment, as well as an unscheduled payment from the voluntary prepayment, refinancing, or foreclosure of the underlying assets. As a result of these unscheduled payments of principal, or prepayments on the underlying assets, the price and yield of RMBS can be adversely affected. For example, during periods of declining interest rates, prepayments can be expected to accelerate, and we may reinvest proceeds at the lower interest rates then available. Prepayments of mortgages that underlie securities purchased at a premium could result in capital losses because the premium may not have been fully amortized at the time the obligation is prepaid. In addition, like other interest-bearing securities, the values of RMBS generally fall when interest rates rise, but when interest rates fall, their potential for capital appreciation may be limited due to the existence of the prepayment feature.
The performance of any RMBS, and the results of hedging arrangements entered into with respect thereto, will be affected by: (1) the rate and timing of principal payments on the underlying assets; and (2) the extent to which such principal payments are applied to reduce, or otherwise result in the reduction of, the principal or notional amount of such RMBS. The rate of principal payments on a pool of RMBS will in turn be affected by the amortization schedules of the assets (which, in the case of assets with an adjustable-rate feature, may change periodically to accommodate adjustments to the mortgage rates thereon) and the rate of principal prepayments thereon (including for this purpose, voluntary prepayments by borrowers and prepayments resulting from liquidations of RMBS due to defaults, casualties, or condemnations affecting the related properties).
The extent of prepayments of principal of the assets underlying RMBS may be affected by a number of factors, including the availability of mortgage credit, the relative economic vitality of the area in which the related properties are located, the servicing of the underlying assets, possible changes in tax laws, other opportunities for investment, homeowner mobility, and other economic, social, geographic, demographic, and legal factors. In general, any factors that increase the attractiveness of selling a mortgaged property or refinancing such property, enhance a borrower’s ability to sell or refinance or increase the likelihood of default under an RMBS which would be expected to cause the rate of prepayment in respect of a pool of RMBS to accelerate. In contrast, any factors having an opposite effect would be expected to cause the rate of prepayment of a pool of RMBS to slow.
The rate of prepayment on a pool of RMBS is likely to be affected by prevailing market interest rates for mortgages of a comparable type, term, and risk level. When the prevailing market interest rate is below a mortgage coupon, a borrower generally has an increased incentive to refinance. Even in the case of assets with an adjustable-rate component, as prevailing market interest rates decline, and without regard to whether the mortgage rates on such assets decline in a manner consistent therewith, the related borrowers may have an increased incentive to refinance for purposes of either: (1) converting to a fixed-rate security; or (2) taking advantage of a different index, margin, or rate cap or floor on another adjustable-rate note. Therefore, as prevailing market interest rates decline, prepayment speeds would be expected to accelerate.
Increases in monthly payments on adjustable-rate mortgages due to higher interest rates may result in greater future delinquency rates. Borrowers with adjustable payments may be exposed to increased monthly payments when the related mortgage interest rate adjusts upward from the initial fixed rate or a low introductory rate, as applicable, to the rate computed in accordance with the applicable index and margin. This increase in borrowers’ monthly payments, together with any increase in prevailing market interest rates, may result in significantly increased monthly payments for borrowers subject to adjustable rates.
Borrowers seeking to avoid these increased monthly payments by refinancing may no longer be able to find alternatives at comparably low interest rates. A decline in housing prices may also leave borrowers with insufficient equity in their homes to permit them to refinance. Furthermore, borrowers who intend to sell their homes on or before the expiration of the fixed-rate periods may find that they cannot sell their properties for an amount equal to or greater than their unpaid principal balances. These events, alone or in combination, may contribute to higher delinquency rates and therefore potentially higher losses on RMBS.
Our investments in RMBS may involve structural and legal risks.
RMBS have structural characteristics that distinguish them from other asset backed securities. For example, the rate of interest payable on RMBS may be set or effectively capped at the weighted average net coupon of the underlying mortgage loans themselves. Generally, our return on these investments is dependent on the relative timing and rate of delinquencies, defaults and prepayments of mortgage loans, including mortgage loans bearing a higher rate of interest. In general, early prepayments will have a greater impact on the yield to investors. U.S. federal and state law may also affect the return to investors by capping the interest rates payable by certain mortgagors.
In addition, structural and legal risks of RMBS include the possibility that, in a bankruptcy or similar proceeding involving the originator or the servicer (often the same entity or affiliates), the assets of the issuer could be treated as never having been truly sold by the originator or other seller to the related issuing entity and could be substantively consolidated with those of such originator or seller, or the transfer of such assets to the issuing entity could be voided as a fraudulent transfer. Challenges based on such doctrines could result also in cash flow delays and losses on the related issue of RMBS. Our target assets for investment include re-performing loans. Given that such loans have a history of non-performance, they are inherently risky, and when compared to loans with no history of non-performance, there is a higher risk that such loans will become non-performing loans again.
It is expected that a substantial portion of the RMBS in which we invest will not be guaranteed or insured by any governmental agency or instrumentality or by any other person, although we are permitted to invest in direct obligations of, or that are fully guaranteed as to principal and interest by, the United States or certain instrumentalities thereof. To the extent the RMBS are not guaranteed or insured by the United States or certain instrumentalities thereof, distributions on RMBS will depend solely upon the amount and timing of payments and other collections on the related underlying mortgage loans, and no other transaction party will be obligated to make payment on the RMBS.
The market for the U.S. performing and re-performing whole mortgage loans and other residential mortgage loans in which we invest is subject to various layers of regulation and oversight.
Numerous federal, state and local consumer protection laws in the United States impose substantive requirements upon mortgage lenders and holders of mortgage loans in connection with the origination, servicing and enforcement of the mortgage loans. Applicable federal, state and local laws regulate, among other things, interest rates and other charges, closing practices, compensation and licensing of brokers, lenders, holders and individual loan originators and may require certain disclosures. In addition, other federal, state and local laws, public policy and general principles of equity relating to the protection of consumers, unfair, deceptive and abusive practices, and debt collection practices may be applied to the origination, ownership, servicing and collection of the mortgage loans.
State and federal banking regulatory agencies, state attorneys general offices, the Federal Trade Commission, the U.S. Department of Justice, the U.S. Department of Housing and Urban Development (“HUD”) and state and local governmental authorities continue to monitor lending practices by some originators, including practices sometimes referred to as “predatory lending” practices, as well as fair lending requirements. Federal, state and local governmental agencies have imposed sanctions on originators for practices including, but not limited to, charging borrowers excessive fees, steering borrowers to loans with higher costs or more onerous terms, imposing higher interest rates than the borrower’s credit risk warrants, and failing to adequately disclose the material terms of residential loans to the borrowers.
Additional requirements may be imposed under federal, state or local laws on so-called “high cost mortgage loans” or “higher-priced mortgage loans,” which typically are defined as loans secured by a consumer’s dwelling that have interest rates or origination costs in excess of prescribed levels. These laws may limit certain loan terms, such as prepayment charges, balloon payments or late fees, or the ability of a creditor to refinance a loan unless it is in the borrower’s interest, and may require counselling of borrowers before a loan is originated. In addition, certain of these laws may allow claims against loan brokers or originators, including claims based on fraud or misrepresentations, to be asserted against persons acquiring the loans, such as us.
U.S. state and local governments may require originators, servicers and holders of residential mortgage loans to obtain certain licenses and permits. Although the Sub-Advisor has an approved MSR investment platform that is licensed to do business in all fifty states, we have not obtained any licenses or permits in connection with holding the residential mortgage loans and no assurance can be given that a state or local government will not assert that we must obtain a particular license or permit or that we will be able to rely on the Sub-Advisor and its affiliates for certain of our operations.
In addition to those addressed above, numerous federal laws in the United States apply to the origination, servicing, collection and enforcement of residential mortgage loans. Violations of certain provisions of these federal, state and local laws may limit the ability of the applicable servicer to collect all or part of the principal of, or interest on, the related mortgage loans and in addition could subject us to damages and administrative enforcement (including disgorgement of prior interest and fees paid). In particular, an originator’s failure to comply with certain requirements of federal and state laws could subject us (and other assignees of residential mortgage loans) to monetary penalties, and result in the obligors’ rescinding the residential mortgage loans against either us or subsequent holders of such residential mortgage loans. It is possible in the future that governmental authorities or attorneys general may take actions against us that could prohibit servicers of such mortgage loans from pursuing foreclosure actions, provide new defenses to foreclosure, or otherwise limit the ability of any servicer, to take actions (such as pursuing ) that may be essential to preserve the value of such mortgage loan. Any such would affect our ability to realize on residential mortgage loans.
Reinvestment risk could affect the price for our shares or their overall returns.
Reinvestment risk is the risk that income from our portfolio will decline if we invest the proceeds from matured, traded or called securities at market interest rates that are below our real estate debt portfolio’s current earnings rate. A decline in income could affect the NAV of our shares or their overall returns.
Debt-oriented real estate investments face a number of general market-related risks that can affect the creditworthiness of borrowers, and modifications to certain loan structures and market terms make it more difficult to monitor and evaluate investments.
We will invest in real estate-related debt investments. Any deterioration of real estate fundamentals generally, and in the United States in particular, could negatively impact our performance by making it more difficult for borrowers to satisfy their debt payment obligations, increasing the default risk applicable to borrowers, and/or making it relatively more difficult for us to generate attractive risk-adjusted returns. Changes in general economic conditions will affect the creditworthiness of borrowers and/or real estate collateral relating to our investments and may include economic and/or market fluctuations, changes in environmental and zoning laws, casualty or condemnation losses, regulatory limitations on rents, decreases in property values, changes in the appeal of properties to tenants, changes in supply and demand for competing properties in an area (as a result, for instance, of overbuilding), fluctuations in real estate fundamentals, changes in the financial resources of borrowers, changes in the availability of debt financing which may render the sale or refinancing of properties or , changes in building, environmental and other laws, energy and supply , various or uninsurable risks, natural , political events, trade , currency exchange controls, changes in government regulations (such as rent control), changes in real property tax rates and operating expenses, changes in interest rates, changes in the availability of debt financing and/or mortgage funds which may render the sale or refinancing of properties or , increased mortgage , increases in borrowing rates, outbreaks of an infectious disease, epidemics/pandemics or other public health , developments in the economy or political climate that travel activity (including restrictions on travel or quarantines imposed), environmental liabilities, contingent liabilities on the disposition of assets, acts of God, terrorist attacks, war, demand and/or real estate values generally and other factors that are beyond the control of the Advisor and Sub-Advisor. Such changes may develop rapidly and it may be to determine the comprehensive impact of such changes on our investments, particularly for investments that may have inherently limited liquidity. These changes may also create significant in the markets for our investments which could cause rapid and large fluctuations in the values of such investments. There can be no assurance that there will be a ready market for the resale of our debt investments because such investments may not be liquid. may result from the of an established market for the investments, as well as legal or contractual restrictions on their resale by us.
The Advisor and Sub-Advisor cannot predict whether economic conditions generally, and the conditions for real estate debt investing in particular, will deteriorate in the future. Declines in the performance of the U.S. and global economies or in the real estate debt markets could have a material adverse effect on our investment activities. In addition, market conditions relating to real estate debt investments have evolved since the financial crisis, which has resulted in a modification to certain loan structures and market terms. For example, it has become increasingly difficult for real estate debt investors in certain circumstances to receive full transparency with respect to underlying investments because transactions are often effectuated on an indirect basis through pools or conduit vehicles rather than directly with the borrower. These and other similar changes in loan structures or market terms may make it more difficult for us to monitor and evaluate investments.
Difficult conditions in the residential mortgage and residential real estate markets as well as general market concerns, including macroeconomic events, may adversely affect the value of residential mortgage loans, including U.S. performing and re-performing whole mortgage loans and other target assets in which we invest.
Our business is materially affected by conditions in the residential credit market, the residential real estate market, the financial markets, and the economy, including increasing inflation, energy costs, unemployment, geopolitical issues, pandemics, concerns over the creditworthiness of governments worldwide and the stability of the global banking system. In particular, the residential credit market in the United States has experienced, in the past, a variety of difficulties and challenging economic conditions, including defaults, credit losses, and liquidity concerns. Certain commercial banks, investment banks, insurance companies, and mortgage-related investment vehicles (including publicly traded mortgage REITs) incurred extensive losses from exposure to the residential credit market as a result of these difficulties and conditions. Continuing concerns over these factors have contributed to increased volatility and unclear expectations for the economy and markets going forward and continue to impact investor perception of the risks associated with the residential real estate market, residential mortgage loans and various other target assets in which we may invest. As a result, values for residential mortgage loans, including U.S. performing and re-performing whole mortgage loans, and various other target assets in which we invest, have also experienced, and may continue to experience, significant . Any of the residential credit market and investor perception of the risks associated with residential mortgage loans, including U.S. performing and re-performing whole mortgage loans, and various other of our target assets could have a material effect on us.
Although obtaining collateral from counterparties is intended to help mitigate our potential exposure to a default by or the insolvency of a counterparty, such risks cannot be completely removed.
Although obtaining collateral from counterparties and any collateral management system implemented is intended to help mitigate our potential exposure to a default by or the insolvency of a counterparty, such risks cannot be completely removed. The collateral provided may not be sufficient to meet the counterparty’s obligations for a number of reasons. In addition, the value of the underlying real estate provided as collateral may not have a live quoted price.
There is no guarantee that the collateral will be correctly and accurately valued. To the extent that the collateral is not correctly valued, we may suffer a loss. Even if the collateral is correctly valued, the collateral may decrease in value between the time of default or insolvency of the counterparty and the time at which title to the collateral is obtained. The risk of a decrease in the value of collateral may be greater for illiquid assets (specifically real estate), due to the length of time it may take to obtain title to such assets, and such assets may comprise all or a significant portion of the collateral provided. While the collateral management process will be monitored by the Sub-Advisor, to the extent that the management process is not correctly adhered to and implemented, we may suffer a loss in the event of default or insolvency of the counterparty.
Our operating results are dependent upon the Sub-Advisor’s ability to source a large volume of U.S. performing and re-performing whole mortgage loans and other target assets for our investments on attractive terms.
Our operating results are dependent upon the Sub-Advisor’s ability to source a large volume of desirable U.S. performing and re-performing whole mortgage loans and other target assets for our investment on attractive terms, and the Sub-Advisor may be unable to do so for many reasons. The Sub-Advisor may be unable to identify originators that are able or willing to originate U.S. performing and re-performing whole mortgage loans and other target assets that meet our standards on favorable terms or at all. General economic factors, such as recession, declining home values, unemployment, and high interest rates, may limit the supply of available U.S. performing and re-performing whole mortgage loans and other target assets. Moreover, competition for U.S. performing and re-performing whole mortgage loans and other target assets may drive down supply or drive up prices, making it uneconomical to purchase such loans or other target assets. For instance, in acquiring U.S. performing and re-performing whole mortgage loans and other target assets from unaffiliated parties, we compete with a broad spectrum of institutional investors. Increased competition for, or a reduction in the available supply of, qualifying investments could result in higher prices for (and thus lower yields on) such investments, which could narrow the yield spread over borrowing costs. Competition may also reduce the number of investment available to us and may affect the terms upon which investments can be made. We may incur due diligence or other costs on investments which may not be or may not be completed at all (otherwise referred to as “ deal” costs.) As a result, we may incur additional costs to acquire a sufficient volume of U.S. performing and re-performing whole mortgage loans and other target assets or be to acquire such loans and other target assets at reasonable prices or at all. There can be no assurance that investments will be available for us or that available investments will meet our strategies. If we cannot source an adequate volume of U.S. performing and re-performing whole mortgage loans and other target assets on terms or at all, we may be materially and affected.
Although we do not intend to invest in non-performing residential mortgage loans, if we do acquire non-performing loans, this could increase our risk of loss.
We do not presently intend to invest in non-performing residential mortgage loans which we define as a loan where the borrower has failed to make timely payments of principal and/or interest within the prior three months. It is possible that our investment strategy may change such that we invest in non-performing residential mortgage loans. These mortgage loans could be considered to be “distressed.” It is possible we may acquire a loan which was performing upon acquisition but subsequently becomes non-performing. Borrowers on non-performing residential mortgage loans may be in economic distress and/or may have become unemployed, bankrupt, or otherwise unable or unwilling to make payments when due. Furthermore, borrowers of non-performing mortgage loans may be in economic distress due to changes in the general economic climate or local conditions (such as an oversupply of space or a reduction in demand for space), competition based on rental rates, attractiveness and location of the properties, changes in the financial condition of tenants, and changes in operating costs. assets may entail characteristics that make disposition or more , including, among other things, document or underlying real estate located in states with extended timelines. Additionally, many of these loans may have LTVs in excess of 100%, meaning the amount owed on the loan exceeds the value of the underlying real estate. Any we may incur on such investments may be significant and could materially and affect us.
Non-QM loans are loans that are underwritten pursuant to less stringent underwriting guidelines, and to the extent we invest in Non-QM loans, we could experience higher rates of delinquencies, defaults and foreclosures than those experienced by loans underwritten to more stringent underwriting guidelines and be subject to increased risks.
Non-QM loans have flexibility in underwriting guidelines and are subject to credit risk. The underwriting guidelines for Non-QM loans may be permissive as to the borrower’s debt-to-income, credit history, and/or income documentation. Loans that are underwritten pursuant to less stringent underwriting guidelines could experience substantially higher rates of delinquencies, defaults and foreclosures than those experienced by loans underwritten to more stringent underwriting guidelines. Non-QM loans also include “scratch and dent” loans which are recently originated mortgage loans closed with the intent to be delivered or sold in the secondary market, typically to a GSE, however, at some point an underwriting exception was discovered and caused the loan to be repurchased and then resold to investors like us. Although scratch and dent Non-QM loans are often the result of trivial or non-material underwriting exceptions and are often performing, there is no guarantee such will be the case with any scratch and dent Non-QM loans we acquire. If our Non-QM loans are underwritten to more flexible guidelines which have increased risk and may cause higher delinquency, default, or rates given economic , the performance of our investments in our Non-QM loan portfolio could be correspondingly affected, which could materially and affect us. A Non-QM loan is directly to resulting from . Therefore, the value of the underlying property, the creditworthiness and financial position of the borrower, and the priority and enforceability of the lien will significantly impact the value of any such Non-QM loan. In the event of a , we may assume direct ownership of the underlying real estate. The proceeds upon the sale of such real estate may not be sufficient to recover our cost basis in the Non-QM loan, and any costs or involved in the or process may increase . The value of Non-QM loans is also subject to property caused by , such as earthquakes or environmental , not covered by standard property insurance policies and to a reduction in a borrower’s mortgage debt by a court. In addition, may be assessed us because of our position as a mortgage holder or property owner, including assignee liability, environmental and other liabilities. In some cases, these may lead to exceeding the purchase price of the related Non-QM loan or property. Unlike Agency RMBS, Non-QM loans are not guaranteed by the U.S. Government or any GSE.
The U.S. performing and re-performing whole mortgage loans and other residential mortgage loans in which we invest are subject to a risk of default, among other risks.
Our strategy includes making credit-sensitive investments primarily in U.S. performing and re-performing whole mortgage loans. We also may invest in other target assets. Further, we may identify and acquire our target assets through the secondary market when market conditions and asset prices are conducive to making attractive purchases. Such acquisitions and investments will subject us to risks which include, among others:
declines in the value of real estate, and in particular the value of residential real estate;
risks related to general and local economic conditions, including unemployment rates;
lack of available mortgage funding for borrowers to refinance or sell their homes or other properties;
overbuilding and/or housing availability;
increases in property taxes;
changes in U.S. federal and state lending laws;
changes in zoning laws;
costs resulting from the clean-up of, and liability to third parties for damages resulting from, environmental problems, such as indoor mold;
casualty or condemnation losses;
acts of God, terrorism, social unrest, and civil disturbances;
uninsured damages from floods, earthquakes, or other natural disasters, including those resulting from global climate change;
limitations on and variations in rents;
fluctuations in interest rates;
undetected or unknown fraudulent activity by borrowers, originators, sellers of mortgage loans and/or other third-party service providers;
undetected deficiencies and/or inaccuracies in underlying mortgage loan documentation and calculations which cause a material diminution in the value of such loan from underwriting; and
failure of the borrower to adequately maintain the property.
To the extent that assets underlying our investments are concentrated geographically, by property type or in certain other respects, we may be subject to certain of the foregoing risks to a greater extent. Additionally, we may be required to foreclose on a mortgage loan and such actions would subject us to greater concentration of the risks of the real estate markets and risks related to the ownership and management of real property.
We may face material risks around security arrangements.
The security arrangements under a loan in which we have invested may not have been properly created or perfected, or may be subject to other legal or regulatory restrictions. While we will invest in secured loans, the security arrangements in relation to such loans will be subject to such security having been correctly created and perfected and any applicable legal or regulatory requirements which may restrict the giving of security by a borrower under a loan, such as, for example, thin capitalization, over-indebtedness, financial assistance and corporate benefit requirements. If the loans in which we invest do not benefit from the expected security arrangements, this may affect the value of such investments. A lender also risks such liability on foreclosure of the mortgage. Any such lien arising with respect to a mortgaged property would adversely affect the value of the mortgaged property and could make impracticable foreclosure on the mortgaged property in the event of a default by the related debtor.
The operating and financial risks of borrowers may adversely affect our results of operations and financial condition.
Our investments involve credit or default risk, which is the risk that a borrower will be unable to make principal and interest payments on its outstanding debt when due. We may acquire interests in loans which thereafter may become nonperforming for a variety of reasons. The risk of default and losses on real estate debt instruments will be affected by a number of factors, including global, regional and local economic conditions, interest rates, the U.S. residential real estate market in general as well as general economic conditions. Furthermore, the financial condition of one or more of our borrowers could deteriorate as a result of, among other things, an economic downturn. As a result, underlying borrowers that we expected to be stable may otherwise have a weak financial condition or be experiencing financial distress and subject our investments to additional risk of loss and .
We will face risks associated with hedging transactions.
Subject to maintaining our qualification as a REIT, we intend to utilize a wide variety of derivative and other hedging instruments, including interest rate hedges, for risk management purposes, the use of which is a highly specialized activity that may entail greater than ordinary investment risks. Any such derivatives and other hedging transactions may not be effective in mitigating risk in all market conditions or against all types of risk (including unidentified or unanticipated risks), thereby resulting in losses to us. Engaging in derivatives and other hedging transactions may result in a poorer overall performance for us than if we had not engaged in any such transaction, and the Sub-Advisor may not be able to effectively hedge against, or accurately anticipate, certain risks that may adversely affect our investment portfolio. In addition, our investment portfolio will always be exposed to certain risks that cannot be fully or effectively hedged, such as credit risk relating both to particular securities and counterparties as well as interest rate risks. See “—We intend to invest in derivatives, which involve numerous risks” below.
We intend to invest in derivatives, which involve numerous risks.
Subject to maintaining our status as a REIT and in connection with any financing arrangements we put in place, we intend, from time to time, to engage in a variety of hedging transactions that seek to mitigate the effects of fluctuations in interest rates and their effects on our cash flows. These hedging transactions could take a variety of forms, including interest rate swaps, total return swaps, credit default swaps and indices thereon, short sales (typically related to treasuries), futures, options and similar financial instruments.
Derivative instruments, especially when purchased in large amounts, may not be liquid in all circumstances, so that in volatile markets we may not be able to close out a position without incurring a loss. Our use of derivative instruments may be particularly speculative and involves investment risks and transaction costs to which we would not be subject absent the use of these instruments, and use of derivatives generally involves leverage in the sense that the investment exposure created by the derivatives may be significantly greater than our initial investment in the derivative. Leverage magnifies investment, market and certain other risks. Thus, the use of derivatives may result in losses in excess of principal and greater than if they had not been used. The value of such derivatives also depends upon the price of the underlying instrument or commodity. Such derivatives and other customized instruments also are subject to the risk of non-performance by the relevant counterparty. In addition, actual or implied daily limits on price fluctuations and speculative position limits on the exchanges or over-the-counter markets in which we may conduct our transactions in derivative instruments may prevent prompt liquidation of positions, us to the potential of . Derivative instruments that may be purchased or sold by us may include instruments not traded over-the-counter or on an exchange. The risk of by the obligor on such an instrument may be , and the ease with which we can of or enter into transactions with respect to such an instrument may be less than in the case of an exchange-traded instrument. In addition, significant may exist between “bid” and “asked” prices for derivative instruments that are traded over-the-counter and not on an exchange. Such over-the-counter derivatives are also subject to types and levels of investor protections or governmental regulation that may differ from exchange-traded instruments.
The ability to successfully use derivative investments depends on the ability of the Advisor and Sub-Advisor. The skills needed to employ derivatives strategies are different from those needed to select portfolio investments and, in connection with such strategies, the Advisor and Sub-Advisor must make predictions with respect to market conditions, liquidity, market values, interest rates or other applicable factors, which may be inaccurate. The use of derivative investments may require us to sell or purchase portfolio investments at inopportune times or for prices below or above the current market values, may limit the amount of appreciation we can realize on an investment or may cause us to hold a security that we might otherwise want to sell. We will also be subject to credit risk with respect to the counterparties to our derivatives contracts (whether a clearing corporation in the case of exchange-traded instruments or another third party in the case of over-the-counter instruments). In addition, the use of derivatives will be subject to additional unique risks associated with such instruments including a lack of sufficient asset correlation, heightened volatility in reference to interest rates or prices of reference instruments and duration/term mismatch, each of which may create additional risk of .
Failure to hedge effectively against interest rate changes may materially adversely affect our results of operations and financial condition.
Subject to any limitations required to maintain qualification as a REIT, in addition to acquiring MSRs, we intend to seek to manage our exposure to interest rate volatility by using interest rate hedging arrangements, such as interest rate cap or collar agreements and interest rate swap agreements. These agreements involve risks, such as the risk that counterparties may fail to honor their obligations under these arrangements and that these arrangements may not be effective in reducing our exposure to interest rate changes. These interest rate hedging arrangements may create additional assets or liabilities from time to time that may be held or liquidated separately from the underlying property or loan for which they were originally established. Hedging may reduce the overall returns on our investments. Failure to hedge effectively against interest rate changes may materially adversely affect our results of operations and financial condition.
Failure to obtain and maintain an exemption from being regulated as a commodity pool operator could subject us to additional regulation and compliance requirements that could materially adversely affect our business, results of operations and financial condition.
Registration with the U.S. Commodity Futures Trading Commission (the “CFTC”) as a “commodity pool operator” or any change in our operations necessary to maintain our ability to rely upon the exemption from being regulated as a commodity pool operator could adversely affect our ability to implement our investment program, conduct our operations and/or achieve our objectives and subject us to certain additional costs, expenses and administrative burdens. Furthermore, any determination by us to cease or to limit investing in interests which may be treated as “commodity interests” in order to comply with the regulations of the CFTC may have a material adverse effect on our ability to implement our investment objectives and to hedge risks associated with our operations.
Political changes may affect the real estate debt markets.
The current regulatory environment in the United States may be impacted by future legislative developments, such as amendments to key provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The U.S. Department of the Treasury has issued a series of recommendations in several reports for streamlining banking regulation and changing key features of the Dodd-Frank Act and other measures taken by regulators following the 2008 financial crisis.
Any significant changes in, among other things, economic policy (including with respect to interest rates and foreign trade), the regulation of the investment management industry, tax law, immigration policy and/or government entitlement programs of the current presidential administration could have a material adverse impact on us and our investments.
We may need to foreclose on certain of the residential mortgage loans we acquire, which could result in losses that materially and adversely affect us.
We may find it necessary or desirable to foreclose on certain of the residential mortgage loans we acquire, and the foreclosure process may be lengthy and expensive. There are a variety of factors that may inhibit the ability to foreclose upon a residential mortgage loan and liquidate real property. These factors include, without limitation: (1) extended foreclosure timelines in states that require judicial foreclosure, including states where we may hold high concentrations of residential mortgage loans; (2) significant collateral documentation deficiencies; (3) U.S. federal, state or local laws that are borrower friendly, including legislative action or initiatives designed to provide homeowners with assistance in avoiding residential mortgage loan foreclosures and that serve to delay the foreclosure process; (4) programs that require specific procedures to be followed to explore the refinancing of a residential mortgage loan prior to the commencement of a proceeding; and (5) in real estate values and sustained high levels of that increase the number of and place additional pressure on the judicial and administrative systems. In periods following home price , “strategic ” (decisions by borrowers to on their mortgage loans having the ability to pay) also may become more prevalent. Even if we are in on a residential mortgage loan, the proceeds upon sale of the underlying real estate may not be sufficient to recover our cost basis in the loan, resulting in a to us. We will bear a risk of of principal to the extent of any between the value of the collateral and the principal and accrued interest of the residential mortgage loan. Furthermore, any costs or involved in the of the loan or a of the underlying property will further reduce the net proceeds and, thus, increase the . The incurrence of any such could materially and affect us.
Additionally, in the event of the bankruptcy of a residential mortgage loan borrower, the residential mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the residential mortgage loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law. If borrowers default on their residential mortgage loans and we are unable to recover any resulting loss through the foreclosure process, we could be materially and adversely affected.
We may be affected by deficiencies in foreclosure practices of third parties, as well as related delays in the foreclosure process.
There continues to be uncertainty regarding the timing and ability of servicers to remove delinquent borrowers from their homes, so that they can liquidate the underlying properties and ultimately pass the liquidation proceeds through to owners of the residential mortgage loans or other assets. Since the 2008 housing crisis, and in response to the well-publicized failures of many servicers to follow proper foreclosure procedures (such as those involving “robo-signing”), mortgage servicers are being held to much higher foreclosure-related documentation standards than they previously were. However, because many mortgages have been transferred and assigned multiple times (and by means of varying assignment procedures), mortgage servicers have historically had difficulty, and may continue to have difficulty, furnishing the requisite documentation to initiate or complete foreclosures. This leads to stalled or suspended foreclosure proceedings and ultimately additional -related costs. -related also tend to increase ultimate loan as a result of property , amplified legal and other costs, and other factors. Many factors , such as borrower lawsuits and judicial backlog and , are outside a servicer’s control and have , and will likely continue to , processing in both judicial states (where require court involvement) and non-judicial states. The about in practices of servicers and related in the process may impact our assumptions and affect the values of, and our returns on, our investments in residential mortgage loans, including Non-QM loans, and in other target assets. Additionally, a servicer’s to remove borrowers from their homes in a timely manner could increase our costs, affect the value of the property and residential mortgage loans, and have a material effect on us.
Mortgage loan modification programs and future legislative action may adversely affect the value of, and the returns on, our target assets, which could materially and adversely affect us.
The U.S. Government, through the U.S. Treasury, the Federal Housing Administration, and the Federal Deposit Insurance Corporation, has in the past, and may in the future, implement programs designed to provide homeowners with assistance in avoiding mortgage loan foreclosures. The programs may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the loans or to extend the payment terms of the loans.
Loan modification and refinance programs may adversely affect the performance of our residential mortgage loans and other target assets. A significant number of loan modifications relating to our investments in residential mortgage loans and other target assets, including those related to principal forgiveness and coupon reduction, could negatively impact the realized yields and cash flows on such investments. In addition, it is also likely that loan modifications would result in increased prepayments on our investments. See “— General Risks Related to Our Investments—Prepayment rates may adversely affect the value of our portfolio ” for information relating to the impact of prepayments on our investments.
The U.S. Congress and various state and local legislatures may pass mortgage-related legislation that would affect our business, including legislation that would allow judicial modification of loan principal in the event of personal bankruptcy. We cannot predict whether or in what form Congress or the various state and local legislatures may enact legislation affecting our business or whether any such legislation will require us to change our practices or make changes in our portfolio in the future. These changes, if required, could materially and adversely affect us, particularly if we make such changes in response to new or amended laws, regulations, or ordinances in any state where we hold a significant portion of our investments.
Existing loan modification programs, together with future legislative or regulatory actions, including possible amendments to the bankruptcy laws, which result in the modification of outstanding residential mortgage loans and/or changes in the requirements necessary to qualify for refinancing of mortgage loans with Fannie Mae, Freddie Mac, or the Government National Mortgage Association (“Ginnie Mae”), may adversely affect the value of, and the returns on, our target assets, which could materially and adversely affect us.
Competition for investment opportunities may reduce our profitability and the return on an investor’s investment.
We face competition from various entities for investment opportunities, including other REITs, pension funds, insurance companies, investment funds and companies, partnerships and developers. In addition to third-party competitors, other programs sponsored by the Advisor, the Sub-Advisor and their respective affiliates, particularly those with investment strategies that overlap with ours (including vehicles which are or may be sponsored in the future), may seek allocations of investment opportunities in accordance with the Advisor’s or the Sub-Advisor’s prevailing policies and procedures. Some of these entities may have greater access to capital to acquire assets than we have. Competition from these entities may reduce the number of suitable investment opportunities offered to us or increase the bargaining power of counterparties seeking to sell. Additionally, disruptions and dislocations in the credit markets could have a material impact on the cost and availability of debt to finance asset acquisitions, which is a key component of our acquisition strategy. The lack of available debt on reasonable terms or at all could result in a further reduction of suitable investment opportunities and create a competitive for other entities that have financial resources than we do. In addition, over the past several years, a number of real estate funds and publicly traded and non-traded REITs have been formed and others have been consolidated (and many such existing funds have grown in size) for the purpose of investing in real estate debt and real estate-related assets. Additional real estate funds, vehicles and REITs with similar investment objectives are expected to be formed in the future by other unrelated parties and further consolidations may occur (resulting in larger funds and vehicles). Consequently, it is expected that competition for appropriate investment would reduce the number of investment available to us and affect the terms, including price, upon which investments can be made. This competition may cause us to acquire real estate debt and other investments at higher prices or by using less-than- capital structures, and in such case our returns will be lower and the value of our assets may not appreciate or may decrease significantly below the amount we paid for such assets. If such events occur, an investor may experience a lower return on their investment.
Accounting rules for certain of our transactions are highly complex and involve significant judgment and assumptions. Changes in accounting interpretations or assumptions could impact our consolidated financial statements.
Accounting rules for transfers of financial assets, securitization transactions, consolidation of variable interest entities and other aspects of our anticipated operations are highly complex and involve significant judgment and assumptions. These complexities could lead to a delay in preparation of financial information and the delivery of this information to our stockholders. Changes in accounting interpretations or assumptions could impact our consolidated financial statements and our ability to timely prepare our consolidated financial statements. Our inability to timely prepare our consolidated financial statements in the future would likely materially and adversely affect us.
If we fail to develop, enhance and implement strategies to adapt to changing conditions in the residential real estate and capital markets, our financial condition and results of operations may be materially and adversely affected.
The manner in which we compete and the types of assets in which we seek to invest will be affected by changing conditions resulting from sudden changes in our industry, regulatory environment, the role of GSEs, the role of credit rating agencies or their rating criteria or process, or the U.S. and global economies generally. If we do not effectively respond to these changes, or if our strategies to respond to these changes are not successful, we may be materially and adversely affected. In addition, we may not be successful in executing our business strategies and, even if we successfully implement our business strategies, we may not generate revenues or profits.
We may make joint-venture investments on an opportunistic basis, including with affiliates of the Advisor or the Sub-Advisor. Joint-venture investments could be adversely affected by our lack of sole decision-making authority, our reliance on the financial condition of our joint-venture partners and disputes between us and our joint-venture partners.
We may, on an opportunistic basis and subject to the requirements in our charter and investment policy, co-invest in the future with affiliates of the Advisor or the Sub-Advisor or third parties in partnerships or other entities that own assets. We may enter into joint ventures as part of an acquisition with the seller of the assets. We may acquire non-controlling interests or shared control interests in joint ventures. Even if we have some control in a joint venture, we would not be in a position to exercise sole decision-making authority regarding the joint venture. Additionally, with respect to the structure of our MSR investments, we will acquire the right to receive certain revenue streams relating to underlying mortgages within portfolios of residential MSRs through a joint venture with an affiliate of Balbec that is licensed and approved to purchase MSRs and that will act in a non-economic, controlling capacity.
Investments in joint ventures may, under certain circumstances, involve risks not present were another party not involved, including the possibility that joint venture partners might become bankrupt or fail to fund their required capital contributions. Joint venture partners may have economic or other business interests or goals that are inconsistent with our business interests or goals, and may be in a position to take actions contrary to our policies or objectives. Such investments may also have the potential risk of impasses on decisions, such as a sale, because neither we nor the joint venture partner would have full control over the joint venture. Disputes between us and joint venture partners may result in litigation or arbitration that would increase our expenses and prevent our officers and directors from focusing their time and effort on our business. Consequently, actions by or disputes with joint venture partners might result in subjecting assets owned by the joint venture to additional risk. In some cases, our joint venture partner may be entitled to asset management fees, promote or other incentive fee payments as part of the arrangement of the joint venture. In addition, we may in certain circumstances be liable for the actions of our joint venture partners.
Furthermore, we may have conflicting fiduciary obligations if we acquire assets with our affiliates or other related entities; as a result, in any such transaction we may not have the benefit of arm’s-length negotiations of the type normally conducted between unrelated parties.
In our due diligence review of potential investments, we may rely on third-party consultants and advisors and representations made by sellers of potential assets, and we may not identify all relevant facts that may be necessary or helpful in evaluating potential investments and such decisions may be made on an expedited basis.
Before making investments, due diligence will typically be conducted in a manner that we deem reasonable and appropriate based on the facts and circumstances applicable to each investment. Due diligence may entail evaluation of important and complex business, financial, tax, accounting, environmental, social and governance (“ESG”), legal, and regulatory and macroeconomic trends. Although the Advisors will take into consideration such non-financial investment factors, we should not be considered an ESG investment and should not be relied upon as such. There is no guarantee that ESG considerations will be a factor in making an investment decision and, if considered, there is no assurance that any ESG benefits will be achieved. Outside consultants, legal advisors, appraisers, accountants, investment banks and other third parties, including affiliates of the Advisor and the Sub-Advisor, may be involved in the due diligence process to varying degrees depending on the type of investment, the costs of which will be borne by us. Moreover, investment analyses and decisions by the Sub-Advisor may frequently be required to be undertaken on an expedited basis to take advantage of investment opportunities. In such cases, the information available to the Sub-Advisor at the time of making an investment decision may be limited, and they may not have access to detailed information regarding such investment.
Involvement of third-party advisors or consultants may present a number of risks primarily relating to the Advisor’s and the Sub-Advisor’s reduced control of the functions that are outsourced. Where affiliates of the Advisor or the Sub-Advisor are utilized, the Advisor’s management fee will not be offset for the fees paid or expenses reimbursed to such affiliates. In addition, if the Advisor or the Sub-Advisor is unable to timely engage third-party providers, the ability to evaluate and acquire more complex targets could be adversely affected. In the due diligence process and making an assessment regarding a potential investment, the Advisor and the Sub-Advisor will rely on the resources available to it, including information provided by the target of the investment and, in some circumstances, third-party investigations. The due diligence investigation carried out with respect to any investment opportunity may not reveal or highlight all relevant facts that may be necessary or helpful in evaluating such investment opportunity, particularly for large portfolio investments. We may incur broken deal costs on investments which may not be completed at all. Moreover, such an will not necessarily result in the investment being . There can be no assurance that attempts to provide downside protection with respect to investments, including pursuant to risk management procedures described in this Form 10-K, will their effect, and potential investors should regard an investment in us as being speculative and having a high degree of risk.
There can be no assurance that the Advisor or the Sub-Advisor will be able to detect or prevent irregular accounting, employee misconduct or other fraudulent practices or material misstatements or omissions during the due diligence phase of potential investments or during our efforts to monitor and disclose information about the investment on an ongoing basis or that any risk management procedures implemented by us will be adequate.
When conducting due diligence and making an assessment regarding an investment, the Advisor and the Sub-Advisor will rely on the resources available to it, including information provided or reported by the seller of the investment and, in some circumstances, third-party investigations. The due diligence investigation that the Sub-Advisor carries out with respect to any investment opportunity may not reveal or highlight all relevant facts that may be necessary or helpful in evaluating such investment opportunity. Moreover, such an investigation will not necessarily result in the investment being successful. Conduct occurring at the portfolio asset, even activities that occurred prior to our investment therein, could have an adverse impact on us.
In the event of fraud by the seller of any asset, we may suffer a partial or total loss of capital invested in that asset. An additional concern is the possibility of material misrepresentation or omission on the part of the seller. Such inaccuracy or incompleteness may adversely affect the value of our investments in such portfolio asset. We will rely upon the accuracy and completeness of representations made by sellers of portfolio assets in the due diligence process to the extent reasonable when we make our investments but cannot guarantee such accuracy or completeness.
In addition, we rely on information, including financial information and non-GAAP metrics, provided by sellers of our investments for disclosure to our investors about potential acquisitions or current assets owned by us. Accordingly, although we believe such information to be accurate, such information cannot be independently verified by the Sub-Advisor, and in some cases such information has not been independently reviewed or audited while under our ownership or control or at all. We cannot assure investors that the financial statements or metrics of assets we will acquire would not be materially different if such statements or metrics had been independently audited or reviewed.
Consultants, legal advisors, appraisers, accountants, investment banks and other third parties may be involved in the due diligence process and/or the ongoing operation of our portfolio assets to varying degrees depending on the type of investment. For example, certain asset management and finance functions, such as data entry relating to a portfolio asset, may be outsourced to a third-party service provider whose fees and expenses will be borne by such portfolio asset or us. Such involvement of third-party advisors or consultants may present a number of risks primarily relating to our reduced control of the functions that are outsourced.
A change to the conservatorship of Fannie Mae and Freddie Mac and related actions, along with any changes in laws and regulations affecting the relationship between Fannie Mae and Freddie Mac and the U.S. Government, could materially and adversely affect us.
Since 2008, Fannie Mae and Freddie Mac have been in conservatorship, with their primary regulator, the Federal Housing Finance Agency, acting as conservator. While Fannie Mae and Freddie Mac currently act as the primary sources of liquidity in the residential mortgage markets, both by purchasing mortgage loans for their own portfolios and by guaranteeing mortgage-backed securities, the U.S. Government may enact structural changes to one or more of the GSE s , including privatization, consolidation and/or a reduction in the ability of GSEs to purchase mortgage loans or guarantee mortgage obligations. We cannot predict if, when or how the conservatorships will end, or what associated changes (if any) may be made to the structure, mandate or overall business practices of either of the GSEs. Accordingly, there continues to be uncertainty regarding the future of the GSEs, including whether they will continue to exist in their current form and whether they will continue to meet their guarantees and other obligations. A substantial reduction in mortgage-purchasing activity by the GSEs could result in increased volatility in the residential housing market.
Certain actions by the U.S. Federal Reserve could materially and adversely affect us.
Changing benchmark interest rates, and the U.S. Federal Reserve’s actions and statements regarding monetary policy, can affect the fixed-income and mortgage finance markets in ways that could adversely affect the value of, and returns on, our investments, which could materially and adversely affect us. Statements by the U.S. Federal Reserve regarding monetary policy and the actions it takes to set or adjust monetary policy may affect the expectations and outlooks of market participants in ways that adversely affect our investments. Over the past few years, statements made by the Chair and other members of the U.S. Federal Reserve Board and by other U.S. Federal Reserve officials regarding the U.S. economy, future economic growth, the U.S. Federal Reserve’s future open market activity and monetary policy had a significant impact on, among other things, benchmark interest rates, the value of residential mortgage loans and, more generally, the fixed-income markets. In addition, recently the U.S. Federal Reserve Board has lowered, and may further lower in the future, certain benchmark interest rates in an effort to encourage economic growth. In 2022 and much of 2023, in response to inflationary pressures, the Federal Reserve increased interest rates substantially. However, in 2024 and 2025, in response to decreasing rates of inflation, the Federal Reserve decreased interest rates and may continue to decrease rates in the future. These statements and actions of the U.S. Federal Reserve, and other factors, also significantly impacted many market participants’ expectations and outlooks regarding future levels of benchmark interest rates and the expected yields these market participants would require to invest in fixed-income instruments. To the extent benchmark interest rates rise, one of the immediate potential impacts on our assets would be a reduction in the overall value of our assets and the overall value of the pipeline of mortgage loans that the Sub-Advisor identifies. Rising benchmark interest rates also generally have a impact on the overall cost of borrowings we may use to finance our acquisitions and holdings of assets, including as a result of the requirement to post additional margin (or collateral) to lenders to offset any associated in value of the assets we finance with the use of leverage. Rising benchmark interest rates may also cause sources of leverage that we may use to finance our investments to be or more limited in their availability in the future. These and other developments could materially and affect us.
The ownership of residential mortgage loans could subject us to legal, administrative, regulatory, and other risks, including those arising under U.S. federal consumer protection laws and regulations designed to regulate residential mortgage loan underwriting and originators’ lending processes, standards and disclosures to borrowers.
These laws and regulations include the CFPB’s “Know Before You Owe” mortgage disclosure rule, the ATR rules, and qualifying mortgage loan regulations, in addition to various U.S. federal, state, and local laws and regulations intended to discourage predatory lending practices by residential mortgage loan originators. Application of certain standards set forth in the ATR rules is highly subjective and subject to interpretive uncertainties. As a result, a court may determine that a residential mortgage loan did not meet the standard or test even if the originator reasonably believed such standard or test had been satisfied. Failure of residential mortgage loan originators or servicers to comply with these laws and regulations could subject us, as a purchaser or an assignee of these loans (or as an investor in securities backed by these loans), to monetary penalties assessed by the CFPB through its administrative enforcement authority and by mortgagors through a private right of action against lenders or as a defense to foreclosure, including by recoupment or setoff of finance charges and fees collected, and could result in rescission of the affected residential mortgage loans, which could materially and affect us. Such risks may be higher in connection with the acquisition of Non-QM loans, which is currently the focus of our strategy. Borrowers under Non-QM loans may be more likely to the analysis conducted under the ATR rules by lenders. Even if a borrower does not in the , additional costs may be incurred in connection with and such , which may be more in judicial jurisdictions than in non-judicial jurisdictions, and there may be more of a likelihood such are made since the borrower is already to the judicial system to process the .
Increases in interest rates could adversely affect the value of our assets, cause our interest expense to increase, increase the risk of default on our assets and cause a decrease in the volume of certain of our target assets, which could materially and adversely affect us.
Our operating results depend in large part on the difference between the income from our assets, net of credit losses, and financing costs. We anticipate that, in many cases, the income from our assets will respond more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, to the extent not offset by our interest rate hedges or MSRs, may significantly influence our financial results. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations, and other factors beyond our control. For example, recently, there has been a significant rise in inflation and the U.S. Federal Reserve Board has raised, and may continue to raise, interest rates in an effort to curb inflation. These increases in interest rates and inflation have led, and may continue to lead, to economic volatility, increased borrowing costs, price increases and risks of recession.
Fixed income assets typically decline in value if interest rates increase. If long-term interest rates were to increase significantly, not only would the market value of these assets be expected to decline, but these assets could lengthen in duration because, for example, borrowers would be less likely to prepay their mortgages. Further, an increase in short-term interest rates would increase the rate of interest payable on any short-term borrowings used to finance these assets. Subject to maintaining our qualification as a REIT and maintaining our exclusion from registration as an investment company under the Investment Company Act, we expect to continue to utilize various derivative instruments and other hedging instruments to mitigate interest rate risk, but there can be no assurances that our hedges will be successful or that we will be able to enter into or maintain such hedges. As a result, interest rate fluctuations can cause significant losses, reductions in income, and could materially and adversely affect us.
In addition, rising interest rates generally reduce the demand for mortgage loans due to the higher cost of borrowing. A reduction in the volume of mortgage loans originated may affect the volume of target assets available to us, which could adversely affect our ability to acquire assets that may satisfy our investment objectives. If rising interest rates cause us to be unable to acquire a sufficient volume of our target assets with a yield that is above our borrowing cost, it could materially and adversely affect us. Even though MSR assets can act as a “natural hedge” in our overall portfolio in response to rising interest rates, the hedge is not perfect, either in amount or timing. Likewise, if interest rates were to fall, there could be an immediate negative effect on revenue from a decrease in the fair value of residential MSRs.
An increase in interest rates could also cause financial strain on borrowers with adjustable-rate mortgages, who might then be more likely to default. In addition, we cannot ensure that our access to capital and other sources of funding will not become constrained, which could adversely affect the availability and terms of future borrowings, renewals or refinancings.
Such future constraints could increase our borrowing costs, which would make it more difficult or expensive to obtain additional financing or refinance existing obligations and commitments, which could slow or deter future growth.
Credit ratings assigned to our investments are or will be subject to ongoing evaluations and revisions, and we cannot assure investors that those ratings will not be downgraded.
Some of our investments, including securities issued in our existing or future securitization transactions for which we would be required to retain a portion of the credit risk, are or may be rated by rating agencies. Any credit ratings on our investments are subject to ongoing evaluation by credit rating agencies, and we cannot assure investors that any such ratings would not be changed or withdrawn by a rating agency in the future if, in its judgment, circumstances warrant. If rating agencies assign a lower-than-expected rating or reduce or withdraw, or indicate that they may reduce or withdraw, their ratings of our investments in the future, the value and liquidity of our investments could significantly decline, which would adversely affect the value of our portfolio and could result in losses.
Our investment in lower rated non-Agency RMBS resulting from the securitization of our assets or otherwise exposes us to the first loss on the mortgage assets held by the securitization vehicle. Additionally, the principal and interest payments on non-Agency RMBS are not guaranteed by any entity, including any government entity or GSE, and therefore are subject to increased risks, including credit risk.
Our target portfolio includes non-Agency RMBS which are backed by residential mortgage loans that are not issued or guaranteed by an Agency or a GSE. Within a securitization of residential mortgage loans, various securities are created, each of which has varying degrees of credit risk. Our investments in non-Agency RMBS generally are concentrated in lower-rated and unrated securities in which we are exposed to the first loss on the residential mortgage loans held by the securitization vehicle, which subjects us to the most concentrated credit risk associated with the underlying residential mortgage loans.
Additionally, the principal and interest on non-Agency RMBS, unlike those on Agency RMBS, are not guaranteed by GSEs such as Fannie Mae and Freddie Mac or, in the case of Ginnie Mae, the U.S. Government. Non-Agency RMBS are subject to many of the risks of the respective underlying mortgage loans. A residential mortgage loan is typically secured by a single-family residential property and is subject to risks of delinquency and foreclosure and risk of loss. The ability of a borrower to repay a loan secured by a residential property is dependent upon the income or assets of the borrower. A number of factors, including, but not limited to, a general economic downturn, unemployment, acts of God, terrorism, social unrest, and civil disturbances, may impair the borrower’s ability to repay its mortgage loan. In periods following home price declines, “strategic defaults” (decisions by borrowers to default on their mortgage loans having the ability to pay) also may become more prevalent. In the event of under residential mortgage loans backing any of our non-Agency RMBS, we will bear a risk of of principal to the extent of any between the value of the collateral and the principal and accrued interest of the residential mortgage loan.
Additionally, in the event of the bankruptcy of a residential mortgage loan borrower, the residential mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the residential mortgage loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law. Foreclosure of a residential mortgage loan can be an expensive and lengthy process which could have a substantial negative effect on our anticipated return on the foreclosed residential mortgage loan. If borrowers default on the residential mortgage loans backing our non-Agency RMBS and we are unable to recover any resulting loss through the foreclosure process, we could be materially and adversely affected.
We target the acquisition of MSRs and excess MSRs, which would expose us to significant risks.
We target the acquisition of MSRs and excess MSRs. MSRs would arise from contractual agreements between us and investors (or their agents) in mortgage loans and mortgage securities. The determination of the value of MSRs will require us to make numerous estimates and assumptions. Such estimates and assumptions include, without limitation, estimates of future cash flows associated with MSRs based upon assumptions involving interest rates as well as the prepayment rates, delinquencies, and foreclosure rates of the underlying serviced mortgage loans. The ultimate realization of the fair value of MSRs may be materially different than the values of such MSRs estimated under our valuation policy. The use of different estimates or assumptions in connection with the valuation of these assets could produce materially different fair values for such assets, which could have a material adverse effect on us.
Changes in interest rates are a key driver of the performance of MSRs. Historically, the fair value of MSRs has increased when interest rates rise and decreased when interest rates decline due to the effect those changes in interest rates have on prepayment estimates. To the extent we do not hedge against changes in the value of MSRs, our investments in MSRs would be more susceptible to volatility due to changes in the value of, or cash flows from, the MSRs as interest rates change.
Prepayment speeds significantly affect MSRs. Prepayment speed is the measurement of how quickly borrowers pay down the unpaid principal balance of their loans or how quickly loans are otherwise brought current, modified, liquidated, or charged off. We may base the price we pay for MSRs and the rate of amortization of those assets on, among other things, projections of the cash flows from the related pool of mortgage loans. The Sub-Advisor’s expectation of prepayment speeds is a significant assumption underlying those cash flow projections. If prepayment speed expectations increase significantly, the value of the MSRs could decline. Furthermore, a significant increase in prepayment speeds could materially reduce the ultimate cash flows we receive from MSRs, and we could ultimately receive substantially less return on such assets. Moreover, delinquency rates have a significant impact on the valuation of any MSRs. An increase in delinquencies generally results in lower revenue because typically we would only collect servicing fees for performing loans. The Sub-Advisor’s expectation of delinquencies is also a significant assumption underlying projections of potential returns. If delinquencies are significantly than expected, the estimated value of the MSRs could be . If the estimated value of MSRs is reduced, we could a .
Furthermore, MSRs and the related servicing activities are subject to numerous U.S. federal, state, and local laws and regulations and may be subject to various judicial and administrative decisions imposing various requirements and restrictions on the holders of such investments. Our failure to comply, or the failure of the servicer to comply, with the laws, rules, or regulations to which they are subject by virtue of ownership of MSRs, whether actual or alleged, could expose us to fines, penalties, or potential litigation liabilities, including costs, settlements, and judgments, any of which could have a material adverse effect on us. An affiliate of the Sub-Advisor has a captive master servicing team to aid in effecting our investment strategy, along with a Freddie-Mac approved MSR investment platform that is licensed to do business in all fifty states. The Sub-Advisor’s affiliated MSR investment platform also has a pending application with Fannie Mae; however, there can be no assurance such application will be granted.
Because excess MSRs are a component of the related MSR, the risks of owning an excess MSR are similar to the risks of owning an MSR. The valuation of excess MSRs is based on many of the same estimates and assumptions used to value MSR assets, thereby creating the same potential for material differences between estimated value and the actual value that is ultimately realized. Also, the performance of excess MSRs is impacted by the same drivers as the performance of MSR assets, including interest rates, prepayment speeds, and delinquency rates.
We rely on analytical models and other data to analyze potential asset acquisition and disposition opportunities and to manage our portfolio. Such models and other data may be incorrect, misleading, or incomplete, which could cause us to purchase assets that do not meet our expectations or to make asset management decisions that are not in line with our strategy.
We rely on the analytical models (both proprietary and third-party models) of the Sub-Advisor and information and data supplied by third parties. The Sub-Advisor’s proprietary models rely on the use of sourced “big data” and/or artificial intelligence (“A.I.”) to review and summarize such data, which may be in the form of satellite and other images. Models and data are used to value assets or potential assets, assess asset acquisition and disposition opportunities, manage our portfolio, and assess the timing and amount of cash flows expected to be collected, and will also be used in connection with any hedging of our investments. Many of the models are based on historical trends. These trends may not be indicative of future results.
Furthermore, the assumptions underlying the models may prove to be inaccurate, causing the models to also be incorrect. In the event models and data prove to be incorrect, faulty, misleading or incomplete, any decisions made in reliance thereon expose us to potential risks. For example, by relying on incorrect models and data, especially valuation or cash flow models, we may be induced to buy certain assets at prices that are too high, to sell certain other assets at prices that are too low, to overestimate or underestimate the timing or amount of cash flows expected to be collected, or to miss favorable opportunities altogether. Similarly, any hedging activities based on faulty models and data may prove to be .
Some of the risks of relying on analytical models and third-party data include the following:
collateral cash flows and/or liability structures may be incorrectly modeled in all or only certain scenarios or may be modeled based on simplifying assumptions that lead to errors;
information about assets or the underlying collateral may be incorrect, incomplete, or misleading;
asset, collateral or RMBS historical performance (historical prepayments, defaults, cash flows, etc.) may be incorrectly reported, or subject to interpretation; and
asset, collateral or RMBS information may be outdated, in which case the models may contain incorrect assumptions as to what has occurred since the date information was last updated.
Some models, such as prepayment models or default models, may be predictive in nature. The use of predictive models has inherent risks. For example, such models may incorrectly forecast future behavior, leading to potential losses. In addition, the predictive models used by the Sub-Advisor could differ substantially from those models used by other market participants, with the result that valuations based on these predictive models may be substantially higher or lower for certain assets than actual market prices. Furthermore, because predictive models are usually constructed based on historical data supplied by third parties, the success of relying on such models may depend heavily on the accuracy and reliability of the supplied historical data, and, in the case of predicting performance in scenarios with little or no historical precedent (such as extreme broad-based declines in home prices or deep economic recessions or depressions), such models would employ much greater degrees of extrapolation and would therefore be more speculative and would have limited reliability. To the extent that a model relies on A.I. to review and summarize data, the A.I. could to accurately summarize such data and cause the model to produce results.
All valuation models rely on correct market data inputs. If incorrect market data is entered into even a well-founded valuation model, the resulting valuations will be incorrect. However, even if market data is input correctly, “model prices” may differ substantially from market prices. If our market data inputs are incorrect or our model prices differ substantially from market prices, we could be materially and adversely affected.
The lack of liquidity in our assets may have a material adverse effect on us.
The investments made or to be made by us in our target assets may be or may become illiquid. Market conditions could significantly and negatively impact the liquidity of these investments. Illiquid assets typically experience greater price volatility, as a ready market may not exist, and can be more difficult to value. It may be difficult or impossible to obtain third-party pricing on the assets that we acquire. If third-party pricing is obtained, validating such pricing may be more subjective than it would be for more liquid assets due to the uncertainties inherent in valuing assets for which reliable market quotations are not available. Any illiquidity of our assets may make it difficult for us to sell such assets on favorable terms or at all. If we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the intrinsic value of the assets and/or the value at which we previously recorded such assets.
Assets that are illiquid are more difficult to finance using leverage. When we use leverage to finance assets and such assets subsequently become illiquid, we may lose or be subject to reductions on the financing supporting our leverage. Assets tend to become less liquid during times of financial stress, which is often when liquidity is most needed. As a result, our ability to sell assets or vary our portfolio in response to changes in economic and other conditions may be limited by liquidity constraints, which could have a material adverse effect on us.
Additionally, our investment strategy involves the use of securitizations to finance the acquisition and accumulation of mortgage loans or other mortgage-related assets that will be subject to the U.S. Risk Retention Rules. Securitizations for which we act as “sponsor” (as defined in the U.S. Risk Retention Rules), and/or have previously acted as co-sponsor and were selected to be the party obligated to comply with the U.S. Risk Retention Rules, require us (or a “majority-owned affiliate” within the meaning of the U.S. Risk Retention Rules) to retain a 5% interest in the related securitization issuing entity (the “Risk Retention Securities”). The Risk Retention Securities are required to be (1) a first loss residual interest in the issuing entity representing 5% of the fair value of the securities and other interests issued as part of the securitization transaction (a “horizontal slice”), (2) 5% of each class of the securities and other interests issued as part of the securitization transaction (a “vertical slice”) or (3) a combination of a horizontal slice and a vertical slice that, in the aggregate, represents 5% of the transaction. Regardless of the form of risk retention selected, we or a majority-owned affiliate will be required to hold the Risk Retention Securities until the end of the time period required under the U.S. Risk Retention Rules (i.e., the respective risk retention holding period). We are or will be, as the case may be, generally prohibited from hedging the credit risk of the Risk Retention Securities or from financing the Risk Retention Securities except on a “full recourse” basis in accordance with the U.S. Risk Retention Rules. Accordingly, some of our securitizations require, or in the case of certain future securitizations, will require us to hold Risk Retention Securities for an extended period and contribute to the of liquidity in our assets, which may have a material effect on us.
We may be exposed to environmental liabilities with respect to properties in which we have an interest.
In the course of our business, we may take title to real estate, and, if we do take title, we could be subject to environmental liabilities with respect to these properties. In such a circumstance, we may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation, and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, the presence of hazardous substances may adversely affect an owner’s ability to sell real estate or borrow using real estate as collateral. To the extent that an owner of an underlying property becomes liable for removal costs, the ability of the owner to make debt payments may be reduced, which in turn may materially adversely affect the value of the relevant mortgage-related assets held by us.
Insurance proceeds on a property may not cover all losses, which could result in the corresponding non-performance of or loss on our investment related to such property.
There are certain types of losses, generally of a catastrophic nature, such as acts of God, earthquakes, floods, hurricanes and other weather events, terrorism, or acts of war, which may be uninsurable or not economically insurable. Inflation, changes in building codes and ordinances, environmental considerations, and other factors, including acts of God, terrorism, or acts of war, also might result in insurance proceeds that are insufficient to repair or replace a property if it is damaged or destroyed. Under these circumstances, the insurance proceeds received with respect to a property relating to one of our investments might not be adequate to restore our economic position with respect to our investment. Any uninsured loss could result in the corresponding non-performance of or loss on our investment related to such property.
Risks Related to Debt Financing
We may encounter adverse changes in the credit markets.
Any adverse changes in the global credit markets could make it more difficult for us to obtain favorable financing. Our ability to generate attractive investment returns for our stockholders will be adversely affected to the extent we are unable to obtain favorable financing terms. If we are unable to obtain favorable financing terms, we may not be able to adequately leverage our portfolio, may face increased financing expenses or may face increased restrictions on our investment activities, any of which would negatively impact our performance.
We may use leverage in executing our business strategy, which may materially and adversely affect us.
We may use leverage in connection with the investment in and holding of mortgage loans and other assets, and we expect to finance a substantial portion of our mortgage loans through securitizations. Leverage will magnify both the gains and the losses on an investment. Leverage will increase our returns as long as we earn a greater return on investments purchased with borrowed funds than our cost of borrowing such funds although there can be no assurance that we would be able to earn such a greater return. Moreover, if we use leverage to acquire an asset and the value of the asset decreases, the leverage will increase our losses.
Our charter precludes us from borrowing in excess of 300% of the value of our net assets, which is generally expected to approximate 75% of the aggregate cost of our investments before deducting loan loss reserves, other non-cash reserves and depreciation. However, we may exceed this limit if our board of directors, including a majority of our independent directors, approves each borrowing in excess of the limit and we disclose the justification for doing so to our stockholders. Such additional leverage could exacerbate any losses we incur.
We may be required to post large amounts of cash as collateral or margin to secure our leveraged positions. In the event of a sudden, precipitous drop in the value of our financed assets, we might not be able to liquidate assets quickly enough to repay our borrowings, further magnifying losses. Even a small decrease in the value of a leveraged asset may require us to post additional margin or cash collateral. This may materially and adversely affect us.
If we seek to obtain and draw on a line of credit or otherwise incur leverage to fund repurchases or for any other reason, our financial leverage ratio could increase beyond our target.
We may seek to obtain a line of credit in an effort to provide for a ready source of liquidity for any business purpose, including to fund repurchases of shares in the event that repurchase requests exceed our operating cash flow and/or net proceeds from our continuous offering. There can be no assurances that we will be able to obtain a line of credit on financially reasonable terms. In addition, we may not be able to obtain lines of credit of an appropriate size for our business. If we borrow under a line of credit to fund repurchases of shares, our financial leverage will increase and may exceed our target leverage ratio. Our leverage may remain at the higher level until we receive additional net proceeds from our continuous offering or generate sufficient operating cash flow or proceeds from asset sales to repay outstanding indebtedness. In connection with a line of credit, distributions may be subordinated to payments required in connection with any indebtedness contemplated thereby. Increases in interest rates could increase the amount of our loan payments and adversely affect our ability to make distributions to our stockholders.
Interest we pay on our loan obligations will reduce cash available for distributions. To the extent we obtain variable rate debt, increases in interest rates could increase our interest costs, which could reduce our cash flows and our ability to make distributions to our stockholders. In addition, if we need to repay existing loans 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 such investments.
Volatility in the financial markets and challenging economic conditions could adversely affect our ability to secure debt financing on attractive terms and our ability to service or refinance any future indebtedness that we may incur.
The volatility of the global credit markets could make it more difficult to obtain favorable financing for investments. During periods of volatility, which often occur during economic downturns, generally credit spreads widen, interest rates rise, and investor demand for high-yield debt declines. These trends result in reduced willingness by investment banks and other lenders to finance new investments and deterioration of available terms. If the overall cost of borrowing increases, either by increases in the index rates or by increases in lender spreads, the increased costs may result in future acquisitions generating lower overall economic returns and potentially reducing future cash flow available for distribution. Disruptions in the debt markets negatively impact our ability to borrow monies to finance the purchase of assets. If we are unable to borrow monies on terms and conditions that we find acceptable, we likely will have to reduce the number of assets we can purchase, and the return on the assets we do purchase may be lower. In addition, we may find it , or to refinance indebtedness that is maturing. Moreover, to the extent that such marketplace events are not temporary, they could have an impact on the availability of credit to businesses generally and could lead to an overall of the U.S. economy.
Lenders may require us to enter into restrictive covenants relating to our operations, which could limit our ability to make distributions to our stockholders.
When providing financing, a lender may impose restrictions on us that affect our distribution and operating policies and our ability to obtain additional loans. Loan documents we enter into may contain covenants that limit our ability to further mortgage or dispose of the property or discontinue insurance coverage. In addition, loan documents may limit our ability to enter into or terminate certain operating or lease agreements related to the property. Loan documents may also require lender approval of certain actions, and as a result of the lender’s failure to grant such approval, we may not be able to take a course of action we deem most profitable. These or other limitations may adversely affect our flexibility and our ability to make distributions to our stockholders and the value of their investment.
Market conditions and other factors may affect our ability to securitize assets, which could increase our financing costs and materially and adversely affect us.
We expect to continue to use loan financing lines to finance the acquisition and accumulation of mortgage loans or other mortgage-related assets pending their eventual securitization. Upon accumulating an appropriate amount of assets, we expect to continue to finance a substantial portion of our mortgage loans utilizing fixed rate term securitization funding that provides long-term financing for our mortgage loans and locks in our cost of funding, regardless of future interest rate movements, but also exposes us to the risk of first loss. Our ability to continue to obtain permanent non-recourse financing through securitizations is affected by a number of factors, including:
conditions in the securities markets, generally;
conditions in the asset-backed securities markets, specifically;
yields on our portfolio of mortgage loans;
the credit quality of our portfolio of mortgage loans; and
our ability to obtain any necessary credit enhancement.
Securitization markets are negatively impacted by any factors which reduce liquidity, increase risk premiums for issuers, reduce investor demand, cause financial distress among financial guaranty insurance providers, or by a general tightening of credit and/or increased regulation. Conditions such as these may from time to time result in a delay in the timing of our securitization of mortgage loans or may reduce or even eliminate our ability to securitize mortgage loans and sell securities in the RMBS market, any of which would increase the cost of funding our mortgage loan portfolio. Our loan financing lines may not be adequate to fund our mortgage loan purchasing activities until such time as disruptions in the securitization markets subside. This would require us to hold the mortgage loans we acquire on our balance sheet, which would significantly delay our ability to fund the acquisition of additional mortgage loans or use equity capital to acquire any other target assets. Disruptions in the securitization market, including any adverse change, delay, or to access the securitization market, could therefore materially and affect us.
Low investor demand for asset-backed securities could also force us to hold mortgage loans until investor demand improves, but our capacity to hold such mortgage loans in our portfolio is not unlimited. Additionally, adverse market conditions could result in increased costs and reduced margins earned in connection with our securitization transactions.
Our ability to execute securitizations may be impacted, delayed, limited, or precluded by legislative and regulatory reforms applicable to asset-backed securities and the institutions that sponsor, service, rate, or otherwise participate in, or contribute to, the successful execution of a securitization transaction. With respect to any securitization transaction engaged in by us, these factors could limit, delay, or preclude our ability to execute securitization transactions and could also reduce the returns we would otherwise expect to earn in connection with securitization transactions.
The Dodd-Frank Act imposed significant changes to the legal and regulatory framework applicable to the asset-backed securities markets and securitizations, directing various U.S. federal regulators to engage in rule-making actions aimed at dramatically reforming regulation of U.S. financial markets. Included among those changes were the adoption of several rules by the SEC as part of Regulation Asset-Backed Securities II (“Regulation AB II”), which set forth disclosure requirements for securitization transactions, and the joint establishment of the U.S. Risk Retention Rules by a group of U.S. federal regulators, which require that the sponsors of securitizations (or their “majority-owned affiliates,” as defined under Credit Risk Retention) retain a minimum of 5% of the credit risk of the assets collateralizing any securitization transaction they bring to market, subject to certain exemptions and exclusions. While many of the rule-makings required by the Dodd-Frank Act have been finalized and are either effective or pending effectiveness, others remain to be finalized or even proposed. Further, many of the rules that have been finalized have been subject to modification or interpretation since their effective date, oftentimes in order to clarify ambiguities present in the final rules. Accordingly, it is difficult to predict with certainty how the Dodd-Frank Act and the other regulations that have been proposed, finalized or recently implemented will affect our ability to execute securitizations.
In addition to the Dodd-Frank Act, its related rules and Regulation AB II, other U.S. federal or state laws and regulations that could affect our ability to execute securitization transactions may be proposed, enacted, modified or implemented. In addition, the securitization industry continues to craft changes to securitization practices, including changes to representations and warranties in securitization transaction documents, new underwriting guidelines and disclosure guidelines. These laws and regulations and changes to securitization practices could alter the structure of securitizations in the future, could pose additional risks to our participation in future securitizations or effectively preclude us from executing securitization transactions, could delay our execution of these types of transactions, or could reduce the returns we would otherwise expect to earn from executing securitization transactions.
Additionally, capital and leverage requirements applicable to banks and other regulated financial institutions that traditionally purchase and hold asset-backed securities, could result in less investor demand for securities issued through securitization transactions or increased competition from other institutions that execute securitization transactions.
We may be unable to profitably execute securitization transactions, which could materially and adversely affect us.
A number of factors may determine whether a securitization transaction that we execute or participate in is profitable. One such factor is the price at which we acquire the mortgage loans that we intend to securitize, which may be impacted by, among other things, the level of competition in the marketplace or the relative desirability to originators, of retaining mortgage loans as investments versus selling them to third parties such as us. Another factor that impacts the profitability of a securitization transaction is the cost of the short-term debt used to finance our holdings of mortgage loans after acquisition and prior to securitization. This cost may vary depending on the availability of short-term financing, interest rates, the duration of the financing, and the extent to which third parties are willing to provide such financing. Additionally, the value of mortgage loans held by us prior to securitization may vary over the course of the holding period due to changes in interest rates or the credit quality of the mortgage loans. To the extent we seek to hedge against interest rate fluctuations that affect loan value, the cost of any hedging transaction will decrease returns on the respective securitization transaction. The price that investors pay for securities issued in our securitization transactions will also significantly affect our profitability margin. Additionally, in effecting securitization transactions, we may incur transaction costs or may incur or be required to make reserves for any liability in connection with executing a transaction, and such costs can also reduce the of a transaction. Furthermore, in the securitization transactions we participate in, we make certain representations and warranties about the underlying mortgage loans that we intend to securitize and we assume the obligation to repurchase or replace those mortgage loans in certain circumstances if those representations or warranties are untrue. If we are required to repurchase or replace such mortgage loans, it may impact our ability to execute securitizations of mortgage loans. To the extent that we are not to execute securitizations of mortgage loans, we could be materially and affected.
Rating agencies have historically played a central role in the securitization markets. Many purchasers of asset-backed securities require that a security be rated by the agencies at or above a specific grade before they will consider purchasing it. The rating agencies could adversely affect our ability to execute securitization transactions by deciding not to publish ratings for our securitization transactions or assigning ratings that are below the thresholds investors require. Further, rating agencies could alter their ratings processes or criteria after we have accumulated loans for securitization in a manner that reduces the value of previously acquired loans or that requires us to incur additional costs to comply with those processes and criteria.
We use repurchase agreements to finance our securities investments, which may expose us to risks that could result in losses.
We use repurchase agreements as a form of leverage to finance our securities investments, and the proceeds from repurchase agreements are generally invested in additional securities. There is a risk that the market value of the securities acquired from the proceeds received in connection with a repurchase agreement may decline below the price of the securities underlying the repurchase agreement that we have sold but remain obligated to repurchase. Repurchase agreements also involve the risk that the counterparty liquidates the securities we delivered to it under the repurchase agreements following the occurrence of an event of default under the applicable repurchase agreement by us. In addition, there is a risk that the market value of the securities we retain may decline. If the buyer of securities under a repurchase agreement were to file for bankruptcy or experience insolvency, we may be adversely affected. Furthermore, our counterparty may require us to provide additional margin in the form of cash, securities or other forms of collateral under the terms of the derivative contract. Also, in entering into repurchase agreements, we bear the risk of loss to the extent that the proceeds of the repurchase agreement are less than the value of the underlying securities. In addition, the interest costs associated with repurchase agreements transactions may affect our results of operations and financial condition, and, in some cases, we may be off than if we had not used such instruments.
Risks Related to our Relationship with the Advisor, the Sub-Advisor and the Managing Dealer
We depend on the Sub-Advisor, under the oversight of the Advisor and our board of directors, to manage our investments and otherwise conduct our business, and any material adverse change in its financial condition or our relationship with the Advisor and the Sub-Advisor could have a material adverse effect on our business and ability to achieve our investment objectives.
Our stockholders will have no opportunity to control our overall day-to-day operations, including investment and disposition decisions. We will be relying on the experience and knowledge of the Advisor and Sub-Advisor under the oversight of our board of directors. Our success is dependent upon our relationship with, and the performance of, the Advisor and Sub-Advisor in the implementation of our investment strategy and day-to-day management of our investments. The Advisor or the Sub-Advisor may suffer or become distracted by adverse financial or operational problems in connection with either CNL’s or Balbec’s business and activities unrelated to us and over which we have no control. Should the Advisor or the Sub-Advisor fail to allocate sufficient resources to perform its responsibilities to us for any reason, we may be unable to achieve our investment objectives or to pay distributions to our stockholders.
The prior performance of the Advisor’s and Sub-Advisor’s prior programs or investments are not necessarily indicative of our future results. Stockholders should be aware that investment results cannot be predicted or projected reliably, that the realization of investment results is subject to significant uncertainties and contingencies and that the investment results may change materially in response to changes in one or more of such experiences, and do not constitute a prediction as to future events. Because of the uncertainties and subjective judgments inherent in selecting the assumptions and because future events and circumstances cannot be predicted, the actual investment results may differ, and may differ materially, from previous results achieved by the Advisor and/or Sub-Advisor.
Each of the Advisor and the Sub-Advisor can resign on 60 days’ notice and the Advisor and the Sub-Advisor have separately agreed to resign if the other is terminated for anything other than cause and we may not be able to find suitable replacement(s) within that time, resulting in a disruption in our operations that could adversely affect our financial condition, business and results of operations.
The Advisor has the right, under the Advisory Agreement, to resign at any time on 60 days’ written notice, whether we have found a replacement or not. If the Advisor resigns, we may not be able to contract with a new Advisor or hire internal management with similar expertise and ability to provide the same or equivalent services on acceptable terms within 60 days, or at all, in which case our operations are likely to experience a disruption and our financial condition, business and results of operations as well as our ability to pay distributions are likely to be adversely affected. In addition, the coordination of our internal management, business activities and supervision of our businesses is likely to suffer if we are unable to identify and reach an agreement with a single institution or group of executives having the expertise possessed by the Advisor and its affiliates. Even if we are able to retain comparable management, whether internal or external, the integration of such management and their lack of familiarity with our businesses may result in additional costs and time that may affect our financial condition, business and results of operations.
The Sub-Advisor also has the right, under the Sub-Advisory Agreement, to resign at any time on 60 days’ written notice, whether we or the Advisor has found a replacement or not. If the Sub-Advisor resigns, we and the Advisor may not be able to contract with a new sub-advisor. The Advisors and certain of their respective affiliates have also agreed separately that, in the event the Advisor or the Sub-Advisor is terminated or not renewed as an advisor or sub-advisor, other than for cause, the other will also terminate the Advisory Agreement or Sub-Advisory Agreement, as applicable. In such case, our operations are likely to experience a disruption and our financial condition, business and results of operations as well as our ability to pay distributions are likely to be adversely affected.
The Advisor’s or the Sub-Advisor’s inability to retain the services of key professionals could hurt our performance.
The Advisor has delegated the authority to make investment decisions to the Sub-Advisor, subject to the oversight of the Advisor. The Sub-Advisor’s power to approve the acquisition of a particular investment, finance or refinance any new or existing investment or dispose of an existing investment rests with particular professionals employed by the Sub-Advisor, subject to the oversight of the Advisor. Accordingly, our success depends to a significant degree upon the contributions of certain key professionals employed by the Advisor and the Sub-Advisor, each of whom would be difficult to replace. There is ever increasing competition among alternative asset firms, financial institutions, private equity firms, investment advisors, investment managers, real estate investment companies, real estate investment trusts and other industry participants for hiring and retaining qualified investment professionals and there can be no assurance that such professionals will continue to be associated with us, the Advisor or the Sub-Advisor, particularly in light of our perpetual-life nature, or that replacements will perform well. Neither we nor the Advisor or the Sub-Advisor have employment agreements with these individuals and they may not remain associated with us. If any of these persons were to cease their association with us, our operating results could suffer. Our future depends, in large part, upon the Advisor’s and the Sub-Advisor’s ability to attract and retain highly skilled managerial, operational and marketing professionals. If the Advisor or the Sub-Advisor or is to obtain the services of highly skilled professionals, our ability to implement our investment strategies could be or .
The fees we will pay in connection with our private offering, other offerings, and the agreements entered into with the Advisor and its affiliates were not determined on an arm’s-length basis and therefore may not be on the same terms we could achieve from a third party.
The compensation paid to the Advisor, the Sub-Advisor, the Managing Dealer and their respective affiliates for services they provide us was not determined on an arm’s-length basis. All service agreements, contracts or arrangements between or among the Advisor, the Sub-Advisor, their respective affiliates and us were not negotiated at arm’s-length. Such agreements include the Advisory Agreement, the Sub-Advisory Agreement, the Administrative Services Agreement, a master servicing agreement (the “Master Servicing Agreement”) with PRP Advisors, LLC (“PRPA”), the Managing Dealer Agreement and other agreements we may enter into with affiliates of the Advisor or the Sub-Advisor from time to time.
Risks Related to Conflicts of Interest
Various potential and actual conflicts of interest will arise, and these conflicts may not be identified or resolved in a manner favorable to us.
Each of CNL and Balbec has conflicts of interest, or conflicting loyalties, as a result of the numerous activities and relationships of CNL, Balbec, the Managing Dealer, the Advisor, the Sub-Advisor and the affiliates, partners, members, shareholders, officers, directors and employees of the foregoing, some of which are described herein. However, not all potential, apparent and actual conflicts of interest are included herein, and additional conflicts of interest could arise as a result of new activities, transactions or relationships commenced in the future. If any matter arises that we and our affiliates (including the Advisor and Sub-Advisor) determine in our good faith judgment constitutes an actual and material conflict of interest, we and our affiliates (including the Advisor and Sub-Advisor) will take such actions as we determine appropriate to mitigate the conflict. In accordance with our charter, transactions between us and the Advisor, the Sub-Advisor, one or more of our directors or any of their respective affiliates require approval by our board of directors, including a majority of our independent directors. However, there is no guarantee that the policies and procedures adopted by us, the terms and conditions of the Advisory Agreement, the Sub-Advisory Agreement, or the policies and procedures adopted by the Advisor, the Sub-Advisor, CNL, Balbec and their affiliates will us to identify, address or mitigate these of interest and there can be no assurance that our board of directors, CNL or Balbec will identify or all of interest in a manner that is to us.
The Advisors face conflicts of interest because the fees they receive for services performed are based in part on our NAV, which the Advisors are ultimately responsible for determining.
The Advisors are paid management fees for their services based on our NAV, which is calculated by the Administrator, based on valuations provided by the Advisors. The calculation of our NAV includes certain subjective judgments with respect to estimating, for example, the value of our portfolio and our accrued expenses, net portfolio income and liabilities, and, therefore, our NAV may not correspond to realizable value upon a sale of those assets. The Advisors may benefit from us retaining ownership of our assets at times when our stockholders may be better served by the sale or disposition of our assets in order to avoid a reduction in our NAV. If our NAV is calculated in a way that is not reflective of our actual NAV, then the purchase price of our shares or the price paid for the repurchase of an investor’s shares on a given date may not accurately reflect the value of our portfolio, and such investor’s shares may be worth less than the purchase price or more than the repurchase price. The valuation of our investments will affect the amount of the management fees paid to the Advisors. As a result, there may be circumstances where the Advisors are incentivized to determine valuations that are higher than the actual fair value of our investments.
The Advisor’s and the Sub-Advisor’s management fee and total return incentive fee may not create proper incentives or may induce the Advisors or their affiliates to make certain investments, including speculative investments, that increase the risk of our real estate portfolio.
We will pay the Advisor and the Sub-Advisor a management fee regardless of the performance of our portfolio. The Advisor’s and the Sub-Advisor’s entitlement to a management fee, which is not based upon performance metrics or goals, might reduce its incentive to devote its time and effort to seeking investments that provide attractive risk-adjusted returns for our portfolio. We would be required to pay the Advisor and the Sub-Advisor a management fee in a particular period even if we experienced a net loss or a decline in the value of our portfolio during that period. We will also be required to reimburse the Advisor and the Sub-Advisor for certain expenses described in the Advisory Agreement and Sub-Advisory Agreement.
The existence of the Advisor’s and the Sub-Advisor’s total return incentive fee, which is based on the investment return provided to stockholders (the “total return to stockholders”) for each share class in any calendar year, may create an incentive for the Advisor or the Sub-Advisor to make riskier or more speculative investments on our behalf or cause us to use more leverage than it would otherwise make in the absence of such performance-based compensation. In addition, the change in NAV per share will be based on the value of our investments on the applicable measurement dates and not on realized gains or losses. As a result, the Advisor and the Sub-Advisor may receive the total return incentive fee based on unrealized gains in certain assets at the time of such fees and such gains may not be realized when those assets are eventually disposed of.
Because the management fee and total return incentive fee are based on our NAV, the Advisor and/or the Sub-Advisor may also be motivated to accelerate acquisitions in order to increase NAV or, similarly, delay or curtail repurchases to maintain a higher NAV, which would, in each case, increase amounts payable to the Advisor and the Sub-Advisor, but may make it more difficult for us to efficiently deploy new capital. If our interests and those of the Advisor and the Sub-Advisor are not aligned, the execution of our business plan and our results of operations could be adversely affected, which could adversely affect our results of operations and financial condition. The Advisor, the Sub-Advisor and their respective affiliates, including certain of our officers and some of our directors, will face conflicts of interest including conflicts that may result from compensation arrangements. The Advisor compensates the members of its management team with incentive-based compensation, asset-based compensation and/or bonuses and awards which will vary based on the Advisor’s performance.
CNL and Balbec personnel work on other projects, and conflicts may arise in the allocation of personnel between us and other projects.
The Advisor, the Sub-Advisor and their affiliates will devote such time as they determine to be necessary to conduct our business affairs in an appropriate manner. However, CNL and Balbec personnel, including members of the investment committee, will work on other projects, serve on other committees (including boards of directors) and source potential investments for and otherwise assist the investment programs of other investment vehicles and their portfolio entities, including other investment programs to be developed in the future, including other REITs. Time spent on these other initiatives diverts attention from our activities, which could negatively impact us. Furthermore, CNL, Balbec and their respective personnel derive financial benefit from these other activities, including fees and performance-based compensation. Our sponsors’ personnel share in the fees and performance-based compensation generated by other investment vehicles. These and other factors create conflicts of interest in the allocation of time by such personnel.
We do not have a policy that expressly prohibits our directors, officers, or affiliates from engaging for their own account in business activities of the types conducted by us.
We do not have a policy that expressly prohibits our directors, officers, or affiliates from engaging for their own account in business activities of the types conducted by us. However, the Code of Business Conduct and Code of Ethics adopted by our board of directors contains a conflicts of interest policy that prohibits our directors, executive officers and certain affiliates from engaging in any transaction that involves an actual conflict of interest with us. Notwithstanding the prohibitions in the Code of Business Conduct and Code of Ethics adopted by our board of directors, after considering the relevant facts and circumstances of any actual conflict of interest, a majority of our directors, may, on a case-by-case basis and in their sole discretion, waive such conflict of interest. In addition, the Advisory Agreement and the Sub-Advisory Agreement do not prevent the Advisor, the Sub-Advisor and their respective affiliates, subject to an exclusivity agreement between the Advisor and the Sub-Advisor, from engaging in additional business opportunities, some of which could compete with us, except as agreed to by the Advisor and the Sub-Advisor.
We may source, sell and/or purchase assets either to or from the Advisors and their affiliates, and such transactions may cause conflicts of interest.
Subject to our charter and the restrictions in our investment policy, we may directly or indirectly source, sell and/or purchase all or any portion of an asset (or portfolio of assets/investments) to or from the Advisor, the Sub-Advisor and their respective affiliates, their respective related parties or investment vehicles or accounts sponsored, managed or advised by any of the foregoing, including parties which such affiliates or related parties own or have invested in. Pursuant to our charter and the conflicts of interest policy in the Code of Business Conduct and Code of Ethics adopted by our board of directors, such transactions will be subject to the approval of a majority of our directors not otherwise interested in the transaction. Subject to our charter and the restrictions in our investment policy, we may also source, sell to and/or purchase from third parties interests in or assets issued by affiliates of the Advisor, the Sub-Advisor, their respective related parties or investment vehicles or account sponsored, managed or advised by any of the foregoing and such transactions would not require approval by our directors or an offset of any fees we otherwise owe to the Advisor or its affiliates. The transactions referred to in this paragraph involve conflicts of interest, as our sponsors and their respective affiliates may receive fees and other benefits, directly or indirectly, from or otherwise have interests in both parties to the transaction.
The Advisor and the Sub-Advisor will experience conflicts of interest in connection with the management of our business affairs and their respective other accounts and clients.
The Advisor and the Sub-Advisor will experience conflicts of interest in connection with the management of our business affairs relating to the allocation of investment opportunities by the Advisor, the Sub-Advisor and their respective affiliates to us and other clients; compensation to the Advisor, the Sub-Advisor and their respective affiliates; services that may be provided by the Advisor, the Sub-Advisor and their respective affiliates to our businesses; co-opportunities for us and the allocation of such opportunities to us and other clients of the Advisor and/or the Sub-Advisor; the formation of investment vehicles by the Advisor or the Sub-Advisor; and differing recommendations given by the Advisor and/or the Sub-Advisor to us versus other clients.
Under certain circumstances, subject to the allocation policy adopted by our board of directors, the Sub-Advisor may determine not to pursue some or all of an investment opportunity within our investment objectives and guidelines, including, without limitation, as a result of our prior investments, business or other reasons applicable to us, CNL, Balbec or their respective affiliates.
Under certain circumstances, subject to the allocation policy adopted by our board of directors, the Sub-Advisor may determine not to pursue some or all of an investment opportunity within our investment objectives and guidelines, including, without limitation, as a result of business, reputational or other reasons applicable to us, the Advisor, the Sub-Advisor or their respective affiliates. In addition, the Sub-Advisor, the Advisor and/or their respective affiliates may determine that we should not pursue some or all of an investment opportunity, including, by way of example and without limitation, because we have already invested sufficient capital in the investment, sector, industry, geographic region or markets in question, as determined by the Sub-Advisor, the Advisor and/or their respective affiliates in their good faith discretion, or the investment is not appropriate for us for other reasons as determined by the Sub-Advisor, the Advisor and/or their respective affiliates in their good faith and reasonable discretion. In any such case affiliates of the Advisor and/or the Sub-Advisor could, thereafter, offer such opportunity to other parties, portfolio entities, joint-venture partners, related parties or third parties. Any such entities may be advised by a different CNL or Balbec business group with a different investment committee, which could determine an investment to be more than the Sub-Advisor and/or the Advisor believes to be the case. In any event, there can be no assurance that the Sub-Advisor’s and/or the Advisor’s, as applicable, assessment will prove correct or that the performance of any investments actually pursued by us will be comparable to any investment that are not pursued by us. CNL or Balbec, including their personnel, will, in certain circumstances, receive compensation from any such party that makes the investment, including an allocation of carried interest or referral fees, and any such compensation could be than amounts paid by us to the Advisor or Sub-Advisor. In some cases, CNL or Balbec earn fees when their other affiliates participate alongside or instead of us in an investment.
When the Advisor, the Sub-Advisor and their affiliates determine not to pursue some or all of an investment opportunity for us that would otherwise be within our investment objectives and strategies, and CNL or Balbec provide the opportunity or offer the opportunity to their affiliates, CNL or Balbec, including their personnel, can be expected to receive compensation from their affiliates, whether or not in respect of a particular investment, including an allocation of carried interest or referral fees, and any such compensation could be greater than amounts paid by us to the Advisor or Sub-Advisor. As a result, the Advisor or the Sub-Advisor (including personnel who receive such compensation) could be incentivized to allocate investment opportunities away from us to or source investment opportunities for their affiliates.
The Advisor, the Sub-Advisor and their affiliates make good faith determinations for allocation decisions based on expectations that will, in certain circumstances, prove inaccurate. Information unavailable to the Advisors, or circumstances not foreseen by the Advisors at the time of allocation, may cause an investment opportunity to yield a different return than expected. Conversely, an investment that the Advisor, the Sub-Advisor and their affiliates expect to be consistent with our return objectives will, in certain circumstances, fail to achieve them. There is no assurance that any conflicts arising out of the foregoing will be resolved in our favor. Each of CNL and Balbec is entitled to amend its policies and procedures at any time without our consent.
Certain principals and employees will, in certain circumstances, be involved in and have a greater financial interest in the performance of other CNL or Balbec funds or accounts, and such activities may create conflicts of interest in making investment decisions on our behalf.
Certain CNL or Balbec personnel will, in certain circumstances, be subject to a variety of conflicts of interest relating to their responsibilities to us, other investment vehicles and portfolio entities, and their outside personal or business activities, including as members of investment or advisory committees or boards of directors of or advisors to investment funds, corporations, foundations or other organizations. Such positions create a conflict if such other entities have interests that are adverse to ours, including if such other entities compete with us for investment opportunities or other resources. The CNL or Balbec personnel in question may have a greater financial interest in the performance of the other entities than our performance. This involvement may create conflicts of interest in making investments on our behalf and on behalf of such other funds, accounts and other entities. Although the Advisors will generally seek to minimize the impact of any such conflicts, there can be no assurance they will be resolved favorably for us. Also, CNL or Balbec personnel are generally permitted to invest in alternative investment funds, private equity funds, real estate funds, hedge funds and other investment vehicles, as well as engage in other personal trading activities relating to companies, assets, securities or instruments (subject to CNL’s or Balbec’s Code of Ethics requirements), some of which will involve of interest. Such personal securities transactions will, in certain circumstances, relate to securities or instruments, which can be expected to also be held or acquired by us or other investment vehicles, or otherwise relate to companies or issuers in which we have or acquire a different principal investment (including, for example, with respect to seniority). There can be no assurance that of interest arising out of such activities will be resolved in our favor. Investors will not receive any from any such investments, and the financial incentives of CNL or Balbec personnel in such other investments could be than their financial incentives in relation to us.
Tax Risks Related to Ownership of Our Shares
We would be subject to adverse consequences if we fail to qualify as a REIT.
We believe that we have been organized and intend to operate in a manner so as to qualify for taxation as a REIT for U.S. federal income tax purposes commencing with our taxable year ended December 31, 2025. Our qualification as a REIT, however, depends and will continue to depend on our ability to meet various requirements concerning, among other things, the ownership of our outstanding stock, the nature of our assets, the sources of our income and the amount of our distributions to our stockholders. Our compliance with the REIT income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis. Our ability to satisfy these asset tests depends upon our analysis of the characterization of our assets for U.S. federal income tax purposes and fair market values of our assets. For example, the determination of whether a debt instrument is treated as a qualifying asset generating qualifying income for purposes of the REIT income and asset tests may depend on whether the instrument is treated as debt or equity for U.S. federal income tax purposes and whether the instrument is treated as secured by real property for purposes of the REIT rules, which in some circumstances could be uncertain. In addition, the fair market values of certain of our assets are not susceptible to a precise determination.
If we were to fail to qualify as a REIT for any taxable year, we would not be allowed a deduction for dividends to our stockholders in computing our net taxable income and would be subject to U.S. federal income tax on our net taxable income at regular corporate rates and applicable state and local taxes. We would also be disqualified from treatment as a REIT for the four subsequent taxable years following the year during which our REIT qualification was lost unless we were entitled to relief under certain Internal Revenue Code provisions and obtained a ruling from the Internal Revenue Service (the “IRS”). If disqualified and unable to obtain relief, we may need to borrow money or sell assets to pay taxes. As a result, cash available for distribution would be reduced for each of the years involved. Furthermore, it is possible that future economic, market, legal, tax or other considerations may cause our REIT qualification to be revoked. This could have a material adverse effect on our business and the market price of our stock.
To qualify as a REIT, we may be forced to borrow funds, sell assets or take other actions during unfavorable market conditions.
To qualify as a REIT, we must ensure that we meet the REIT gross income test annually and that, at the end of each calendar quarter, at least 75% of the value of our assets consists of cash, cash items, government securities, shares in REITs and other qualifying real estate assets, including certain mortgage loans and certain kinds of mortgage-backed securities. The remainder of our investments in securities (other than government securities and REIT 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 (other than government securities and securities that are qualifying real estate assets) can consist of the securities of any one issuer, no more than 25% of the value of our total securities (20% for our taxable years beginning before January 1, 2026) can be represented by securities of one or more taxable REIT subsidiaries (“TRS”) and not more than 25% of the value of our assets can consist of debt instruments issued by publicly offered REITs that are not secured by real property. If we fail to comply with these requirements at the end of any calendar quarter, we must correct the failure within 30 days after the end of the calendar quarter or qualify for certain statutory relief provisions to avoid losing our REIT qualification and tax consequences.
In addition, in order to qualify as a REIT, we generally must distribute to our stockholders at least 90% of our net taxable income, excluding net capital gains each year, and we will be subject to U.S. federal income tax, as well as applicable state and local taxes, to the extent that we distribute less than 100% of our net taxable income each year. In addition, we will be subject to a 4% nondeductible excise tax on the amount, if any, by which distributions paid by us in any calendar year are less than the sum of 85% of our ordinary income, 95% of our capital gain net income and 100% of our undistributed income from prior years.
In order to meet these requirements, we may be required to liquidate from our portfolio, or contribute to a TRS, otherwise attractive investments, and may be unable to pursue investments that would be otherwise advantageous to us in order to satisfy the source of income or asset diversification requirements for qualifying as a REIT. Furthermore, in order to meet the distribution requirements, we may be required to: (i) sell assets in adverse market conditions, (ii) borrow on unfavorable terms, (iii) distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt or (iv) make a taxable distribution of our shares as part of a distribution in which stockholders may elect to receive shares or (subject to a limit measured as a percentage of the total distribution) cash, in order to comply with the REIT distribution requirements. All of these actions could reduce our income and amounts available for distribution to our stockholders.
Ordinary dividends paid by REITs generally do not qualify for the reduced tax rates applicable to “qualified dividend income.”
Dividends paid by C corporations to domestic shareholders that are individuals, trusts and estates currently are generally taxed at a maximum U.S. federal income tax rate of 20% as qualified dividend income. Dividends payable by REITs, however, are generally not eligible for the reduced rates applicable to qualified dividend income, except to the extent designated as capital gain dividends or qualified dividend income. The more favorable rates currently applicable to regular corporate dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in shares of non-REIT corporations that pay dividends, even taking into account the deduction of up to 20% of qualified REIT dividends received by non-corporate U.S. shareholders.
The failure of excess MSRs that we hold to qualify as real estate assets, or the failure of the income from excess MSRs to qualify as interest from mortgages, could adversely affect our ability to qualify as a REIT.
We may acquire excess MSRs directly or indirectly. In certain private letter rulings, the IRS ruled that excess MSRs meeting certain requirements would be treated as an interest in mortgages on real property and thus a real estate asset for purposes of the 75% REIT asset test, and interest received by a REIT from such excess MSRs will be considered interest on obligations secured by mortgages on real property for purposes of the 75% REIT gross income test. A private letter ruling may be relied upon only by the taxpayer to whom it is issued, and the IRS may revoke a private letter ruling. Consistent with the analysis adopted by the IRS in such private letter rulings and based on advice of counsel, we intend to treat any excess MSRs that we acquire that meet the requirements provided in the private letter rulings as qualifying assets for purposes of the 75% REIT gross asset test and we intend to treat income from such excess MSRs as qualifying income for purposes of the 75% and 95% gross income tests. Notwithstanding the IRS’s determination in the private letter rulings described above, it is possible that the IRS could successfully assert that any excess MSRs that we acquire do not qualify for purposes of the 75% REIT gross asset test and income from such MSRs does not qualify for purposes of the 75% and/or 95% gross income tests. In addition, it is possible that any excess MSRs that we acquire could have features not directly addressed in such private letter rulings, which could create uncertainty as to whether the analysis in the private letter rulings would apply to such excess MSRs. A of our excess MSRs to be treated as qualifying assets generating qualifying income for purposes of the REIT income and asset tests could cause us to be subject to a tax and could impact our ability to qualify as a REIT.
We may be required to report taxable income for certain investments in excess of the economic income we ultimately realize from them.
We may acquire debt instruments in the secondary market for less than their face amount. The amount of such discount will generally be treated as “market discount” for U.S. federal income tax purposes. Market discount generally is reported as income when, and to the extent that, any payment of principal of the debt instrument is made, unless we elect to include accrued market discount in income as it accrues. Principal payments on certain loans are made monthly, and consequently accrued market discount may have to be included in income each month as if the debt instrument were assured of ultimately being collected in full. If we collect less on the debt instrument than our purchase price plus the market discount we had previously reported as income, we may not be able to benefit from any offsetting loss deductions.
In addition, we may be required to accrue interest and discount income on mortgage loans, RMBS, MSRs and other types of debt securities or interests in debt securities before we receive any payments of interest or principal on such assets. For example, we may recognize income in excess of the cash we receive if we invest in debt instruments with “original issue discount,” or if we engage in certain debt modifications. We may also be required under the terms of the indebtedness that we incur, whether to private lenders or pursuant to government programs, to use cash received from interest payments to make principal payment on that indebtedness. Furthermore, we will generally be required to take certain amounts into income no later than the time such amounts are reflected on our financial statements. As a result of the foregoing, we may generate less cash flow than taxable income in a particular year, which could impact our ability to satisfy the REIT distribution requirements.
The “taxable mortgage pool” rules may increase the taxes that we or our stockholders may incur, and may limit the manner in which we effect future securitizations.
Securitizations by us or by subsidiaries we have or may form in the future could result in the creation of taxable mortgage pools for U.S. federal income tax purposes. As a result, we could have “excess inclusion income.” Certain categories of stockholders, such as non-U.S. stockholders eligible for treaty or other benefits, stockholders with net operating losses, and certain tax-exempt stockholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income from us that is attributable to any such excess inclusion income. In addition, to the extent that our common stock is owned by tax-exempt “disqualified organizations,” such as certain government-related entities and charitable remainder trusts that are not subject to tax on unrelated business income, we may incur a corporate level tax on a portion of any excess inclusion income. Moreover, we could face limitations in selling equity interests in these securitizations to outside investors, or selling any debt securities issued in connection with these securitizations that might be considered to be equity interests for tax purposes. These limitations may prevent us from using certain techniques to maximize our returns from securitization transactions.
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 our assets and operations. Under these provisions, any income that we generate from transactions intended to hedge our interest rate exposure or currency fluctuations will be excluded from gross income for purposes of the REIT 75% and 95% gross income tests if the instrument hedges either (i) interest rate risk on liabilities used to carry or acquire real estate assets, (ii) currency fluctuations with respect to items of income that qualify for purposes of the REIT 75% or 95% gross income tests or assets that generate such income, or (iii) is an instrument that hedges risks described in clause (i) or (ii) for a period following the extinguishment of the liability or the disposition of the asset that was previously hedged by the instrument, and, in each case, such instrument is properly identified under applicable Treasury regulations (as defined below). Income from hedging transactions that do not meet these requirements will generally constitute non-qualifying income for purposes of both the REIT 75% and 95% gross income tests. As a result of these rules, we may have to limit our use of hedging techniques that might otherwise be advantageous or implement those hedges through a TRS. This could increase the cost of our hedging activities because such TRS could be subject to tax on gains or expose us to greater risks associated with changes in interest rates and currency fluctuations than we would otherwise want to bear. In addition, in a TRS will generally not provide any tax to us, although, subject to , such may be carried forward to offset future taxable income of the TRS.
Certain of our business activities may potentially be subject to the prohibited transaction tax, which could reduce the return on an investment. Further, the tax on prohibited transactions will limit our ability to engage in transactions, including certain methods of securitizing mortgage loans, that would be treated as sales for U.S. federal income tax purposes.
For so long as we qualify as a REIT, our ability to dispose of certain properties may be restricted under the REIT rules, which generally impose a 100% penalty tax on any gain recognized on “prohibited transactions,” which refers to the disposition of property, including mortgage loans, that is deemed to be inventory or held primarily for sale to customers in the ordinary course of our business, subject to certain exceptions. Whether property is inventory or otherwise held primarily for sale depends on the particular facts and circumstances. For example, we might be subject to this tax if we were to sell or securitize loans in a manner that was treated as a sale of the loans as inventory for U.S. federal income tax purposes. The Internal Revenue Code provides a safe harbor that, if met, allows a REIT to avoid being treated as engaged in a prohibited transaction. No assurance can be given that any property that we sell will not be treated as property held for sale to customers, or that we can comply with the safe harbor. The 100% tax does not apply to gains from the sale of foreclosure property or to property that is held through a “taxable REIT subsidiary” or other taxable corporation, although such income will be subject to tax in the hands of the corporation at regular corporate rates. We intend to structure our activities to avoid prohibited transaction characterization. Accordingly, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans, other than through a TRS, and we may be required to limit the structures we use for our securitization transactions, even though such sales or structures might otherwise be for us.
Certain of our activities, including our use of TRSs, are subject to taxes that could reduce our cash flows.
Even if we qualify as a REIT for U.S. federal income tax purposes, we will be required to pay some U.S. federal, state, local and non-U.S. taxes on our income and property, including taxes on any undistributed income, taxes on income from certain activities conducted as a result of foreclosures, and property and transfer taxes. We would be required to pay taxes on net taxable income that we fail to distribute to our stockholders. In addition, we may be required to limit certain activities that generate non-qualifying REIT income and/or we may be required to conduct such activities through a TRS. We may hold assets in a TRS, including assets that we may acquire through foreclosure, assets that may be treated as dealer property and other assets that could adversely affect our ability to qualify as a REIT if held at the REIT level. As a result, we will be required to pay income taxes on the taxable income generated by these assets. Furthermore, we will be subject to a 100% penalty tax to the extent our economic arrangements with our TRSs, if any, are not comparable to similar arrangements among unrelated parties. We will also be subject to a 100% tax to the extent we derive income from the sale of assets to customers in the ordinary course of business other than through a taxable REIT subsidiary. To the extent we or our TRSs, if any, are required to pay U.S. federal, state, local or non-U.S. taxes, we will have less cash available for distribution to our stockholders.
A failure to comply with the limits on our ownership of and relationship with one of our taxable REIT subsidiaries, if any, would jeopardize our REIT qualification.
No more than 25% (20% for our taxable years beginning before January 1, 2026) of the value of a REIT’s total assets may consist of stock or securities of one or more taxable REIT subsidiary. This requirement limits the extent to which we can conduct activities through taxable REIT subsidiaries or expand the activities that we conduct through taxable REIT subsidiaries. The values of some of our assets, including assets that we hold through taxable REIT subsidiaries, may not be subject to precise determination, and values are subject to change in the future. Accordingly, there can be no assurance that we will be able to comply with the taxable REIT subsidiary limitation.
In addition, we may from time to time need to make distributions from a taxable REIT subsidiary in order to keep the value of our taxable REIT subsidiaries below the taxable REIT subsidiary limitation. Taxable REIT subsidiary dividends, however, generally will not constitute qualifying income for purposes of the 75% REIT gross income test. While we will monitor our compliance with both this income test and the limitation on the percentage of our total assets represented by taxable REIT subsidiary securities and intend to conduct our affairs so as to comply with both, the two may at times be in conflict with one another. For example, it is possible that we may wish to distribute a dividend from a taxable REIT subsidiary in order to reduce the value of our taxable REIT subsidiary to comply with this limitation, but we may be unable to do so without simultaneously violating the 75% REIT gross income test.
Although there are other measures we can take in such circumstances to remain in compliance with the requirements for REIT qualification, there can be no assurance that we will be able to comply with both of these tests in all market conditions.
We may choose to pay dividends in the form of our own shares, in which case our stockholders may be required to pay income taxes in excess of the cash dividends received.
We may distribute taxable dividends that are payable in cash or our shares. Stockholders (that are not otherwise exempt from U.S. federal income tax) receiving such dividends will be required to include the full amount of the dividend as ordinary income to the extent of our current and accumulated earnings and profits for U.S. federal income tax purposes. As a result, a U.S. stockholder may be required to pay income taxes with respect to such dividends in excess of the cash dividends received. Although a U.S. stockholder may not readily be able to sell or redeem its shares, if a U.S. stockholder is able to and does sell or redeem our shares it receives as a dividend in order to pay this tax, the proceeds may be less than the amount included in income with respect to the dividend, depending on the NAV per share of our common stock at the time of the sale or redemption. In addition, in such case, a U.S. stockholder could have a capital loss with respect to our shares sold that could not be used to offset such dividend income. Furthermore, with respect to certain non-U.S. stockholder, we may be required to withhold U.S. federal income tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in shares.
Characterization of any repurchase agreements we enter into to finance our portfolio assets as sales for tax purposes rather than as secured lending transactions would adversely affect our ability to qualify as a REIT.
We may enter into repurchase agreements with a variety of counterparties to achieve our desired amount of leverage for the assets in which we intend to invest. When we enter into a repurchase agreement, we generally sell assets to our counterparty to the agreement and receive cash from the counterparty. The counterparty is obligated to resell the assets back to us at the end of the term of the transaction. We believe that for U.S. federal income tax purposes we will be treated as the owner of the assets that are the subject of repurchase agreements and that the repurchase agreements will be treated as secured lending transactions notwithstanding that such agreements may transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the IRS could successfully assert that we did not own these assets during the term of the repurchase agreements, in which case we could fail to qualify as a REIT.
Distributions or gain on sale may be treated as unrelated business taxable income to U.S. tax-exempt investors in certain circumstances.
If (1) all or a portion of our assets are subject to the rules relating to taxable mortgage pools and the allocation of “excess inclusion income,” (2) we are a “pension-held REIT,” (3) a U.S. tax-exempt shareholder has incurred debt to purchase or hold shares of our common stock, or (4) any residual REMIC interests we hold or any of our qualified REIT subsidiaries that is treated as a taxable mortgage pool generate “excess inclusion income,” then a portion of the distributions to a U.S. tax-exempt stockholder and, in the case of condition (3), gains realized on the sale of shares of our common stock by such tax-exempt stockholder, may be subject to U.S. federal income tax as unrelated business taxable income under the Internal Revenue Code.
Foreclosures may impact our ability to qualify as a REIT and minimize tax liabilities.
If we foreclose, or consider foreclosing, on properties securing defaulted loans that we hold, we will have to consider the impact that taking ownership of such properties would have on our ability to continue to qualify to be taxed as a REIT and any tax liabilities attributable thereto if we continue to qualify as a REIT. In certain cases, the operation of real property will not generate qualifying rents from real property for purposes of the gross income tests, e.g., income from operation of a hotel. In certain circumstances, we will be able to make an election with the IRS to treat property we take possession of in a foreclosure as “foreclosure property.” If, and for so long as, such property qualifies as “foreclosure property,” income therefrom is treated as qualifying income for purposes of both gross income tests and gain from the sale of such property will not be subject to the 100% prohibited transaction tax for dealer sales, regardless of our how short our holding period in such property is when we sell such property or other dealer sales considerations. On the other hand, net income with respect to a property for which we have made a property election that would not otherwise be qualifying income for purposes of the gross income tests will be taxed at the U.S. federal corporate income tax rate. In certain circumstances, the IRS might that a particular property did not qualify for a property election or that its status as property while we believed it continued to qualify, possibly causing us to one or both gross income tests or causing any from the sale of such property to be subject to the prohibited transaction tax.
Our board of directors is authorized to revoke our REIT election without stockholder approval, which may cause adverse consequences to our stockholders.
Our charter authorizes our board of directors to revoke or otherwise terminate our REIT election, without the approval of our stockholders, if it determines that changes to U.S. federal income tax laws and regulations or other considerations mean it is no longer in our best interests to qualify as a REIT. Our board of directors has duties to us and could only cause such changes in our tax treatment if it determines to do so in good faith and reasonably believes that such changes are in our best interests. In this event, we would become subject to U.S. federal income tax on our taxable income and we would no longer be required to distribute most of our net income to our stockholders, which may cause a reduction in the total return to our stockholders.
An investor may have current tax liability on distributions investors elect to reinvest in our stock.
If an investor participates in our distribution reinvestment plan, such investors will be deemed to have received, and for U.S. federal income tax purposes will be taxed on, the amount reinvested in shares of our stock to the extent the amount reinvested was not a tax-free return of capital. Therefore, unless an investor is a tax-exempt entity, they may be forced to use funds from other sources to pay their tax liability on the reinvested dividends.
Legislative or regulatory tax changes related to REITs could materially and adversely affect us.
The U.S. federal income tax laws and regulations governing REITs and their stockholders, as well as the administrative interpretations of those laws and regulations, are constantly under review and may be changed at any time, possibly with retroactive effect. No assurance can be given as to whether, when, or in what form, the U.S. federal income tax laws applicable to us and our stockholders may be enacted. Changes to the U.S. federal income tax laws and interpretations of U.S. federal tax laws could adversely affect an investment in our stock.
Stockholders are urged to consult with their tax advisors regarding any legislative, regulatory or administrative developments on an investment in our stock.
ERISA Risks
We may be deemed to hold “plan assets” subject to Part 4 of Subtitle B of Title I of ERISA or Section 4975 of the Internal Revenue Code.
There can be no assurance that, notwithstanding our commercially reasonable efforts, our underlying assets will not otherwise be deemed to include “plan assets” for the purposes of Part 4 of Subtitle B of Title I of the Employee Retirement Income Security Act of 1974 (“ERISA”) or Section 4975 of the Internal Revenue Code. If our assets were deemed to be “plan assets”, this could result in, among other things, (i) the application of the prudence and other fiduciary standards of Part 4 of Subtitle B of Title I of ERISA to our investments and (ii) the possibility that certain transactions in which we might otherwise seek to engage in the ordinary course of our business and operation could constitute non-exempt prohibited transactions under section 406 of ERISA or section 4975 of the Internal Revenue Code, which could restrict us from entering into an otherwise desirable investment or from entering into an otherwise favorable transaction. In addition, fiduciaries considering an investment in our shares could, under certain circumstances, be liable for prohibited transactions under section 406 of ERISA or section 4975 of the Internal Revenue Code or other violations as a result of their investment or as co-fiduciaries for actions taken by or on behalf of us, the Advisor, the Sub-Advisor or the Managing Dealer. There may be a U.S. federal, state, local or non-U.S. law or regulation that contains one or more provisions that are similar to the fiduciary responsibility and prohibited transaction provisions of Part 4 of Subtitle B of Title I of ERISA or section 4975 of the Internal Revenue Code (“Similar Law”) that may also apply to an investment in our shares.
