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Section 1: 10-K (10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K


 

☒           ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2016

 

OR

 

☐              TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from            to

 

Commission File Number:  001-35808


 

SUTHERLAND ASSET MANAGEMENT CORPORATION

 

(Exact name of registrant as specified in its charter)


 

 

 

Maryland

90-0729143

(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification No.)

1140 Avenue of the Americas, 7th Floor

 

New York, NY

10036

(Address of principal executive offices)

(Zip Code)

(212) 257-4600

(Registrant's telephone number, including area code)

 


Securities registered pursuant to Section 12(b) of the Act:

 

 

 

 

Title of Each Class

    

Name of Each Exchange on Which Registered

Common Stock, $0.0001 par value

 

New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act:  None


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes ☐     No ☒

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. 

Yes ☐     No ☒

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ☒     No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ☒      No ☐

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Yes ☒      No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

 

 

Large accelerated filer ☐

 

Accelerated filer ☒

Non-accelerated filer ☐

(Do not check if a smaller reporting company)

Smaller reporting company☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes ☐     No ☒

 

As of June 30, 2016, the aggregate market value of the registrant's common stock held by non-affiliates of the registrant was $109,280,847 based on the closing sales price of the registrant’s common stock on June 30, 2016 as reported on the New York Stock Exchange.

 

On March 14, 2017, the registrant had a total of 30,549,084 shares of common stock, $0.0001 par value, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s proxy statement for the 2017 annual meeting of stockholders are incorporated by reference into Part III of this annual report on Form 10-K.

 

 

 

 


 

Table of Contents

TABLE OF CONTENTS

 

 

Page

 

 

PART I 

Item 1. Business 

24 

Item 1A. Risk Factors 

71 

Item 1B. Unresolved Staff Comments 

71 

Item 2. Properties 

71 

Item 3. Legal Proceedings 

72 

Item 4. Mine Safety Disclosures 

72 

PART II 

73 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 

73 

Item 6. Selected Financial Data 

76 

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations 

78 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk 

100 

Item 8. Financial Statements and Supplementary Data 

104 

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 

174 

Item 9A. Controls and Procedures 

174 

Item 9B. Other Information 

174 

PART III 

175 

Item 10. Directors, Executive Officers and Corporate Governance 

175 

Item 11. Executive Compensation 

175 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 

175 

Item 13. Certain Relationships and Related Transactions and Director Independence 

175 

Item 14. Principal Accountant Fees and Services 

175 

PART IV 

176 

Item 15. Exhibits and Financial Statement Schedules 

176 

SIGNATURES 

179 

 

 

 

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FORWARD-LOOKING STATEMENTS

 

 

Except where the context suggests otherwise, the terms “Company,” “we,” “us” and “our” refer to Sutherland Asset Management Corporation and its subsidiaries. We make forward-looking statements in this annual report on Form 10-K within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). For these statements,  we claim the protections of the safe harbor for forward-looking statements contained in such Sections. Forward-looking statements are subject to substantial risks and uncertainties, many of which are difficult to predict and are generally beyond our control. These forward-looking statements include information about possible or assumed future results of our operations, financial condition, liquidity, plans and objectives. When we use the words “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “could,” “would,” “may,” “potential” or the negative of these terms or other comparable terminology, we intend to identify forward-looking statements. Statements regarding the following subjects, among others, may be forward-looking:

 

·

our investment objectives and business strategy;

 

·

our ability to obtain future financing arrangements;

 

·

our expected leverage;

 

·

our expected investments;

 

·

the tolling agreement that GMFS, LLC (“GMFS”), our origination subsidiary, entered into with at least one counterparty relating to mortgage loans that were sold by GMFS to the predecessor to this counterparty, which extends the time period by which this counterparty could bring claims against GMFS;

 

·

estimates or statements relating to, and our ability to make, future distributions;

 

·

our ability to compete in the marketplace;

 

·

the availability of attractive risk-adjusted investment opportunities in small balance commercial loans (“SBC loans”), loans guaranteed by the U.S. Small Business Administration (the “SBA”) under its Section 7(a) loan program (the “SBA Section 7(a) Program”), mortgage backed securities (“MBS”), residential mortgage loans and other real estate-related investments that satisfy our investment objectives and strategies; 

 

·

our ability to borrow funds at favorable rates;

 

·

market, industry and economic trends;

 

·

recent market developments and actions taken and to be taken by the U.S. Government, the U.S. Department of the Treasury and the Board of Governors of the Federal Reserve System, the Federal Depositary Insurance Corporation, the Federal National Mortgage Association (“Fannie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac” and together with Fannie Mae, the “GSEs”), the Government National Mortgage Association (“Ginnie Mae”), Federal Housing Administration (“FHA”) Mortgagee, U.S. Department of Agriculture (“USDA”), U.S. Department of Veterans Affairs (“VA”) and the U.S. Securities and Exchange Commission (“SEC”);

 

·

mortgage loan modification programs and future legislative actions;

 

·

our ability to maintain our qualification as a real estate investment trust (“REIT”);

 

·

our ability to maintain our exemption from qualification under the Investment Company Act of 1940, as amended (the “1940 Act”);

 

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·

projected capital and operating expenditures;

 

·

availability of qualified personnel;

 

·

prepayment rates; and

 

·

projected default rates.

 

Our beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us or are within our control, including:

 

·

factors described in this Annual Report on Form 10‑K, including those set forth under the captions “Risk Factors” and “Business”;

 

·

applicable regulatory changes;

 

·

risks associated with acquisitions, including the integration of ZAIS Financial Corp’s (“ZAIS Financial”) businesses;

 

·

risks associated with achieving expected revenue synergies, cost savings and other benefits from the merger with ZAIS Financial and the increased scale of our Company;

 

·

general volatility of the capital markets;

 

·

changes in our investment objectives and business strategy;

 

·

the availability, terms and deployment of capital;

 

·

the availability of suitable investment opportunities;

 

·

our dependence on our external advisor, Waterfall Asset Management, LLC (“Waterfall” or the “Manager”), and our ability to find a suitable replacement if we or our Manager were to terminate the management agreement we have entered into with our Manager;

 

·

changes in our assets, interest rates or the general economy;

 

·

increased rates of default and/or decreased recovery rates on our investments;

 

·

changes in interest rates, interest rate spreads, the yield curve or prepayment rates; changes in prepayments of our assets;

 

·

limitations on our business as a result of our qualification as a REIT; and

 

·

the degree and nature of our competition, including competition for SBC loans, MBS, residential mortgage loans and other real estate-related investments that satisfy our investment objectives and strategies.

 

Upon the occurrence of these or other factors, our business, financial condition, liquidity and consolidated results of operations may vary materially from those expressed in, or implied by, any such forward-looking statements.

 

Although we believe that the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, levels of activity, performance or achievements. These forward-looking statements apply only as of the date of this annual report on Form 10-K. We are not obligated, and do not intend, to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. See Item 1A, “Risk Factors” of this annual report on Form 10-K.

 

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PART I

 

Item 1. Business.

 

GENERAL

Overview

 

We are a real estate finance company that acquires, originates, manages, services and finances primarily small balance commercial loans (“SBC loans”). SBC loans range in original principal amount of between $500,000 and $10 million and are used by small businesses to purchase real estate used in their operations or by investors seeking to acquire small multi-family, office, retail, mixed use or warehouse properties. Our acquisition and origination platforms consist of the following four operating segments: 

 

·

Loan Acquisitions. We acquire performing and non-performing SBC loans and intend to continue to acquire these loans as part of our business strategy. We seek to maximize the value of the SBC loans acquired by us through proprietary loan modification programs.  We typically acquire non-performing loans at a discount to their unpaid principal balance (“UPB”) when we believe that resolution of the loans will provide attractive risk-adjusted returns.

 

·

SBC Conventional Originations. We originate SBC loans secured by stabilized or transitional investor properties using multiple loan origination channels through our wholly-owned subsidiary, ReadyCap Commercial, LLC (“ReadyCap Commercial”).  Additionally, as part of this segment, we originate and service multi-family loan products under Freddie Mac’s newly launched small balance loan program (the “Freddie Mac program”).

 

·

SBA Originations, Acquisitions and Servicing. We acquire, originate and service owner-occupied loans guaranteed by the SBA under the SBA Section 7(a) Program through our wholly-owned subsidiary, ReadyCap Lending, LLC (“ReadyCap Lending”). We hold an SBA license as one of only 14 non-bank Small Business Lending Companies (“SBLC”) and have been granted preferred lender status by the SBA. In the future, we may originate SBC loans for real estate under the SBA 504 loan program, under which the SBA guarantees subordinated, long-term financing.

 

·

Residential Mortgage Banking. In connection with our merger with ZAIS Financial on October 31, 2016, as described in greater detail below, we added a residential mortgage loan origination segment through our wholly-owned subsidiary, GMFS.  GMFS originates residential mortgage loans eligible to be purchased, guaranteed or insured by Fannie Mae, Freddie Mac, FHA, USDA and VA through retail, correspondent and broker channels.

 

Our objective is to provide attractive risk-adjusted returns to our stockholders, primarily through dividends and secondarily through capital appreciation. In order to achieve this objective, we intend to continue to grow our investment portfolio and we believe that the breadth of our full service real estate finance platform will allow us to adapt to market conditions and deploy capital in our asset classes and segments with the most attractive risk-adjusted returns.

 

We are organized and conduct our operations to qualify as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”). So long as we qualify as a REIT, we are generally not subject to U.S. federal income tax on our net taxable income to the extent that we annually distribute all of our net taxable income to stockholders. We are organized in a traditional umbrella partnership REIT (“UpREIT”) format pursuant to which we serve as the general partner of, and conduct substantially all of our business through Sutherland Partners, LP, or our operating partnership, which serves as our operating partnership subsidiary. We also intend to operate our business in a manner that will permit us to be excluded from registration as an investment company under the 1940 Act. 

 

Our Path to Becoming a Public Company

 

Our history of acquiring SBC loans traces back to August 2007 when the Victoria series of funds (“Victoria Funds”) made their initial acquisition of an equity tranche of an SBC loan securitization. The Victoria Funds were formed and

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managed by our Manager to invest in a range of loan products requiring active management to generate returns. Our business was operated as part of the Victoria Funds until November of 2011 at which time the Victoria Funds contributed substantially all of their SBC loans to our operating partnership in exchange for substantially all of the operating partnership’s units, representing $371.5 million in assets and $262.2 million of equity capital. In November of 2013, we completed the private placement of shares of common stock and operating partnership units (“OP units”), pursuant to which we raised approximately $226 million of equity capital. Concurrently with the closing of the 2013 private placement, we engaged in a series of transactions, referred to as the REIT formation transactions, in order to allow us to conduct our business as a REIT for U.S. federal income tax purposes. As part of these transactions, we became a Maryland corporation.

 

On October 31, 2016, we completed our path to becoming a publicly traded company through our merger with and into a subsidiary of ZAIS Financial, with ZAIS Financial surviving the merger and changing its name to Sutherland Asset Management Corporation. Prior to and as a condition to the merger, ZAIS Financial disposed of its seasoned re-performing mortgage loan portfolio, such that upon the completion of the merger, ZAIS Financial’s assets largely consisted of its GMFS origination subsidiary, cash, conduit loans, and residential mortgage backed securities (“RMBS”).  Additionally, prior to the closing of the merger, ZAIS Financial completed a tender offer, purchasing 4,185,478 shares of common stock from existing ZAIS Financial stockholders at a purchase price of $15.37 per share. In connection with the merger, 25,870,420 shares of common stock were issued to our pre-merger common stockholders and 2,288,663 units in the operating partnership subsidiary (“OP units”) were issued to our pre-merger OP unit holders. Our pre-merger stockholders held approximately 86% of our stockholders’ equity as a result of the merger, with continuing ZAIS Financial stockholders holding approximately 14% of our stockholders’ equity, on a fully diluted basis. We were designated as the accounting acquirer because of our larger pre-merger size relative to ZAIS Financial, the relative voting interests of our stockholders after consummation of the merger, and our senior management and board of directors continuing on after the consummation of the merger.  Because we were designated as the accounting acquirer, our historical financial statements (and not those of ZAIS Financial) are the historical financial statements following the consummation of the merger and are included in this annual report on Form 10-K.  On November 1, 2016, we began trading on the New York Stock Exchange (“NYSE”) under ticker symbol “SLD”.

 

Our Manager

 

We are externally managed and advised by our Manager, an SEC registered investment adviser. Formed in 2005, Waterfall specializes in acquiring, managing, servicing and financing SBC and residential mortgage loans, as well as asset backed securities (“ABS”) and MBS. Waterfall has extensive experience in performing and non-performing loan acquisition, resolution and financing strategies. Waterfall’s investment committee is chaired by Thomas Capasse and Jack Ross, who serve as our Chief Executive Officer and President, respectively. Messrs. Capasse and Ross, who are co-founders of Waterfall, each have over 25 years of experience in managing and financing a range of financial assets, including having executed the first public securitization of SBC loans in 1993, through a variety of credit and interest rate environments. Messrs. Capasse and Ross have worked together in the same organization for more than 19 years. They are supported by a team of approximately 90 investment and other professionals with extensive experience in commercial mortgage credit underwriting, distressed asset acquisition and financing, SBC loan originations, commercial property valuation, capital deployment, financing strategies and legal and financial matters impacting our business. Since 2008 and through December 31, 2016, Waterfall has reviewed approximately 490,000 performing and non-performing SBC and SBA loans, priced approximately 200,000 of these loans and acquired more than 8,400 SBC and SBA loans with aggregate UPB of approximately $3.7 billion for an aggregate purchase price of approximately $2.9 billion.

 

We rely on Waterfall’s expertise in identifying loan acquisitions and origination opportunities. Waterfall uses the data and analytics developed through its experience as an owner of SBC loans and in implementing more than 4,200 SBC loan loss mitigation actions since 2008 to support its origination activities and to develop its loan underwriting standards. Waterfall makes decisions based on a variety of factors, including expected risk-adjusted returns, credit fundamentals, liquidity, availability of financing, borrowing costs and macroeconomic conditions, as well as maintaining our REIT qualification and our exclusion from registration as an investment company under the 1940 Act.

 

Our Investment Strategy and Market Opportunities Across Our Operating Segments

 

Our investment strategy is to opportunistically expand our market presence in our acquisition and origination segments and further grow our SBC securitization capabilities which serve as a source of attractively priced, match-term financing.  Following our 2013 private placement transaction, we capitalized on the dislocation of the credit markets and depressed levels of available capital by acquiring SBC loans from distressed sellers at historically high risk-adjusted

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returns.  Alongside the growth in our acquired loan portfolio and using our experience underwriting and managing such loans, we built out our SBC and SBA origination capabilities and most recently added a residential agency mortgage origination component.  As such, we have become a full-service real estate finance platform and we believe that the breadth of our business allows us to adapt to market conditions and deploy capital in our asset classes with the most attractive risk-adjusted returns.

 

Our acquisition strategy complements our origination strategy by increasing our market intelligence in potential origination geographies, providing additional data to support our underwriting criteria and offering securitization market insight for various product offerings. The proprietary database on the causes of borrower default, loss severity, and market information that we developed from our SBC loan acquisition experience has served as the basis for the development of our SBC and SBA loan origination programs. Additionally, our origination strategy complements our acquisition strategy by providing additional captive refinancing options for our borrowers and further data to support our investment analysis while increasing our market presence with potential sellers of SBC assets.

 

The following table illustrates certain information with respect to our four business segments as of December 31, 2016. 

 

 

 

 

 

 

 

Loan

SBC Conventional

SBA Originations,

Residential Mortgage

 

Acquisitions

Originations

Acquisitions and

Banking

 

 

 

Servicing

 

Coordinating Affiliate / Manager

Waterfall Asset Management, LLC

ReadyCap Commercial

ReadyCap Lending

GMFS

Strategy

SBC loan acquisition

SBC conventional loan origination

SBA loan origination, acquisition and servicing

Residential mortgage origination and servicing

Gross Assets

$1,484.7 million

$170.2 million

$597.2 million

$353.1 million

Net Equity

$315.1 million

$82.8 million

$88.6 million

$65.6 million

Personnel

90

56

67

263

 

According to the Federal Reserve, the U.S. commercial mortgage market including multi-family residences, and nonfarm, nonresidential mortgages totaled approximately $3.8 trillion as of December 31, 2016.  The commercial mortgage market is largely bifurcated by loan size between “large balance” loans and “small balance” loans.  Large balance commercial loans typically include those loans with original principal balances of at least $20 million and are primarily financed by insurance companies and commercial mortgage backed securities (“CMBS”) conduits.  SBC loans typically include those loans with original principal amounts of between $500,000 and $10 million and are primarily financed by community and regional banks, specialty finance companies and loans guaranteed under the SBA loan programs.

 

SBC loans are used by small businesses to purchase real estate used in their operations or by investors seeking to acquire small multi-family, office, retail, mixed use or warehouse properties. SBC loans represent a special category of commercial mortgage loans, sharing both commercial and residential mortgage loan characteristics. SBC loans are typically secured by first mortgages on commercial properties or other business assets, but because SBC loans are also often accompanied by personal guarantees, aspects of residential mortgage credit analysis are utilized in the underwriting process. Most SBC loans are fully amortizing on a schedule of up to 30 years.

The table presented below illustrates a summary of how our Manager categorizes SBC loans compared to other real estate loan asset classes.

 

 

 

 

 

 

 

Asset Class

 

Average Initial Principal Balance

 

Loan-to-value

 

Yield

Residential housing

 

~ $225,000

 

~ 80%

 

~ 4.0%

Large balance commercial loans

 

at least $20.0 million

 

~ 65%

 

~ 4.0%

Small balance commercial loans

 

~ $2.0 million

 

~ 60%

 

~ 7.0%

 

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We rely on our Manager’s expertise in identifying SBC loans for us to acquire. Our Manager will make decisions based on a variety of factors, including expected risk-adjusted returns, credit fundamentals, liquidity, availability of financing, borrowing costs and macroeconomic conditions, as well as maintaining our REIT qualification and our exclusion from registration as an investment company under the 1940 Act. Our investment decisions will depend on prevailing market conditions and may change over time in response to opportunities available in different economic and capital market environments. As a result, we cannot predict the percentage of its equity that will be invested in any particular asset or strategy at any given time.

Our Loan Portfolio 

      The table below presents a summary of the sourcing of our loan assets as of December 31, 2016 (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan Type (In Thousands)

Segment

 

UPB

 

% of Total
UPB

 

Carrying
Amount

 

% of Total Carrying Amount

 

Fair Value

 

% of Total Fair Value

 

Acquired loans

Loan Acquisitions (1)

 

$
493,374

 

25.1

%

$
429,236

 

23.2

%

$
436,176

 

22.9

%

Originated SBC loans

SBC Conventional Originations

 

554,412

 

28.2

 

569,612

 

30.8

 

564,372

 

29.7

 

Originated Freddie loans

SBC Conventional Originations

 

17,162

 

0.9

 

17,311

 

0.9

 

17,311

 

0.9

 

Originated Transitional loans

SBC Conventional Originations

 

158,401

 

8.0

 

158,903

 

8.6

 

158,698

 

8.3

 

Acquired SBA 7(a) loans

SBA Originations, Acquisitions and Servicing

 

599,652

 

30.5

 

527,990

 

28.6

 

581,728

 

30.6

 

Originated SBA 7(a) loans

SBA Originations, Acquisitions and Servicing

 

16,112

 

0.8

 

15,414

 

0.8

 

15,071

 

0.8

 

Originated Residential Agency loans

Residential Mortgage Banking (2)

 

127,426

 

6.5

 

130,011

 

7.0

 

130,015

 

6.8

 

Total 

 

 

$
1,966,539

 

100.00

%

$
1,848,477

 

100.0%

%

$
1,903,371

 

100.00

%

(1) Excludes real estate acquired in settlement of loans.
(2) Excludes MSR assets.

 

The table presented below illustrates additional information related to our SBC loans, SBA loans, SBC ABS, Residential mortgage loan originations, mortgage servicing rights and servicing rights (“MSRs”) for the year ended December 31, 2016 (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average Carrying Value

 

Gross Yield(1)

 

 

Average Debt Balance

 

Debt Cost(2)

 

Gross Return on Equity(3)

Segment

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan Acquisitions

$

494,924

 

8.2

%

 

$

377,895

 

5.0

%

 

18.4

%

SBC conventional originations

 

674,853

 

6.4

 

 

 

481,873

 

4.2

 

 

11.9

 

SBA originations and acquisitions

 

633,826

 

6.6

 

 

 

552,127

 

3.2

 

 

30.2

 

Residential mortgage banking

 

43,079

 

14.9

 

 

 

27,890

 

2.0

 

 

38.5

 

Total

$

$
1,846,682

 

7.1

%

 

$

1,439,785

 

3.9

%

 

18.4

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1)

Gross yields are based on total income, inclusive of interest income, servicing fee income, and other income generated with the creation of new MSRs for the year ended December 31, 2016. Interest income reflects the contractual interest rates and accretion of discounts based on our estimates of loan performance, including the amount, timing and present value of cash flows, prepayment rates and loss severities. Premiums and discounts associated with the loans at the time of purchase are amortized into interest income over the life of such loans using the effective yield method. Subsequent increases or decreases in the fair value of estimated cash flows will result in an adjustment to a loan’s gross yield. See ‘‘Item 8. Financial Statements and Supplementary Data — Note 3’’ included in this annual report on Form 10-K. The actual income in the periods subsequent to December 2016 will depend on a variety of factors that could impact loan performance, and accordingly, actual gross yield could vary significantly from the gross yields shown in the table.

(2)

We finance the assets included in the Investment Types through securitizations, re-securitizations, repurchase agreements, warehouse facilities and bank credit facilities. Interest expense is calculated based on interest expense for the year ended December 31, 2016. The cost and availability of our financing will depend on a variety of factors that could impact loan performance and gross ROE including those discussed under ‘‘Item 1A. Risk Factors — Risks Related to Financing and Hedging — Our inability to access funding could have a material adverse effect on our results of operations, financial condition and business. We rely on short-term financing and thus are especially exposed to changes in the availability of financing’’ included in this annual report on Form 10-K. Accordingly, actual gross ROE could vary significantly from the estimates shown in the table.

(3)

The gross ROE for each investment type is a percentage equal to the sum of the net interest income of the loans, plus servicing or other income, over the average net equity of the loans for the year ended December 31, 2016. The estimated annual net interest income of the loans represents the estimated gross yields, based on the average carrying values of the loans for the year ended December 31, 2016, less the estimated interest expense for such period, without giving effect to servicing or origination fee expenses, operating expenses or losses. In general, these fees consist of servicing fee expenses and advances for delinquent taxes, insurance and property maintenance. In addition, we pay disposition fees to contracted asset servicers and such fees vary depending on the investment return earned on the asset. Loan servicing fees in the aggregate are included on the statements of operations and by business segment in the segment reporting information included in “Item 8. Financial Statements and Supplementary Data - Note 26”included in this annual report on Form 10-K.

 

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Our SBC Loan Acquisition Platform

 

Our SBC loan acquisition segment represents our investments in acquired SBC loans. We seek to maximize the value of acquired SBC loans through proprietary loan modification programs focused on keeping borrowers in their properties. Where this is not possible, such as in the case of many non-performing loans, we seek to effect property resolution through the use of resolution alternatives to foreclosure.

Our Manager specializes in acquiring SBC loans that are sold by banks, including as part of bank recapitalizations or mergers, and from other financial institutions such as thrifts and non-bank lenders. Other sources of SBC loans include special servicers of large balance SBC ABS and CMBS trusts, the FDIC as receiver for failed banks, servicers of non-performing SBA Section 7(a) Program loans, and CDCs originating loans under the SBA 504 program, GSEs, and state economic development authorities. Over the last several years, our Manager has developed relationships with many of these entities, primarily banks and their advisors. In many cases, we are able to acquire SBC loans through negotiated transactions, at times partnering with acquiring banks or private equity firms in bank acquisitions and recapitalizations. Our Manager estimates that, as of December 31, 2016, 75.0% of the transactions by UPB acquired and 75.0% of the number of transactions closed since it began its SBC loan strategy have been made through a negotiated transaction or in an auction process where our Manager competed with few, if any, other bidders. We believe that our Manager’s experience, reputation and ability to underwrite SBC loans make it an attractive buyer for this asset class, and that its network of relationships will continue to produce opportunities for it to acquire SBC loans on attractive terms.

Competition for SBC loan asset acquisitions has been limited due to the special servicing expertise required to manage SBC loan assets due to the small size of each loan, the uniqueness of the real properties that collateralize the loans, licensing requirements, the high volume of loans needed to build portfolios, and the need to utilize residential mortgage credit analysis in the underwriting process. These factors have limited institutional investor participation in SBC loan acquisitions, which has allowed us to acquire SBC loans with attractive risk-adjusted return profiles.

The following table summarizes our loan acquisitions since 2008, including acquisitions prior to the formation of our operating partnership in November 2011 when our business was operated as part of the Victoria Funds (in thousands), as of December 31, 2016:

 

 

 

 

 

 

 

 

 

 

 

 

 

Acquisition Year

Purchased UPB

Cost

Liquidated UPB

Liquidated Cost

Current UPB

Amortized Cost of Remaining Loans

2008

$

21,887

$

16,197

$

20,108

$

14,784

$

1,577

$

1,115

2009

 

18,604

 

9,351

 

16,754

 

8,326

 

1,682

 

1,616

2010

 

158,448

 

61,460

 

154,717

 

59,594

 

2,717

 

1,642

2011

 

356,378

 

233,444

 

299,524

 

189,969

 

47,577

 

41,412

2012

 

199,041

 

131,671

 

195,852

 

130,512

 

2,960

 

1,653

2013

 

220,437

 

150,473

 

131,625

 

86,793

 

77,135

 

56,394

2014

 

347,809

 

539,322

 

218,559

 

145,159

 

99,720

 

66,381

2015

 

218,484

 

208,999

 

38,025

 

36,069

 

149,801

 

143,436

2016

 

139,723

 

136,980

 

7,785

 

7,613

 

127,008

 

123,624

Total

$

1,680,811

$

1,487,897

$

1,082,949

$

678,819

$

510,177

$

437,273

(1)

Table includes real estate owned balances with current UPB of $16.8 million and a carrying value of approximately $8.0 million.

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The following chart sets forth certain information as of December 31, 2016 related to the yields on our acquired loan portfolio:

Picture 36

The following table sets forth certain information as of December 31, 2016 related to our acquired loan portfolio (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Contractual Status

Original UPB

Current UPB

Average UPB

Carrying Value

Average Cost

Weighted Average Interest Rate

Weighted Average Maturity

Current

$

673,430

$

421,800

$

551

$

390,031

$

511
6.0

%

January 2028

30+

 

9,967

 

7,661

 

383

 

6,224

 

311
4.8

 

February 2025

60+

 

1,490

 

1,016

 

508

 

1,006

 

503
4.5

 

November 2016

90+

 

18,387

 

12,742

 

554

 

9,734

 

423
5.4

 

March 2026

180+

 

55,143

 

38,942

 

487

 

15,167

 

190
5.2

 

August 2019

Bankruptcy

 

11,010

 

8,398

 

254

 

5,306

 

161
5.1

 

February 2027

Foreclosure

 

3,628

 

3,317

 

415

 

2,269

 

284
5.9

 

June 2027

REO

 

26,210

 

16,301

 

959

 

7,536

 

443

 -

 

-

Total

$

799,264

$

510,177

$

538

$

437,273

$

461
5.7

%

December 2026

 

The following chart sets forth certain information as of December 31, 2016 related to the geographic concentration and collateral type of our acquired loan portfolio:

 

 

Picture 8

Picture 9

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Waterfall’s extensive experience in securitization strategies for SBC loans dates to the first SBC ABS for performing loans and liquidating trusts for non-performing loans purchased from the Resolution Trust Corporation in 1993. In 2011, we believe we were the first post-financial crisis issuer of SBC ABS and have since completed 10 SBC bond issues backed by $1.4 billion of newly originated and acquired SBC and SBA 7(a) loan assets. The following table summarizes our acquired loan securitization activities:

 

 

 

 

 

 

 

 

 

 

Deal Name

Asset Class

 

Issuance

 

Ratings

 

Collateral Securitized

Advance Rate

Weighted Average Debt Cost

WVMT 2011-SBC1

SBC Acquired Loans - NPL

 

February 2011

 

NR(1)

 

$   40.5 million

70.6%
7.0%

WVMT 2011-SBC2

SBC Acquired Loans

 

March 2011

 

DBRS(2)

 

  97.7 million

84.1%
5.1%

WVMT 2011-SBC3

SBC Acquired Loans - NPL

 

October 2011

 

NR(1)

 

143.4 million

45.6%
6.4%

SCML 2015-SBC4

SBC Acquired Loans - NPL

 

August 2015

 

NR(1)

 

125.4 million

83.3%
4.0%

 Total

 

 

 

 

 

 

$ 406.9 million

73.5%
5.2%

(1)

Not rated.

(2)

DBRS is an SEC-registered nationally recognized statistical rating organization.

 

Our Loan Origination Platforms

  

We originate SBC loans generally ranging in initial principal amount of between $500,000 and $10 million, and typically with a duration of six years at origination. Our origination platform, which focuses on first mortgage loans, provides conventional SBC mortgage financing for SBC properties nationwide through the following programs:

 

·

First mortgage loans. Loans for the acquisition or refinancing of stabilized properties secured by traditional commercial properties such as multi-family, office, retail, mixed use or warehouse properties, which are often guaranteed by the property owners. The loans are typically amortizing and have maturities of five to 20 years.

 

·

Transitional loans. Loans for the acquisition of properties requiring more substantial expenditures for stabilization, secured by traditional commercial properties such as multi-family, office, retail, mixed use or warehouse properties which may be guaranteed by the property owners. The loans are typically interest-only and have maturities of two to four years.

 

·

SBA loans. Loans secured by real estate, machinery, equipment and inventory that are guaranteed, typically 75% under the SBA Section 7(a) Programs. SBA loans include personal guarantees of the borrower and are typically amortizing and have maturities of seven to 25 years.

 

·

Freddie Mac loans. Origination of loans ranging from $1 to $5 million secured by multi-family properties through the recently launched Freddie Mac program. Loans are 90% guaranteed through the program. We sell qualifying loans to Freddie Mac, which, in turn, sells such loans to securitization structures. We are obligated to purchase the B-pieces secured by its underlying loans.

 

Additionally, as a large regional mortgage lender, we are approved to originate and service Fannie Mae, Freddie Mac and Ginnie Mae eligible loans through the residential mortgage loan programs. These include prime, subprime and alternative-A and alternative-B mortgage loans, which may be adjustable-rate, hybrid and/or fixed-rate residential mortgage loans and pay option adjustable rate mortgage loans (“ARMs”).

 

Our origination platforms include the following segments: (i) SBC Conventional Originations (ii) SBA Originations and (iii) Residential Mortgage Originations.

 

SBC Conventional Originations

 

We operate our SBC loan originations segment through ReadyCap Commercial. ReadyCap Commercial is a specialty-finance nationwide originator focused on originating commercial real estate mortgage loans through its conventional,

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agency multi-family and transitional loan programs. The following table summarizes the loan features of ReadyCap Commercial’s three product types:

 

 

 

 

 

 

Stabilized Conventional/Agency
Commercial Real Estate Lending

Transitional, Value-Add and Event Driven Commercial Real Estate Lending

 

Conventional Product

Agency Multi-Family Product

Transitional Product

Loan Purpose

Purchase, Cash-Out Refinance, Rate & Term Refinance

Purchase, Cash-Out Refinance, Rate & Term Refinance

Purchase, Cash-Out Refinance, Rate & Term Refinance, Transitional

Product Highlights

Stabilized Properties, Single-Tenants, Earn-Outs

>= 90% Occupancy

Unstabilized Properties, Earn-outs, Rehab/Renovation, Construction, Lease Roll Issues, Vacancy Issues

Core Property Types

Multi-family, Mixed Use, Retail, Office, Industrial

Multi-family

Multi-family, Mixed Use, Retail, Office, Industrial

Rates

From 4.75% (Fixed)

From 3.0% (Fixed)

From 4.75% (Primarily Floating)

Loan Size

$750,000 - $10,000,000

$1,000,000 - $5,000,000

$5,000,000 - $20,000,000

Terms

2 - 10 Years

5 - 20 Years

< 5 Years

Amortization

20 - 30 Years

20 - 30 Years

Full Term Interest Only

Leverage

Up to 75% LTV

Up to 80% LTV

Up to 80% LTV

Take Out

Term Securitization

GSE Wrap Securitization

CLO Securitization

Origination Fees

Up to 1%

Up to 1%

Up to 1% & Up to 1% Exit Fee

 

Through December 31, 2016, we have originated more than $1.4 billion in SBC loans in 36 states since ReadyCap Commercial’s inception in September 2012.    The following chart summarizes our SBC conventional loan originations since ReadyCap Commercial’s formation:

Picture 30

As of December 31, 2016, our originated SBC loans held in our portfolio had a UPB of $730.0 million and a carrying value of approximately $745.8 million. Our originated SBC loans, substantially all of which are currently classified as performing loans, represented approximately 40.2% of the carrying value and 36.9% of the UPB of our total

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loan portfolio as of December 31, 2016.  The following table sets forth certain information as of December 31, 2016 related to our originated SBC conventional loans:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted Average

 

 

Asset Type

 

Loan Type

 

Number of Loans

 

UPB
(in 000s)

 

Coupon Type(1)

 

Coupon

 

Debt Yield

 

Orig Fee

 

Exit Fee

 

Maturity

 

Original LTV

 

DSCR(2)

 

Collateral Type

Transitional

 

Sr. Mortgage

 

1

 

$

8,539

 

FX

 

6.8%

 

26.8%

 

1.0%

 

0.0%

 

4.2

 

32.9%

 

1.72

 

Industrial, Mixed-Use, Multi-family, Office, Retail

Transitional

 

Sr. Mortgage

 

24

 

 

149,863

 

AR

 

6.8%

 

4.6%

 

2.7%

 

2.6%

 

1.7

 

75.1%

 

0.55

 

Mixed-Use, Multi-family, Office, Self-Storage

Freddie

 

Sr. Mortgage

 

8

 

 

17,162

 

FX

 

4.0%

 

9.3%

 

0.0%

 

0.0%

 

14.7

 

61.1%

 

1.79

 

Multi-family

SBC Investor

 

Sr. Mortgage

 

224

 

 

554,411

 

FX

 

6.0%

 

12.0%

 

0.6%

 

0.4%

 

5.7

 

64.4%

 

1.52

 

Data Center, Industrial, Mixed Use, Multi-family, Office, Retail, Self-Storage

Total

 

 

 

257

 

$

729,975

 

 

 

6.1%

 

10.6%

 

1.0%

 

0.8%

 

5.1

 

66.2%

 

1.33

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1) “FX” refers to loans with fixed coupon interest rates and “AR” refers to loans with adjustable coupon interest rates.

(2) Represents the loan’s debt-service coverage ratio, which is the ratio of interest income available for debt servicing to interest and principal on the loan.

The following chart sets forth certain information as of December 31, 2016 related to the geographic concentration and collateral type of our originated SBC loan portfolio:

 

 

Picture 22

Picture 32

 

The following table summarizes our SBC originated loan securitization activities:

 

 

 

 

 

 

 

 

 

 

 

 

Deal Name

Asset Class

 

Issuance

 

Ratings

 

Collateral Securitized

Advance Rate

Weighted Average Debt Cost

RCMT 2014-1

SBC Originated Conventional

 

September 2014

 

MDY(1) / DBRS

 

$

181.7 million

79.6%
3.2%

RCMT 2015-2

SBC Originated Conventional

 

November 2015

 

MDY / Kroll(2)

 

 

218.8 million

75.5%
4.0%

FRESB 2016-SB11

Originated Agency Multi-family

 

January 2016

 

GSE Wrap(3)

 

 

110.0 million

90.0%
2.8%

FRESB 2016-SB18

Originated Agency Multi-family

 

July 2016

 

GSE Wrap

 

 

118.0 million

90.0%
2.2%

RCMT 2016-3

SBC Originated Conventional

 

November 2016

 

MDY / Kroll

 

 

162.1 million

82.6%
3.4%

Total

 

 

 

 

 

 

$

790.6 million

82.5%
3.2%

(1)

Moody’s is a rating agency and an SEC-registered nationally recognized statistical rating organization.

(2)

Kroll Bond Rating Agency is a rating agency and an SEC-registered nationally recognized statistical rating organization.

(3)

GSE wrap guarantee.

 

Additionally, ReadyCap has been approved by Freddie Mac as one of 11 originators and servicers for multi-family loan products under the Freddie Mac program. As of December 31, 2016, ReadyCap employs 56 people focused on originating and supporting the SBC loan origination business.

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The SBC loan origination market is highly fragmented, with few dedicated lenders. Furthermore, we believe that as economic conditions continue to stabilize or strengthen, the volume of short-term loan extensions and restructurings of existing SBC loans will be reduced, resulting in increased opportunities for it to originate new SBC loans.

As illustrated by the following diagram, which shows real estate property values from July 2006 through October 31, 2016, while commercial property prices have fully recovered to their 2007 peak, SBC property prices have increased only 21.5% from the 2012 trough.  We believe this trend suggests continued tight credit in SBC lending and supports our belief that credit spreads in the SBC loan asset class should for the foreseeable future remain wider compared to large balance commercial mortgage loans.  As a result, we believe that as the economy strengthens, we will see increased demand for loans directly from borrowers and this increased demand will provide us with attractive opportunities to originate loans. 

Picture 1

We believe that we have significant opportunity to originate SBC loans at attractive risk-adjusted returns. We believe that many banks have restrictive credit guidelines for our target assets. In addition, large banks are not focused on the SBC market and smaller banks only lend in specific geographies. We see an opportunity to earn an attractive risk spread premium by lending to borrowers that do not fit the credit guidelines of many banks. We believe that increased demand, coupled with the fragmentation of the SBC lending market, provides us with attractive opportunities to originate loans to borrowers with strong credit profiles and real estate collateral that supports ultimate repayment of the loans.

 

We expect to continue to source SBC loan originations through the following loan origination channels:

 

·

Direct and indirect lending relationships.  We will generate origination loan leads directly through our extensive relationships with commercial real estate brokers, bank loan officers and mortgage brokers that refer leads to our loan officers. To a lesser extent, we will also source loan leads through commercial real estate realtors, trusted advisors such as financial planners, lawyers, and CPAs and through direct-to-the-borrower transactions.

 

·

Other direct origination sources for SBC loans.  From time to time, we may enter into strategic alliances and other referral programs with servicers, sub-servicers, strategic partners and vendors targeted at the refinancing of SBC loans.

 

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SBA Origination, Acquisition and Servicing Platform

We operate our SBA loan origination, acquisition, and servicing segment through ReadyCap Lending. We acquire, originate and service owner-occupied loans guaranteed by the SBA under the SBA Section 7(a) Program through  ReadyCap Lending’s license, one of only 14 licensed non-bank SBLC’s. In the future, we may also originate SBC loans for real estate under the SBA 504 loan program, pursuant to which the SBA guarantees subordinated, long-term financing.

We believe investor demand for pass-through securities backed by the guaranteed portions of SBA Section 7(a) Program loans has been strong because the principal and interest payments are guaranteed by the full faith and credit of the United States Government. For this reason, we believe that SBA participating lenders that have sold the guaranteed portions of SBA Section 7(a) Program loans in recent years have been able to recognize attractive gains.

The SBA was created out of the Small Business Act in 1953. The SBA’s function is to protect the interests of small businesses. The SBA classifies a small business as a business that is organized for profit and is an independently owned and operating primarily within the United States with less than $15 million in tangible net worth and not more than $5 million in average after-tax net income. The SBA supports small businesses by administering several programs that provide loan guarantees against default on qualified loans made to eligible small businesses.

The SBA Section 7(a) Program is the SBA’s primary program for providing financing for start-up and existing small businesses. The SBA typically guarantees 75% of qualified loans over $150,000. While the eligibility requirements of the SBA Section 7(a) Program vary depending on the industry of the borrower and other factors, the general eligibility requirements include the following: (i) gross sales of the borrower cannot exceed size standards set by the SBA (e.g., $30.0 million for limited service hospitality properties) or, alternatively, average net income cannot exceed $5.0 million for the most recent two fiscal years, (ii) liquid assets of the borrower and affiliates cannot exceed specified limits, (iii) tangible net worth of the borrower must be less than $15.0 million, (iv) the borrower must be a U.S. citizen or legal permanent resident and (v) the maximum aggregate SBA loan guarantees to a borrower cannot exceed $3.75 million. The table below provides information on the SBA Section 7(a) Program’s key features, including its eligible uses, maximum loan amount, loan maturity, interest rate, guarantee fee, yearly fee and personal guarantee.

Key Feature

  

Program Summary

Use of Proceeds

 

Fixed assets, working capital, financing of start-up or to purchase an existing business. Some debt payment allowed but lender’s loan exposure may not be reduced with the proceeds.

Maximum Loan Amount

 

$5,000,000

Maturity

 

Five to seven years for working capital and up to 25 years for equipment and real estate. All other loan purposes have a maximum term of ten years.

Interest Rate

 

Negotiated between applicant and lender and is subject to maximums. The current maximums are Prime Rate plus 2.25% for maturities fewer than seven years and Prime Rate plus 2.75% for maturities of seven years for longer. Spreads on loans with an initial UPB below $50,000 have higher maximums.

Guaranty Fee

 

Based on the loan’s maturity and the dollar amount guaranteed. The lender initially pays the guaranty fee and has the option to pass the expense on to the borrower at closing. A fee of 0.25% of the guaranteed portion of the loan is charged for loans with maturities of 12 months or less. For loans with maturities over 12 months, the fees are 2% for loans of $150,000 or less; 3% for loans of $150,001 to $700,000; 3.5% for loans over $700,000; and 3.75% for guaranteed portion over $1 million.

Yearly Fee

 

The on-going yearly fee due from lenders to SBA is 0.52% of the guaranteed portion of the outstanding balance on the 7(a) loan.

Personal Guarantee

 

Required from all owners of 20% or more of the equity of the business. Lenders can require personal guarantees of owners with less than 20% ownership.

 

Sources:  SBA, Business Development Corporation, Office of the Comptroller of the Currency, Congressional Research Service

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      Our return on equity related to the SBA 7(a) program is generated through retained yield on the unguaranteed principal balance as well as sale premium and retained servicing on the guaranteed principal balance as displayed by the following:

 

Picture 24

 

      The following table sets forth certain information as of December 31, 2016 related to our acquired SBA 7(a) loan portfolio (in thousands):

 

Contractual Status

Original UPB

Current UPB

Average UPB

Carrying Value

Average Cost

Weighted Average Rate

Weighted Average Maturity

Current

$
1,146,288
$
555,076
$
267
$
501,184
$
241
5.2

%

November 2013

30+

45,858
12,068
128
10,107
108
5.5

 

April 2011

60+

24,950
7,342
179
5,608
137
5.3

 

June 2010

90+

18,395
4,434
120
2,656
72
5.2

 

May 2012

180+

70,118
13,306
112
4,698
39
5.3

 

January 2010

Bankruptcy

35,262
6,926
117
3,236
55
5.0

 

December 2010

REO

9,041
501
36
501
36

 -

 

-

Total

$
1,349,913
$
599,652
$
245
$
527,990
$
216
5.2

%

August 2013

 

We have originated more than $51.5 million in SBA loans in 24 states since the program’s inception in mid-2015 through December 31, 2016. As of December 31, 2016, our originated SBA loans held in our loan portfolio had a UPB of $16.1 million and a fair value of approximately $15.1 million. The following table sets forth certain information as of December 31, 2016 related to our originated SBA loans (loan balances in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted Average

 

 

Asset Type

 

Number of Loans

 

UPB (Owned)

 

Guaranteed Balance

 

Carrying Amount

 

Coupon Type

 

Coupon

 

Service Fee

 

Maturity

 

Collateral Type

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SBA 7(a)

 

76

 

$16,112

 

$12,642

 

$15,414

 

AR

 

6.0%

 

0.9%

 

Oct-35

 

Professional services, Day Care, Food & Lodging, Other

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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The following table sets forth certain information as of December 31, 2016 related to our sale of originated SBA loans (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Quarter

 

Proceeds Received for Sale of Guaranteed Portion of Loans
(in 000s)

 

UPB Sold
(in 000s)

 

Net Proceeds (in 000s)

 

Weighted Average Sales Premium

Q3 2014

 

$
51,767

 

$
49,392

 

$
2,375

 

4.8

  %

Q4 2014

 

1,252

 

1,252

 

 -

 

 -

 

Q1 2016

 

10,344

 

9,271

 

1,072

 

11.6

 

Q2 2016

 

6,964

 

6,186

 

778

 

12.6

 

Q3 2016

 

14,414

 

12,879

 

1,535

 

11.9

 

Q4 2016

 

12,857

 

11,732

 

1,125

 

9.6

 

      Total

 

$
97,598

 

$
90,713

 

$
6,885

 

7.59

%

 

 

 

 

 

 

 

 

 

 

 

      The following table sets forth certain information as of December 31, 2016, related to our SBA servicing portfolio (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

Origination Vintage

 

Serviced Principal Balance (in 000s)

 

Weighted Average Servicing Fee

 

Weighted Average Remaining Term (in months)

 

% in Default (1)

< 1994

 

$

69

 

1.7

%

 

33

 

0.0

%

1995 - 1999

 

 

6,916

 

1.3

 

 

71

 

19.5

 

2000 - 2004

 

 

92,453

 

1.5

 

 

114

 

7.5

 

2005 - 2009

 

 

410,568

 

1.9

 

 

151

 

9.2

 

2010 - 2014

 

 

108,982

 

2.0

 

 

206

 

6.2

 

2015 <

 

 

38,085

 

0.9

 

 

224

 

4.0

 

    Total

 

$

657,073

 

1.8

%

 

158

 

8.3

%

(1) Greater than or equal to 90-day equivalent

 

 

 

 

 

 

 

 

 

 

 

 

 

The following chart sets forth certain information as of December 31, 2016 related to the geographic and collateral concentration of our originated and acquired SBA portfolio:

 

 

 

Picture 26

Picture 27

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      We use the securitization markets to access term financing on the unguaranteed retained portion of the SBA 7(a) Program loans. The following table summarizes our SBA loan securitization activities:

 

 

 

 

 

 

 

 

 

 

Deal Name

Asset Class

 

Issuance

 

Ratings

 

Collateral Securitized

Advance Rate

Weighted Average Debt Cost

RCLT 2015-1

SBA 7(a) Loans

 

June 2015

 

S&P(1)

 

$ 189.5 million

60.6%

1.9%

(1)

S&P is a rating agency and an SEC-registered nationally recognized statistical rating organization.

 

Residential Mortgage Origination Platform

In connection with our merger with ZAIS Financial on October 31, 2016, as described above, we added a residential mortgage loan origination component through GMFS, our wholly-owned subsidiary.  GMFS currently originates loans that are eligible to be purchased, guaranteed or insured by Fannie Mae, Freddie Mac, FHA, VA and USDA through retail, correspondent and broker channels. GMFS is licensed in 29 states and provides a wide range of residential mortgage services, including home purchase financing, mortgage refinancing, reverse mortgages, new construction loans and condo financing. GMFS operates through 12 retail branches located in Louisiana, Georgia, Mississippi, Alabama, and Texas. GMFS employs both a servicing retained and servicing released execution strategy, while retaining approximately 85-90% of current production.  Our residential mortgage loan portfolio represented approximately 7.0% of the carrying value and 6.5% of the UPB of our total loan portfolio as of December 31, 2016. Our residential mortgage origination platform employed a total of 263 people as of December 31, 2016. 

GMFS adds a residential origination platform to our sourcing capabilities, allowing access to new credit investment opportunities while controlling the origination process.  We believe we can enhance and grow the GMFS origination platform through better access to capital and an expanded product offering. In addition, using this platform we intend to continue to invest in MSRs through retention and secondary market transactions and to selectively pursue new residential product offerings.

Highlights of the historical GMFS origination activity by purpose for the year ended December 31, 2016 is as follows:

 

Picture 37

 

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      The following table sets forth certain historical information related to the GMFS servicing of residential mortgage loans:

 

Picture 29

      The following chart sets forth certain information as of December 31, 2016 related to the geographic concentration of our originated residential loan portfolio:  

Picture 3

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      Highlights of the GMFS operating activity (which is included in our residential mortgage banking segment) for the year ended December 31, 2016 are as follows:

 

 

 

 

 

Mortgage originations (1) (2)

 

 

 

 Unpaid principal balance

 

$ 2.2 billion

 

 Percentage of originations

 

 

 

 Purchases

 

66.7

%

 Refinancing

 

33.3

%

 

 

 

 

Interest rate locks entered into

 

$ 2.7 billion

 

 

 

 

 

Mortgage loans sold (1) (2)

 

 

 

 Unpaid principal balance

 

$ 2.2 billion

 

 Percentage of unpaid principal balance

 

 

 

Fannie Mae or Freddie Mac securitizations

 

66.2

%

Ginnie Mae securitizations

 

25.3

%

Other investors

 

8.5

%

 

 

 

 

(1) Excludes reverse mortgages.

 

 

 

(2) Balances include 10 months of activity prior to the merger with ZAIS Financial on October 31, 2016.

 

 

 

 

     Our management team has extensive experience and an established track record of operating through multiple market cycles.  We primarily originate, sell and service conventional, conforming agency and government insured residential mortgage loans originated or acquired through our three channels: retail, correspondent and wholesale. Our mortgage lending operation generates origination and processing fees, net of origination costs, at the time of origination as well as gains or unexpected losses when the loans are sold to third party investors, including the GSEs and Ginnie Mae. We retain servicing rights from the mortgage originations and earn servicing fees, net of sub-servicer costs, from our mortgage servicing portfolio.

 

We believe that we have a significant opportunity to expand our footprint within the mortgage banking industry through:

 

·

Expansion of our Texas operation (launched in the Fall of 2015), which originates loans through our retail, correspondent, and wholesale channels. 

 

·

Increased penetration of existing clients and through the addition of new branches and independent originators in our correspondent and wholesale channels.

 

·

Opportunistic geographic expansion in our retail channel.

 

Our Loan Pipeline 

 

  We have a large and active pipeline of potential acquisition and origination opportunities that are in various stages of our investment process. We refer to assets as being part of our acquisition pipeline or our origination pipeline if:

 

·

an asset or portfolio opportunity has been presented to us and we have determined, after a preliminary analysis, that the assets fit within our investment strategy and exhibit the appropriate risk/reward characteristics and

 

·

in the case of acquired loans, we have executed a non-disclosure agreement (“NDA”) or an exclusivity agreement and commenced the due diligence process or we have executed more definitive documentation, such as a letter of intent (“LOI”), and in the case of originated loans, we have issued a LOI, and the borrower has paid a deposit.

 

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As of December 31, 2016, our Manager has identified approximately $665.2 million in potential assets as measured by the UPB of the loans, comprised of:

 

·

$157.8 million in potential acquisitions of conventional SBC loans, with $22.0 million relating to potential loan acquisitions for which our Manager has entered into LOIs or for which it has agreed on pricing terms with the sellers

 

·

$90.0 million in potential acquisitions of SBA loans,

 

·

$151.2 million in SBC loan originations,

 

·

$66.2 million in SBA loan originations, and

 

·

$200 million in commitments to originate residential agency loans.

 

We operate in a competitive market for investment opportunities and competition may limit our ability to originate or acquire the potential investments in the pipeline. The consummation of any of the potential loans in the pipeline depends upon, among other things, one or more of the following: available capital and liquidity, our Manager’s allocation policy, satisfactory completion of our due diligence investigation and investment process, approval of our Manager’s Investment Committee, market conditions, our agreement with the seller on the terms and structure of such potential loan, and the execution and delivery of satisfactory transaction documentation. Historically, we have acquired less than a majority of the assets in our Manager’s pipeline at any one time and there can be no assurance the assets currently in its pipeline will be acquired or originated by our Manager in the future.

 

FINANCING STRATEGY

 

We use prudent leverage to increase potential returns to our stockholders. We finance the loans we originate primarily through securitization transactions, as well through other borrowings. We also plan to sell the guaranteed portion of our SBA loan originations in the secondary market.

 

Our Manager’s extensive experience in non-performing and performing loan acquisition, origination, servicing and securitization strategies has enabled us to complete ten securitizations of SBC loan and SBA 7(a) loan assets since January 2011, issuing bonds with an aggregate face value of $1.4 billion. SBC securitization structures are non-recourse and typically provide debt equal to 50% to 80% of the cost basis of the SBC assets. Non-performing SBC ABS involve liquidating trusts with liquidation proceeds used to repay senior debt. Performing SBC ABS involve longer-duration trusts with principal and interest collections allocated to senior debt and losses on liquidated loans to equity and subordinate tranches. Our strategy is to continue to finance our assets through the securitization market, which will allow us to continue to match fund the SBC loans pledged as collateral to secure these securitizations on a long-term non-recourse basis.

 

We anticipate using other borrowings as part of our financing strategy, including re-securitizations, repurchase agreements, warehouse facilities, bank credit facilities (including term loans and revolving facilities), and public and private equity and debt issuances.

 

As of December 31, 2016, our committed and outstanding financing arrangements included:

 

·

six committed credit facilities and three master repurchase agreements to finance our SBC, SBA and residential mortgage loans with $564.1 million of borrowings outstanding;

 

·

$492.9 million of securitized debt obligations outstanding from $1.4 billion in ABS, which financed our whole loan acquisitions and SBC originations; and

 

·

master repurchase agreements with four counterparties to fund our acquisition of SBC ABS and short term investments with $363.4 million of borrowings outstanding.

 

On February 13, 2017, ReadyCap Holdings, LLC (“ReadyCap Holdings”), an indirect wholly-owned subsidiary of our Company, issued $75.0 million in aggregate principal amount of its 7.50% Senior Secured Notes due 2022 (the “Notes”) in a private placement.  The Notes are senior secured obligations of ReadyCap Holdings and payments of the amounts due

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on the Notes are fully and unconditionally guaranteed (the “Guarantees”) by the Company, our operating partnership, Sutherland Asset I, LLC ( “Sutherland Asset I”) and ReadyCap Commercial, a wholly-owned subsidiary of ReadyCap Holdings (collectively, the “Guarantors,” and each a “Guarantor”). 

 

Although we are not required to maintain any specific debt-to-equity leverage ratio, the amount of leverage we may employ for particular assets will depend upon the availability of particular types of financing and our Manager’s assessment of the credit, liquidity, price volatility and other risks of those assets and financing counterparties. We are currently targeting on a debt-to-equity basis, 3:1 to 4:1 leverage on performing SBC loans we purchase or originate and finance through non-recourse securitization structures and 1:1 to 3:1 leverage on non-performing SBC loans that we purchase. Our expected leverage ratios for our recourse debt are 1.5:1 to 3:1. We believe that these target leverage ratios are conservative for these asset classes and exemplify the conservative levels of borrowings we intend to use over time. We intend to use leverage for the primary purpose of financing our portfolio and not for the purpose of speculating on changes in interest rates. We may, however, be limited or restricted in the amount of leverage we may employ by the terms and provisions of any financing or other agreements that we may enter into in the future, and we may be subject to margin calls as a result of our financing activity. At December 31, 2016, we had a leverage ratio of 2.6x on a debt-to-equity basis, 2.0x excluding $319.7 million in outstanding borrowings under repurchase agreements on U.S Treasury securities.

 

HEDGING STRATEGY

 

Subject to maintaining our qualification as a REIT, we may use derivative financial instruments (or hedging instruments), including interest rate swap agreements, interest rate cap agreements, options on interest rate swaps, or swaptions, financial futures, structured credit indices, and options in an effort to hedge the interest rate and credit spread risk associated with the financing of our portfolio. Specifically, we attempt to hedge our exposure to potential interest rate mismatches between the interest we earn on our assets and our borrowing costs caused by fluctuations in short-term interest rates, and we intend to hedge our SBC loan originations from the date the interest rate is locked until the loan is included in a securitization. We also use hedging instruments in connection with our residential mortgage loan origination platform in an attempt to offset some of the impact of prepayments on our loans. In particular, we use MBS forward sales contracts to manage the interest rate price risk associated with the interest rate lock commitments we make with potential borrowers.  In utilizing leverage and interest rate hedges, our objectives include, where desirable, locking in, on a long-term basis, a spread between the yield on our assets and the cost of our financing in an effort to improve returns to our stockholders. We will undertake to hedge our originated loan inventory pending securitization with respect to changes in securitization liability cost resulting from both changes in benchmark treasuries and credit spreads. Hedges are periodically re-balanced to match expected duration of the securitization and are closed at securitization issuance with the resulting gain or loss allocated to the retained basis in the securitization with the objective of protecting the yield for the aforementioned changes in securitization liabilities.

 

CORPORATE GOVERNANCE

 

We strive to maintain an ethical workplace in which the highest standards of professional conduct are practiced.

 

·

Our board of directors is composed of a majority of independent directors. The Audit, Nominating and Corporate Governance and Compensation Committees of our board of directors are composed exclusively of independent directors.

 

·

In order to foster the highest standards of ethics and conduct in all business relationships, we have adopted a Code of Conduct and Ethics policy, which covers a wide range of business practices and procedures, that applies to our officers, directors, employees, if any, and independent contractors, to our Manager and our Manager’s officers and employees, and to any of our affiliates or affiliates of the Manager, and such affiliates’ officers and employees, who provide services to us or the Manager in respect of our Company. In addition, we have implemented Whistleblowing Procedures for Accounting and Auditing Matters and Code of Conduct and Ethics Violations (the “Whistleblower Policy”) that set forth procedures by which any Covered Persons (as defined in the Whistleblower Policy) may raise, on a confidential basis, concerns regarding, among other things, any questionable or unethical accounting, internal accounting controls or auditing matters and any potential violations of the Code of Conduct and Ethics with our Audit Committee or the Chief Compliance Officer.

 

·

We have adopted an Insider Trading Policy for Trading in the Securities of our Company (the “Insider Trading Policy”), that governs the purchase or sale of our securities by any of our directors, officers, and associates (as

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defined in the Insider Trading Policy), if any, and independent contractors, as well as officers and employees of the Manager and our officers, employees and affiliates, and that prohibits any such persons from buying or selling our securities on the basis of material non-public information. 

 

COMPETITION

 

We compete with numerous regional and community banks, specialty-finance companies, savings and loan associations and other entities, and we expect that others may be organized in the future. The effect of the existence of additional REITs and other institutions may be increased competition for the available supply of SBC and SBA assets suitable for purchase, which may cause the price for such assets to rise. Additionally, origination of SBC loans, SBA loans and residential agency loans by our competitors may increase the availability of these loans, which may result in a reduction of interest rates on these loans.

 

In the face of this competition, we expect to have access to our Manager’s professionals and their industry expertise, which may provide us with a competitive advantage in sourcing transactions and help it assess acquisition and origination risks and determine appropriate pricing for potential assets. Additionally, we believe that we are currently one of only a handful of active market participants in the secondary SBC loan market. Due to the special servicing expertise needed to effectively manage these assets, the small size of each loan, the uniqueness of the real properties that collateralize the loans and the need to bring residential mortgage credit analysis into the underwriting process, we expect a competitive demand for these assets to remain constrained. We seek to manage credit risk through our loan-level pre-origination or pre-acquisition due diligence and underwriting processes, which as of December 31, 2016 has limited the amount of realized losses. However, we may not be able to achieve our business goals or expectations due to the competitive risks that we face. For additional information concerning these competitive risks, see “Item 1A - Risk Factors -- New entrants in the market for SBC loan acquisitions and originations could adversely impact our ability to acquire SBC loans at attractive prices and originate SBC loans at attractive risk-adjusted returns.”

 

EMPLOYEES; STAFFING

 

We are managed by Waterfall pursuant to the management agreement with Waterfall. Frederick Herbst, who is employed by Waterfall and serves as our Chief Financial Officer, is dedicated exclusively to us, and five of Waterfall’s accounting professionals are also dedicated primarily to us. Waterfall or we may in the future hire additional personnel that may be dedicated to our business. Waterfall is not, however, obligated under the management agreement to dedicate any of its personnel exclusively to our business, nor is it or its personnel obligated to dedicate any specific portion of its or their time to our business. Accordingly, with the exception of our Chief Financial Officer, our executive officers are not required to devote any specific amount of time to our business. We are responsible for the costs of our own employees. However, with the exception of our ReadyCap Commercial, ReadyCap Lending and GMFS subsidiaries, which will employ its own personnel, we do not expect to have our own employees.

 

Our corporate headquarters are located at 1140 Avenue of the Americas, 7th Floor, New York, NY 10036, and our telephone number is (212) 257-4600.

 

EXECUTIVE OFFICERS OF THE COMPANY

 

The following sets forth certain information with respect to our directors and executive officers.

 

 

 

 

 

 

Name

    

Age

    

Position with the Company

Thomas E. Capasse

 

59

 

Chairman of the Company Board of Directors and
Chief Executive Officer

Jack J. Ross

 

59

 

President and Director

Frederick C. Herbst

 

59

 

Chief Financial Officer

Thomas Buttacavoli

 

39

 

Chief Investment Officer

 

Set forth below is biographical information for our executive officers and other key personnel.

 

Thomas E. Capasse is a Manager and co-founder of our Manager. Mr. Capasse also serves as Chairman of our board of directors and our Chief Executive Officer. Prior to founding Waterfall, Mr. Capasse managed the principal finance groups at Greenwich Capital from 1995 until 1997, Nomura Securities from 1997 until 2001, and Macquarie Securities

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from 2001 until 2004. Mr. Capasse has significant and long-standing experience in the securitization market as a founding member of Merrill Lynch’s ABS Group (1983 – 1994) with a focus on MBS transactions (including the initial Subprime Mortgage and Manufactured Housing ABS) and experience in many other ABS sectors. Mr. Capasse began his career as a fixed income analyst at Dean Witter and Bank of Boston. Mr. Capasse received a Bachelor of Arts degree in Economics from Bowdoin College in 1979.

 

Jack J. Ross is a Manager and co-founder of our Manager. Mr. Ross also serves as our President and as a member of our board of directors. Prior to founding Waterfall in January 2005, Mr. Ross was the founder of Licent Capital, a specialty broker/dealer for intellectual property securitization. From 1987 until 1999, Mr. Ross was employed by Merrill Lynch where he managed the real estate finance and ABS groups. Mr. Ross began his career at Drexel Burnham Lambert where he worked on several of the early ABS transactions and at Laventhol & Horwath where he served as a senior auditor. Mr. Ross received a Masters of Business Administration degree in Finance with distinction from the University of Pennsylvania’s Wharton School of Business in 1984 and a Bachelor of Science degree in Accounting, cum laude, from the State University of New York at Buffalo in 1978.

 

Thomas Buttacavoli is a Manager, Managing Director and co-founder of our Manager. Mr. Buttacavoli serves as our Chief Investment Officer and Portfolio Manager of our SBC loan portfolio. Prior to joining Waterfall in 2005, Mr. Buttacavoli was a Structured Finance Analyst specializing in intellectual property securitization at Licent Capital. Prior to joining Licent Capital, he was a Strategic Planning Analyst at BNY Capital Markets. Mr. Buttacavoli started his career as a Financial Analyst within Merrill Lynch’s Partnership Finance Group. Mr. Buttacavoli received a Bachelor of Arts degree in Finance and Accounting from New York University’s Stern School of Business in 1999.

 

Frederick C. Herbst serves as the Managing Director of our Manager and as our Chief Financial Officer. Prior to 2009, Mr. Herbst was Chief Financial Officer of Clayton Holdings, Inc., a publicly traded provider of analytics and due diligence services to participants in the mortgage industry. Prior to Clayton Holdings, he was Chief Financial Officer of Arbor Realty Trust, Inc., a publicly traded real estate investment trust, from 2003 until 2005, and of Arbor Commercial Mortgage, LLC from 1999 until 2005. Prior to joining Arbor, Mr. Herbst was Chief Financial Officer of The Hurst Companies, Inc., Controller with The Long Island Savings Bank, FSB, Vice President Finance with Eastern States Bankcard Association and a Senior Manager with Ernst & Young. Mr. Herbst received a Bachelor of Arts degree in Accounting from Wittenberg University in 1979. Mr. Herbst became a Certified Public Accountant in 1983.

 

AVAILABLE INFORMATION

 

We maintain a website at www.sutherlandam.com and will make available, free of charge, on our website (a) our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K (including any amendments thereto), proxy statements and other information (collectively, “Company Documents”) filed with, or furnished to, the SEC, as soon as reasonably practicable after such documents are so filed or furnished, (b) Corporate Governance Guidelines, (c) Director Independence Standards, (d) Code of Conduct and Ethics and (e) written charters of the Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee of the board of directors. Company Documents filed with, or furnished to, the SEC are also available for review and copying by the public at the SEC’s Public Reference Room at 100 F Street, NE., Washington, DC 20549 and at the SEC’s website at www.sec.gov. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. We provide copies of our Corporate Governance Guidelines and Code of Conduct and Ethics, free of charge, to stockholders who request such documents. Requests should be directed to Jacques Cornet, ICR, Inc., at 685 Third Avenue, 2nd Floor, New York, NY 10017.

 

Item 1A. Risk Factors.

 

Our business and operations are subject to a number of risks and uncertainties, the occurrence of which could adversely affect our business, financial condition, consolidated results of operations and ability to make distributions to stockholders and could cause the value of our capital stock to decline. Please refer to the section entitled “Forward-Looking Statements.”

 

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Risks Related to Our Business

 

We anticipate that a significant portion of our investments will be in the form of SBC loans that are subject to increased risks.

 

Our acquired non-performing loans represented in the aggregate 4.5% of the UPB and 2.3% of the carrying value, of our total loan portfolio as of December 31, 2016. As of December 31, 2016, our 360 non-performing loans had a current unpaid principal balance of $88.1 million and a carrying value of $43.1 million. We consider a loan to be performing if the borrower is current on 100% of the contractual payments due for principal and interest during the most recent 90 days. We consider a loan to be non-performing if the borrower does not meet the criteria of a performing loan. Non-performing SBC loans are subject to increased risks of credit loss for a variety of reasons, including, the underlying property is too highly-leveraged or the borrower has experienced financial distress. Whatever the reason, the borrower may be unable to meet its contractual debt service obligation to us or our subsidiaries. Non-performing SBC loans may require a substantial amount of workout negotiations and/or restructuring, which may divert our attention from other activities and entail, among other things, a substantial reduction in the interest rate or capitalization of past due interest. However, even if restructurings are successfully accomplished, risks still exist that borrowers will not be able or willing to maintain the restructured payments or refinance the restructured mortgage upon maturity. Additional risks inherent in the acquisition of non-performing SBC loans include undisclosed claims, undisclosed tax liens that may have priority, higher legal costs and greater difficulties in determining the value of the underlying property.

 

As of December 31, 2016 the average loan-to-value (“LTV”), of ReadyCap’s originated portfolio was 63%. The weighted LTV of our acquired loans was 68% as of December 31, 2016. If such SBC loans with higher LTV ratios become delinquent, we may experience greater credit losses compared to lower-leveraged properties. Additional risks inherent in the acquisition of delinquent SBC loans include undisclosed claims, undisclosed tax liens that may have priority, higher legal costs and greater difficulties in determining the value of the underlying property.

 

The lack of liquidity of our assets may adversely affect our business, including our ability to value and sell our assets.

 

A portion of the SBC loans and asset-backed securities (“ABS”) we own, acquire or originate may be subject to legal and other restrictions on resale or will otherwise be less liquid than publicly-traded securities. The illiquidity of our assets may make it difficult for us to sell such assets if the need or desire arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less value than the value at which we have previously recorded our assets. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be relatively limited, which could adversely affect our results of operations and financial condition.

 

Waterfall’s due diligence of potential SBC loans and ABS assets may not reveal all of the liabilities associated with such SBC loans and ABS assets and may not reveal the other combined weaknesses in such SBC loans and ABS assets, which could lead to investment losses.

 

Before making an investment, Waterfall calculates the level of risk associated with the SBC loan to be acquired or originated based on several factors which include the following: a complete review of seller’s data files, including data integrity, compliance review and custodial file review; rent rolls and other property operating data; personal credit reports of the borrower and owner and/or operator; property valuation review; environmental review; and tax and title search. In making the assessment and otherwise conducting customary due diligence, we will employ standard documentation requirements and require appraisals prepared by local independent third party appraisers it selects. Additionally, we will seek to have sellers provide representations and warranties on SBC loans we acquire, and if we are unable to obtain representations and warranties, we will factor the increased risk into the price we pay for such loans. Despite our review process, there can be no assurance that our due diligence process will uncover all relevant facts or that any investment will be successful.

 

If Waterfall underestimates the credit analysis and the expected risk adjusted return relative to other comparable investment opportunities, we may experience losses.

 

Waterfall expects to value our SBC and SBC ABS investments based on an initial credit analysis and the investment’s expected risk adjusted return relative to other comparable investment opportunities available to us, taking into account estimated future losses on the mortgage loans, and the estimated impact of these losses on expected future cash flows. Waterfall’s loss estimates may not prove accurate, as actual results may vary from estimates. In the event that Waterfall

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underestimates the losses relative to the price we pay for a particular SBC or SBC ABS investment, we may experience losses with respect to such investment.

 

The failure of a third-party servicer or the failure of our own internal servicing system to effectively service our portfolio of mortgage loans would materially and adversely affect us.

 

Most mortgage loans and securitizations of mortgage loans require a servicer to manage collections for each of the underlying loans. We will service our loan portfolio under a “component servicing” model (which includes the use of primary servicing by nationally recognized servicers and sub-servicing by participants in our Qualified Partner Program (“QPP”), who specialize in assets for the particular region in which the asset sits), which allows for highly customized loss mitigation strategies for non-performing and performing loans. Performing SBC loans (either loans purchased with historical activity, i.e., not originated, purchased in the secondary market or ReadyCap originations) will be securitized with us retaining the subordinate tranches. KeyBank Real Estate Capital (“KeyBank”), performs both primary and special servicing with all loss mitigation decisions directed by Waterfall (which also maintains an option to purchase delinquent loans from the securitization trust). Non-performing SBC loans are serviced either through an approved SBC primary servicer providing both primary and special servicing or providing only primary servicing with special servicing contracted to smaller regionally focused SBC operators and servicers who gain eligibility to participate in its QPP. Servicers’ responsibilities include providing collection activities, loan workouts, modifications and refinancings, foreclosures, short sales, sales of foreclosed real estate and financings to facilitate such sales. Both default frequency and default severity of loans may depend upon the quality of the servicer. If a servicer is not vigilant in encouraging the borrowers to make their monthly payments, the borrowers may be far less likely to make these payments, which could result in a higher frequency of default. If a servicer takes longer to liquidate non-performing assets, loss severities may be higher than originally anticipated. Higher loss severity may also be caused by less competent dispositions of real estate owned (“REO”), properties.

 

We will seek to increase the value of non-performing loans through special servicing activities that will be performed by our participating special servicers. Servicer quality is of prime importance in the default performance of SBC loans and SBC ABS. Many servicers have gone out of business in recent years, requiring a transfer of loan servicing to another servicer. Should we have to transfer loan servicing to another servicer, the transfer of loans to a new servicer could result in more loans becoming delinquent because of confusion or lack of attention. Servicing transfers involve notifying borrowers to remit payments to the new servicer, and these transfers could result in misdirected notices, misapplied payments, data input errors and other problems. Industry experience indicates that mortgage loan delinquencies and defaults are likely to temporarily increase during the transition to a new servicer and immediately following the servicing transfer. Further, when loan servicing is transferred, loan servicing fees may increase, which may have an adverse effect on the credit support of assets held by us.

 

Effectively servicing our portfolio of SBC loans is critical to our success, particularly given our strategy of maximizing the value of our portfolio with our loan modifications, loss mitigation, restructuring and other special servicing activities, and therefore, if one of our servicers fails to effectively service the portfolio of mortgage loans, it could have a material and adverse effect on our business, results of operations and financial condition.

 

The bankruptcy of a third-party servicer would adversely affect our business, results of operation and financial condition.

 

Depending on the provisions of the agreement with the servicer of any of our SBC loans, the servicer may be allowed to commingle collections on the mortgage loans owned by us with its own funds for certain periods of time (usually a few business days) after the servicer receives them. In the event of a bankruptcy of a servicer, we may not have a perfected interest in any collections on the mortgage loans owned by us that are in that servicer’s possession at the time of the commencement of the bankruptcy case. The servicer may not be required to turn over to us any collections on mortgage loans that are in its possession at the time it goes into bankruptcy. To the extent that a servicer has commingled collections on mortgage loans with its own funds, we may be required to return to that servicer as preferential transfers all payments received on the mortgage loans during a period of up to one year prior to that servicer’s bankruptcy.

 

If a servicer were to go into bankruptcy, it may stop performing its servicing functions (including any obligations to advance moneys in respect of a mortgage loan) and it may be difficult to find a third party to act as that servicer’s successor. Alternatively, the servicer may take the position that unless the amount of its compensation is increased or the terms of its servicing obligations are otherwise altered it will stop performing its obligations as servicer. If it were to be difficult to

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find a third party to succeed the servicer, we may have no choice but to agree to a servicer’s demands. The servicer may also have the power, with the approval of the bankruptcy court, to assign its rights and obligations to a third party without our consent, and even over its objections, and without complying with the terms of the applicable servicing agreement. The automatic stay provisions of Title 11 of the United States Code (the “Bankruptcy Code”), would prevent (unless the permission of the bankruptcy court were obtained) any action by us to enforce the servicer’s obligations under its servicing agreement or to collect any amount owed to us by the servicer. The Bankruptcy Code also prevents the removal of the servicer as servicer and the appointment of a successor without the permission of the bankruptcy court or the consent of the servicer.

 

Any costs or delays involved in the completion of a foreclosure or liquidation of the underlying property may further reduce proceeds from the property and may increase the loss.

 

In the future, it is possible that we may find it necessary or desirable to foreclose on some, if not many, of the SBC loans we acquire, and the foreclosure process may be lengthy and expensive. Borrowers may resist mortgage foreclosure actions by asserting numerous claims, counterclaims and defenses against us including, without limitation, numerous lender liability claims and defenses, even when such assertions may have no basis in fact, in an effort to prolong the foreclosure action and force us into a modification of the SBC loan or a favorable buy-out of the borrower’s position. In some states, foreclosure actions can sometimes take several years or more to litigate. At any time prior to or during the foreclosure proceedings, the borrower may file for bankruptcy, which would have the effect of staying the foreclosure actions and further delaying the foreclosure process. Foreclosure may create a negative public perception of the related mortgaged property, resulting in a decrease in its value. Even if we are successful in foreclosing on a SBC loan, the liquidation proceeds upon sale of the underlying real estate may not be sufficient to recover its cost basis in the SBC loan, resulting in a loss to us. Furthermore, any costs or delays involved in the completion of a foreclosure of the SBC loan or a liquidation of the underlying property will further reduce the proceeds and thus increase the loss. Any such reductions could materially and adversely affect the value of the commercial SBC loans in which we invests and, therefore, could have a material and adverse effect on our business, results of operations and financial condition.

 

Inaccurate and/or incomplete information received in connection with our due diligence and underwriting process could have a negative impact on our financial condition and results of operation.

 

Our credit and underwriting philosophy for both acquired and originated SBC loans will encompass individual borrower and property diligence, taking into consideration several factors, including (i) the seller’s data files, including data integrity, compliance review and custodial file review; (ii) rent rolls and other property operating data; (iii) personal credit reports of the borrower, owner and/or operator; (iv) property valuations; (v) environmental reviews; and (vi) tax and title searches. We will also ask sellers to provide representations and warranties on SBC loans we acquire, and if we are unable to obtain representations and warranties, we will factor the increased risk into the price we pay for such loans. Our financial condition and results of operations could be negatively impacted to the extent we rely on information that is misleading, inaccurate or incomplete.

 

The use of underwriting guideline exceptions in the SBC loan origination process may result in increased delinquencies and defaults.

 

Although SBC loan originators generally underwrite mortgage loans in accordance with their pre-determined loan underwriting guidelines, from time to time and in the ordinary course of business, originators, including the Company, will make exceptions to these guidelines. On a case-by-case basis, our underwriters may determine that a prospective borrower that does not strictly qualify under our underwriting guidelines warrants an underwriting exception, based upon compensating factors. Compensating factors may include a lower LTV ratio, a higher debt coverage ratio, experience as a real estate owner or investor, borrower net worth or liquidity, stable employment, longer length of time in business and length of time owning the property. Loans originated with exceptions may result in a higher number of delinquencies and defaults, which could have a material and adverse effect on our business, results of operations and financial condition.

 

Deficiencies in appraisal quality in the mortgage loan origination and acquisition process may result in increased principal loss severity.

 

During the mortgage loan underwriting process, appraisals are generally obtained on the collateral underlying each prospective mortgage. The quality of these appraisals may vary widely in accuracy and consistency. The appraiser may feel pressure from the broker or lender to provide an appraisal in the amount necessary to enable the originator to make

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the loan, whether or not the value of the property justifies such an appraised value. Inaccurate or inflated appraisals may result in an increase in the severity of losses on the mortgage loans, which could have a material and adverse effect on our business, results of operations and financial condition.

 

We may be exposed to environmental liabilities with respect to properties to which we take title, which may in turn decrease the value of the underlying properties.

 

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 we 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. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity, and results of operations could be materially and adversely affected. In addition, an owner or operator of real property may become liable under various federal, state and local laws, for the costs of removal of certain hazardous substances released on its property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the release of such hazardous substances. 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 adversely affect the value of the relevant mortgage-related assets held by us.

 

Waterfall will utilize analytical models and data in connection with the valuation of our SBC loans and SBC ABS, and any incorrect, misleading or incomplete information used in connection therewith would subject us to potential risks.

 

As part of the risk management process Waterfall intends to use detailed proprietary models, including loan level non-performing loan models, to evaluate collateral liquidation timelines and price changes by region, along with the impact of different loss mitigation plans. Additionally, Waterfall intends to use information, models and data supplied by third parties. Models and data will be used to value potential target assets. In the event models and data prove to be incorrect, 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 models, Waterfall may be induced to buy certain target assets at prices that are too high, to sell certain other assets at prices that are too low, or to miss favorable opportunities altogether. Similarly, any hedging based on faulty models and data may prove to be unsuccessful.

 

Any disruption in the availability and/or functionality of our technology infrastructure and systems and any failure of our security measures related to these systems could adversely impact our business.

 

Our ability to acquire and originate SBC loans and manage any related interest rate risks and credit risks is critical to our success and is highly dependent upon the efficient and uninterrupted operation of our computer and communications hardware and software systems. For example, we will rely on our proprietary database to track and maintain all loan performance and servicing activity data for loans in our portfolio. This data is used to manage the portfolio, track loan performance, develop and execute asset disposition strategies. In addition, this data is used to evaluate and price new investment opportunities. Some of these systems will be located at our facility and some will be maintained by third party vendors. Any significant interruption in the availability and functionality of these systems could harm our business. In the event of a systems failure or interruption by our third party vendors, we will have limited ability to affect the timing and success of systems restoration. If such interruptions continue for a prolonged period of time, it could have a material and adverse impact on our business, results of operations and financial condition.

 

Our security measures may not effectively prohibit others from obtaining improper access to our information. If a person is able to circumvent our security measures, he or she could destroy or misappropriate valuable information or disrupt our operations. Any security breach could expose us to risks of data loss, litigation and liability and could seriously disrupt our operations and harm our reputation.

 

Difficult conditions in the mortgage, residential and commercial real estate markets may cause us to experience market losses related to our holdings, and there is no assurance that these conditions will improve in the near future.

 

Our results of operations are materially affected by conditions in the mortgage market, the residential and commercial real estate markets, the financial markets and the economy generally. Continuing concerns about the mortgage market and

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a declining real estate market, as well as inflation, energy costs, geopolitical issues, unemployment and the availability and cost of credit, have contributed to increased volatility and diminished expectations for the economy and markets going forward. In particular, the U.S. mortgage market has been severely affected by changes in the lending landscape and has experienced defaults, credit losses and significant liquidity concerns, and there is no assurance that these conditions have fully stabilized or that they will not worsen. This is especially true in the SBC loan sector. Based on publicly available data from Boxwood Means Inc., a real estate research and consulting firm, as of December 31, 2016, while commercial property prices have almost recovered to their 2007 peak, SBC property prices have increased only 21.5% from the 2012, trough. We believe this trend suggests continued tight credit in SBC lending. Disruptions in mortgage markets negatively impact new demand for real estate. A deterioration of the SBC or SBC ABS markets may cause us to experience losses related to our assets and to sell assets at a loss. Our profitability may be materially adversely affected if we are unable to obtain cost effective financing. A continuation or increase in the volatility and deterioration in the SBC and SBC ABS markets as well as the broader financial markets may adversely affect the performance and fair market values of our SBC loan and SBC ABS assets and may adversely affect our results of operations and credit availability, which may reduce earnings and, in turn, cash available for distribution to our stockholders.

 

New entrants in the market for SBC loan acquisitions and originations could adversely impact our ability to acquire SBC loans at attractive prices and originate SBC loans at attractive risk-adjusted returns.

 

Although we believe that we are currently one of only a handful of active market participants in the secondary SBC loan market, new entrants in this market could adversely impact our ability to acquire and originate SBC loans at attractive prices. In acquiring and originating our target assets, we may compete with numerous regional and community banks, specialty finance companies, savings and loan associations, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, other lenders and other entities, and we expect that others may be organized in the future. The effect of the existence of additional REITs and other institutions may be increased competition for the available supply of SBC assets suitable for purchase, which may cause the price for such assets to rise, which may limit our ability to generate desired returns. Additionally, origination of SBC loans by our competitors may increase the availability of SBC loans which may result in a reduction of interest rates on SBC loans. Some competitors may have a lower cost of funds and access to funding sources that may not be available to us. Many of our competitors are not subject to the operating constraints associated with REIT tax compliance or maintenance of an exemption from the 1940 Act. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of SBC loan and ABS assets and establish more relationships than us.

 

We cannot assure you that the competitive pressures we may face will not have a material adverse effect on our business, financial condition and results of operations. Also, as a result of this competition, desirable investments in our target assets may be limited in the future and we may not be able to take advantage of attractive investment opportunities from time to time, as we can provide no assurance that it will be able to identify and make investments that are consistent with our investment objectives.

 

We cannot predict the unintended consequences and market distortions that may stem from far-ranging regulatory reform of the oversight of financial markets.

 

In response to the financial issues affecting the banking system and financial markets and ongoing concerns of, and threats to, commercial banks, investment banks and other financial institutions, the Emergency Economic Stabilization Act (“EESA”), was enacted by the U.S. Congress in 2008. There can be no assurance that the EESA or any other U.S. Government actions will have a beneficial impact on the financial markets. To the extent the markets do not respond favorably to any such actions by the U.S. Government or such actions do not function as intended, our business may not receive the anticipated positive impact from the legislation and such result may have broad adverse market implications.

 

In July 2010, the U.S. Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) in part to impose significant investment restrictions and capital requirements on banking entities and other organizations that are significant to U.S. financial markets. For instance, the Dodd-Frank Act has imposed significant restrictions on the proprietary trading activities of certain banking entities and subject other systemically significant organizations regulated by the U.S. Federal Reserve to increase capital requirements and quantitative limits for engaging in such activities. The Dodd-Frank Act also seeks to reform the asset-backed securitization market (including the MBS market) by requiring the retention of a portion of the credit risk inherent in the pool of securitized assets and by imposing additional registration and disclosure requirements. The Dodd-Frank Act also imposes significant regulatory restrictions on the origination and securitization of commercial mortgage loans. Also, the SEC has proposed significant changes to

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Regulation AB, which, if adopted in their present form, could have sweeping changes to commercial and residential mortgage loan securitization markets as well as to the market for the re-securitization of MBS. The Dodd-Frank Act also created a new regulator, the Consumer Financial Protection Bureau (the “CFPB”), which oversees many of the core laws which regulate the mortgage industry, including the Real Estate Settlement Procedures Act and the Truth in Lending Act. While the full impact of the Dodd-Frank Act and the role of the CFPB cannot be assessed until all implementing regulations are released, the Dodd-Frank Act’s extensive requirements may have a significant effect on the financial markets, and may affect the availability or terms of financing from our lender counterparties and the availability or terms of SBC loans and MBS, both of which may have an adverse effect on our financial condition and results of operations.

 

In addition, the U.S. Government, Federal Reserve, U.S. Treasury, the SEC and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis that began in 2007. We cannot predict whether or when such actions may occur or what effect, if any, such actions could have on our business, results of operations and financial condition. In addition, because the programs are designed, in part, to provide liquidity to restart the market for certain of our targeted assets, the establishment of these programs may result in increased competition for opportunities in its targeted assets. It is also possible that our competitors may utilize the programs which would provide them with debt and equity capital funding from the U.S. government.

 

The increasing number of proposed United States federal, state and local laws may affect certain mortgage-related assets in which we intend to invest and could materially increase our cost of doing business.

 

Various bankruptcy legislation has been proposed that, among other provisions, could allow judges to modify the terms of residential mortgages in bankruptcy proceedings, could hinder the ability of the servicer to foreclose promptly on defaulted mortgage loans or permit limited assignee liability for certain violations in the mortgage loan origination process, any or all of which could adversely affect our business or result in us being held responsible for violations in the mortgage loan origination process even where we were not the originators of the loan. We do not know what impact this type of legislation, which has been primarily, if not entirely, focused on residential mortgage originations, would have on the SBC loan market. We are unable to predict whether United States federal, state or local authorities, or other pertinent bodies, will enact legislation, laws, rules, regulations, handbooks, guidelines or similar provisions that will affect our business or require changes in our practices in the future, and any such changes could materially and adversely affect our cost of doing business and profitability.

 

Failure to obtain or maintain required approvals and/or state licenses necessary to operate our mortgage-related activities may adversely impact our investment strategy.

 

We may be required to obtain and maintain various approvals and/or licenses from federal or state governmental authorities, government sponsored entities or similar bodies in connection with some or all of our activities. There is no assurance that we can obtain and maintain any or all of the approvals and licenses that we desire or that we will avoid experiencing significant delays in seeking such approvals and licenses. Furthermore, we will be subject to various disclosure and other requirements to obtain and maintain these approvals and licenses, and there is no assurance that we will satisfy those requirements. Our failure to obtain or maintain licenses will restrict our options and ability to engage in desired activities, and could subject the us to fines, suspensions, terminations and various other adverse actions if it is determined that we have engaged without the requisite approvals or licenses in activities that required an approval or license, which could have a material and adverse effect on our business, results of operation and financial condition.

 

Some of our SBC loans will have interest rate features that adjust over time, and any interest rate caps on these loans may reduce our income or cause it to suffer a loss during periods of rising interest rates.

 

Our adjustable rate mortgages (“ARMs”) are subject to periodic and lifetime interest rate caps. Periodic interest rate caps limit the amount an interest rate can increase during any given period. Lifetime interest rate caps limit the amount an interest rate can increase through maturity of a loan. Our borrowings, including our repurchase agreement and securitizations, are not subject to similar restrictions. Accordingly, in a period of rapidly increasing interest rates, the interest rates paid on our borrowings could increase without limitation while interest rate caps would limit the interest rates on our ARMs. This problem is magnified for our ARMs that are not fully indexed. Further, some ARMs may be subject to periodic payment caps that result in a portion of the interest being deferred and added to the principal outstanding. As a result, we could receive less cash income on ARMs than we need to pay interest on our related borrowings. These factors could lower our net interest income or cause us to suffer a loss during periods of rising interest rates.

 

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Our inability to manage future growth effectively could have an adverse impact on our financial condition and results of operations.

 

Our ability to achieve our investment objectives will depend on our ability to grow, which will depend, in turn, on Waterfall’s ability to identify, acquire, originate and invest in SBC loans and ABS that meet our investment criteria. Our ability to grow our business will depend in large part on our ability to expand our SBC loan origination activities. Any failure to effectively manage our future growth, including a failure to successfully expand our SBC loan origination activities could have a material and adverse effect on our business, financial condition and results of operations.

 

Accounting rules for certain of our transactions are highly complex and involve significant judgment and assumptions, and changes in such rules, accounting interpretations or our assumptions could adversely impact our ability to timely and accurately prepare our consolidated financial statements.

 

We are subject to Financial Accounting Standards Board (“ FASB”) standards and interpretations that can result in significant accounting changes that could have a material and adverse impact on our results of operations and financial condition. Accounting rules for financial instruments, including the acquisition and sales or securitization of mortgage loans, investments in ABS, derivatives, investment consolidations and other aspects of our anticipated operations are highly complex and involve significant judgment and assumptions. For example, the Company estimates and judgments are based on a number of factors, including projected cash flows from the collateral securing our SBC loans, the likelihood of repayment in full at the maturity of a loan, potential for a SBC loan refinancing opportunity in the future and expected market discount rates for varying property types. These complexities could lead to a delay in the preparation of financial information and the delivery of this information to our stockholders.

 

Changes in accounting rules, interpretations or our assumptions could also undermine our ability to prepare timely and accurate financial statements, which could result in a lack of investor confidence in our financial information and could materially and adversely affect the market price of our common stock.

 

We will depend on Waterfall and its key personnel for our success. We may not find a suitable replacement for Waterfall if the management agreement with Waterfall is terminated, or if key personnel leave the employment of Waterfall or otherwise become unavailable to us.

 

We will be dependent on Waterfall for our day-to-day management. Frederick Herbst, who is employed by Waterfall and serves as our Chief Financial Officer, is dedicated exclusively to our business, and five of Waterfall’s accounting professionals are also dedicated exclusively to our business, and such persons are expected to be dedicated to us. In addition, Waterfall or we may in the future hire additional personnel that may be dedicated to our business. Waterfall is not, however, obligated under the management agreement to dedicate any of its personnel exclusively to our business, nor is it or its personnel obligated to dedicate any specific portion of its or their time to our business. We will also be responsible for the costs of our own employees. However, with the exception of our ReadyCap and GMFS subsidiaries, which will employ their own personnel, we do not expect to have our own employees. Accordingly, we believe that our success will depend to a significant extent upon the efforts, experience, diligence, skill and network of business contacts of the executive officers and key personnel of Waterfall. The executive officers and key personnel of Waterfall will evaluate, negotiate, structure, close and monitor our acquisitions of assets, and our success will depend on its continued service. The departure of any of the executive officers or key personnel of Waterfall could have a material adverse effect on our performance. In addition, we offer no assurance that Waterfall will remain our Manager or that we will continue to have access to Waterfall’s principals and professionals. The initial term of our management agreement with Waterfall only extends for three years from the closing of the ZAIS Financial merger, with automatic one-year renewal terms starting on the third anniversary of the closing of the ZAIS Financial merger. If the management agreement is terminated and no suitable replacement is found to manage the Company, we may not be able to execute our business plan.

 

Should one or more of Waterfall’s key personnel leave the employment of Waterfall or otherwise become unavailable to the Company, Waterfall may not be able to find a suitable replacement and the Company may not be able to execute certain aspects of our business plan.

 

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There are various conflicts of interest in our relationship with Waterfall which could result in decisions that are not in the best interests of our stockholders.

 

We are subject to conflicts of interest arising out of our relationship with Waterfall and its affiliates. Frederick Herbst, who is employed by Waterfall and will serve as the Company’s Chief Financial Officer, is dedicated exclusively to the Company and five of Waterfall’s accounting professionals also are expected to be dedicated exclusively to our Company. With the exception of our ReadyCap and GMFS subsidiaries, which will employ their own personnel, we do not expect to have our own employees. In addition, we expect that the Chief Executive Officer, President, portfolio managers and any other appropriate personnel of Waterfall will devote such portion of their time to our affairs as is necessary to enable us to effectively operate its business. Waterfall and our officers may have conflicts between their duties to us and their duties to, and interests in, Waterfall and its affiliates. Waterfall is not required to devote a specific amount of time or the services of any particular individual to our operations. Waterfall manages or provides services to other clients, and we will compete with these other clients for Waterfall’s resources and support. The ability of Waterfall and its officers and personnel to engage in other business activities may reduce the time they spend advising us.

 

There may also be conflicts in allocating assets that are suitable for us and other clients of Waterfall and its affiliates. Waterfall manages a series of funds and a limited number of separate accounts, which focus on a range of ABS and other credit strategies. With the exception of the Waterfall Olympic Offshore Fund,Ltd. (the “Olympic Fund”) discussed below, none of these other funds or separate accounts focus on SBC loans as their primary business strategy.

 

To address certain potential conflicts arising from our relationship with Waterfall or its affiliates, Waterfall has agreed in the side letter agreement that, for so long as the management agreement is in effect, neither it nor any of its affiliates will (i) sponsor or manage any additional investment vehicle where we do not participate as an investor whose primary investment strategy will involve SBC mortgage loans, unless Waterfall obtains the prior approval of a majority of our board of directors (including a majority of our independent directors), or (ii) acquire a portfolio of assets, a majority of which (by value or UPB) are SBC mortgage loans on behalf of another investment vehicle (other than acquisitions of SBC ABS), unless we are first offered the investment opportunity and a majority of our board of directors (including a majority of our independent directors) decide not to acquire such assets.

 

In March 2014, due to the size of SBC mortgage loan opportunities, which exceeded our financing capacity at that time, Waterfall sponsored the Olympic Fund. The Olympic Fund was established to invest in assets that may not be qualifying assets for REIT purposes or to invest in SBC loan assets that we decline to purchase for any reason. The Olympic Fund purchased SBC mortgage loans for $480.6 million over 16 transactions from March 31, 2014 through December 31, 2016. These opportunities were first presented to us and a majority of our board of directors (including a majority of our independent directors) decided not to acquire such assets and consented to the formation of the Olympic Fund. Waterfall will continue to seek the consent of the Company board of directors (including a majority of the Company’s independent directors) before allocating asset opportunities to the Olympic Fund, and anticipates that as our debt and equity financing sources continue to grow, Waterfall will only allocate asset opportunities to the Olympic Fund that are not qualifying REIT assets.

 

The side letter agreement does not cover SBC ABS acquired in the market and non-real estate secured loans and we may compete with other existing clients of Waterfall and its affiliates, including the Olympic Fund, other funds managed by Waterfall that focus on a range of ABS and other credit strategies and separately managed accounts, and future clients of Waterfall and its affiliates in acquiring SBC ABS, non-real estate secured loans and portfolios of assets less than a majority of which (by value or UPB) are SBC loans, and in acquiring other target assets that do not involve SBC loans. As of December 31, 2016, the Olympic Fund, these other funds and the separately managed accounts had funds available for investment of $80.2 million, $480.5 million and $128.2 million, respectively.  

 

We will pay Waterfall substantial management fees regardless of the performance of our portfolio. Waterfall’s entitlement to a base management fee, which is not based upon performance metrics or goals, might reduce its incentive to devote its time and effort to seeking assets that provide attractive risk-adjusted returns for our portfolio. This in turn could hurt both our ability to make distributions to our stockholders and the market price of our common stock.

 

The management agreement was negotiated between related parties and their terms, including fees payable, may not be as favorable to us as if they had been negotiated with unaffiliated third parties.

 

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