Claros Mortgage Trust, Inc.: Form 10-Q for the period ended Sep 30, 2023

The following discussion should be read in conjunction with our unaudited consolidated financial statements and notes thereto appearing elsewhere in this quarterly report on Form 10-Q. References herein to “Claros Mortgage Trust,” “Company”, “we”, “us” or “our” refer to Claros Mortgage Trust, Inc. and its subsidiaries unless the context specifically requires otherwise. References to our “Manager” refer to Claros REIT Management LP and references to our "Sponsor" refer to Mack Real Estate Credit Strategies, L.P. (“MRECS”), the CRE lending and debt investment business affiliated with our Manager and Mack Real Estate Group, LLC (“MREG”). Although MRECS and MREG are distinct legal entities, for convenience, references to our “Sponsor” are deemed to include references to MRECS and MREG, individually or collectively, as appropriate for the context and unless otherwise indicated.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

We make forward-looking statements herein and will make forward-looking statements in future filings with the SEC, press releases or other written or oral communications 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 business, financial condition, liquidity, results of operations, plans and objectives. When we use the words “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” or similar expressions, it intends to identify forward-looking statements. Statements regarding the following subjects, among others, may be forward-looking: the macro- and micro-economic impact of the COVID-19 pandemic and secondary effects thereof on our financial condition, results of operations, liquidity and capital resources; market trends in our industry, interest rates, real estate values, the debt securities markets or the general economy; the demand for commercial real estate loans; our business and investment strategy; our operating results; actions and initiatives of the U.S. government and governments outside of the United States, changes to government policies and the execution and impact of these actions, initiatives and policies; the state of the economy generally or in specific geographic regions; changes in geopolitical conditions; economic trends and economic recoveries; our ability to obtain and maintain financing arrangements, including secured debt arrangements and securitizations; the timing and amount of expected future fundings of unfunded commitments; the availability of debt financing from traditional lenders; the volume of short-term loan extensions; the demand for new capital to replace maturing loans; expected leverage; general volatility of the securities markets in which we participate; changes in the value of our assets; the scope of our target assets; interest rate mismatches between our target assets and any borrowings used to fund such assets; changes in interest rates and the market value of our target assets; changes in prepayment rates on our target assets; effects of hedging instruments on our target assets; rates of default or decreased recovery rates on our target assets; the degree to which hedging strategies may or may not protect us from interest rate volatility; impact of and changes in governmental regulations, tax law and rates, accounting, legal or regulatory issues or guidance and similar matters; our continued maintenance of our qualification as a REIT for U.S. federal income tax purposes; our continued exclusion from registration under the Investment Company Act of 1940, as amended (the “1940 Act”); the availability of opportunities to acquire commercial mortgage-related, real estate-related and other securities; the availability of qualified personnel; estimates relating to our ability to make distributions to our stockholders in the future; our present and potential future competition; and unexpected costs or unexpected liabilities, including those related to litigation.

The forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. Forward-looking statements are not predictions of future events. These beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us. See “Item 1A. Risk Factors” of this Quarterly Report on Form 10-Q and our Annual Report. These and other risks, uncertainties, and factors, including those described in the annual, quarterly and current reports that we file with the SEC, could cause our actual results to differ materially from those included in any forward-looking statements we make. All forward-looking statements speak only as of the date they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Introduction

We are a CRE finance company focused primarily on originating loans on transitional CRE assets located in major U.S. markets, including mortgage loans secured by a first priority or subordinate mortgage on transitional CRE assets, and subordinate loans including mezzanine loans secured by a pledge of equity ownership interests in the direct or indirect property owner rather than directly in the underlying commercial properties. These loans are subordinate to a mortgage loan but senior to the property owner’s equity ownership interests. Transitional CRE assets are properties that require repositioning, renovation, rehabilitation, leasing, development or redevelopment or other value-added elements in order to maximize value. We believe our Sponsor’s real estate development, ownership and operations experience and infrastructure differentiates us in lending on these transitional CRE assets. Our objective is to be a premier provider of debt capital for transitional CRE assets and, in doing so, to generate attractive risk-adjusted returns for our stockholders over time, primarily through dividends. We strive to create a diversified investment portfolio of CRE loans that we generally intend to hold to maturity. We focus primarily on originating loans ranging from $50 million to $300 million on transitional CRE assets located in major markets with attractive fundamental characteristics supported by macroeconomic tailwinds.

We were organized as a Maryland corporation on April 29, 2015 and commenced operations on August 25, 2015, and are traded on the New York Stock Exchange, or NYSE, under the symbol “CMTG”. We have elected and believe we have qualified to be taxed as a REIT for U.S. federal income tax purposes commencing with our taxable year ended December 31, 2015. We are externally managed and advised by our Manager, an investment adviser registered with the SEC pursuant to the Investment Advisers Act of 1940, as amended (the “Advisers Act”). We operate our business in a manner that permits us to maintain our exclusion from registration under the Investment Company Act of 1940, as amended (the “1940 Act”).

I. Key Financial Measures and Indicators

As a CRE finance company, we believe the key financial measures and indicators for our business are net income (loss) per share, dividends declared per share, Distributable Earnings (Loss) per share, Distributable Earnings per share prior to realized gains and losses, which includes principal charge-offs, book value per share, adjusted book value per share, Net Debt-to-Equity Ratio and Total Leverage Ratio. During the three months ended September 30, 2023, we had net loss per share of $(0.50), dividends declared per share of $0.25, Distributable Loss per share of ($0.16), and Distributable Earnings per share prior to realized gains and principal charge-offs of $0.35. As of September 30, 2023, our book value per share was $16.25, our adjusted book value per share was $17.00, our Net-Debt-to-Equity Ratio was 2.3x, and our Total Leverage Ratio was 2.7x. We use Net Debt-to-Equity Ratio and Total Leverage Ratio, financial measures which are not prepared in accordance with GAAP, to evaluate our financial leverage, which in the case of our Total Leverage Ratio, makes certain adjustments that we believe provide a more conservative measure of our financial condition.

Net (Loss) Income Per Share and Dividends Declared Per Share

The following table sets forth the calculation of basic and diluted net (loss) income per share and dividends declared per share ($ in thousands, except share and per share data):

During the quarter ended September 30, 2023, the Company declared a dividend of $0.25 per share of common stock. One of the Company’s objectives in declaring the third quarter dividend was to establish a dividend level believed to be sustainable, assuming that the real estate capital market dislocation continues for the foreseeable future.

Distributable Earnings (Loss)

Distributable Earnings (Loss) is a non-GAAP measure used to evaluate our performance excluding the effects of certain transactions, non-cash items and GAAP adjustments, as determined by our Manager. Distributable Earnings (Loss) is a non-GAAP measure, which we define as net income in accordance with GAAP, excluding (i) non-cash stock-based compensation expense, (ii) real estate depreciation and amortization, (iii) any unrealized gains or losses from mark-to-market valuation changes (other than permanent impairments) that are included in net income for the applicable period, (iv) one-time events pursuant to changes in GAAP and (v) certain non-cash items, which in the judgment of our Manager, should not be included in Distributable Earnings (Loss). Furthermore, the Company presents Distributable Earnings prior to realized gains and losses, which includes principal charge-offs, as the Company believes this more easily allows our Board, Manager, and investors to compare our operating performance to our peers, to assess our ability to pay dividends, and to determine our compliance with certain financial covenants. Pursuant to the Management Agreement, we use Core Earnings, which is substantially the same as Distributable Earnings (Loss) excluding incentive fees, to determine the incentive fees we pay our Manager. Distributable Earnings (Loss) is substantially the same as Core Earnings, as defined in the Management Agreement, for the periods presented.

We believe that Distributable Earnings (Loss) and Distributable Earnings prior to realized gains and losses provide meaningful information to consider in addition to our net income and cash flows from operating activities in accordance with GAAP. Distributable Earnings (Loss) and Distributable Earnings prior to realized gains and losses do not represent net income or cash flows from operating activities in accordance with GAAP and should not be considered as an alternative to GAAP net income, an indication of our cash flows from operating activities, a measure of our liquidity or an indication of funds available for our cash needs. In addition, our methodology for calculating these metrics may differ from the methodologies employed by other companies to calculate the same or similar supplemental performance measures and, accordingly, our reported Distributable Earnings (Loss) and Distributable Earnings prior to realized gains and losses may not be comparable to the Distributable Earnings (Loss) and Distributable Earnings prior to realized gains and losses reported by other companies.

In order to maintain our status as a REIT, we are required to distribute at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gain, as dividends. Distributable Earnings (Loss), Distributable Earnings prior to realized gains and losses, and other similar measures, have historically been a useful indicator over time of a mortgage REIT’s ability to cover its dividends, and to mortgage REITs themselves in determining the amount of any dividends to declare. Distributable Earnings (Loss) and Distributable Earnings prior to realized gains and losses are key factors, among others, considered by the Board in setting the dividend each quarter and as such we believe Distributable Earnings (Loss) and Distributable Earnings prior to realized gains and losses are useful to investors.

While Distributable Earnings (Loss) excludes the impact of our unrealized provision for or reversal of current expected credit loss reserves, loan losses are charged off and recognized through Distributable Earnings (Loss) when deemed non-recoverable. Non-recoverability is determined (i) upon the resolution of a loan (i.e., when the loan is repaid, fully or partially, or when we acquire title in the case of foreclosure, deed-in-lieu of foreclosure, or assignment-in-lieu of foreclosure), or (ii) with respect to any amount due under any loan, when such amount is determined to be non-collectible. During the three months ended September 30, 2023, we recorded a $110.2 million provision for CECL reserve, which has been excluded from Distributable Earnings (Loss). During the three months ended June 30, 2023, we recorded a $41.5 million provision for CECL reserve, which has been excluded from Distributable Earnings (Loss).

In determining Distributable Earnings (Loss) per share and Distributable Earnings per share prior to realized gains and losses, the dilutive effect of unvested RSUs is considered. The weighted-average diluted shares outstanding used for Distributable Earnings (Loss) has been adjusted from weighted-average diluted shares under GAAP to include unvested RSUs.

The table below summarizes the reconciliation from weighted-average diluted shares under GAAP to the weighted-average diluted shares used for Distributable Earnings (Loss):

The following table provides a reconciliation of net (loss) income attributable to common stock to Distributable Earnings (Loss) ($ in thousands, except share and per share data):

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Book Value Per Share

We believe that presenting book value per share adjusted for the general current expected credit loss reserve, accumulated depreciation, and accumulated amortization is useful for investors as it enhances the comparability across the industry. We believe that our investors and lenders consider book value excluding these items as an important metric related to our overall capitalization.

The following table sets forth the calculation of our book value and our adjusted book value per share ($ in thousands, except share and per share data):

(1) Calculated as (i) total equity divided by (ii) number of shares of common stock outstanding and RSUs at period end.

II. Our Portfolio

The below table summarizes our loan portfolio as of September 30, 2023 ($ in thousands):

(1) Loan commitment represents principal outstanding plus remaining unfunded loan commitments.

(2) Net of specific CECL reserves of $71.9 million.

(3) Weighted averages are based on unpaid principal balance.

(4) Represents the weighted average annualized yield to initial maturity of each loan, inclusive of coupon, and fees received, based on the applicable floating benchmark rate/floors (if applicable), in place as of September 30, 2023. For loans placed on non-accrual, the annualized yield to initial maturity used in calculating the weighted average annualized yield to initial maturity is 0%.

(5) Fully extended maturity assumes all extension options are exercised by the borrower upon satisfaction of the applicable conditions.

(6) LTV represents “loan-to-value” or “loan-to-cost”, which is calculated as our total loan commitment from time to time, as if fully funded, plus any financings that are pari passu with or senior to our loan, divided by our estimate of either (1) the value of the underlying real estate, determined in accordance with our underwriting process (typically consistent with, if not less than, the value set forth in a third-party appraisal) or (2) the borrower’s projected, fully funded cost basis in the asset, in each case as we deem appropriate for the relevant loan and other loans with similar characteristics. Underwritten values and projected costs should not be assumed to reflect our judgment of current market values or project costs, which may have changed materially since the date of origination. LTV is updated only in connection with a partial loan paydown and/or release of collateral, material changes to expected project costs, the receipt of a new appraisal (typically in connection with financing or refinancing activity) or a change in our loan commitment. Totals represent weighted average based on loan commitment, including non-consolidated senior interests and pari passu interests. Loans with specific CECL reserves are reflected as 100% LTV.

Portfolio Activity and Overview

The following table summarizes changes in unpaid principal balance within our loan portfolio for the three and nine months ended September 30, 2023 ($ in thousands):

The following table details our loan investments individually based on unpaid principal balances as of September 30, 2023 ($ in thousands):

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(1) Loan commitment represents principal outstanding plus remaining unfunded loan commitments.

(2) Net of specific CECL reserves of $71.9 million.

(3) Fully extended maturity assumes all extension options are exercised by the borrower upon satisfaction of the applicable conditions.

(4) Classification of property type and construction status reflect the state of collateral as of September 30, 2023.

(5) Percent of total construction loans based on loan commitments, as of September 30, 2023.

Real Estate Owned, Net

On February 8, 2021, we acquired legal title to a portfolio of seven hotel properties located in New York, NY through a foreclosure and recognized real estate owned of $414.0 million. Prior to February 8, 2021, the hotel portfolio represented the collateral for the $103.9 million mezzanine loan that we held, which was in default as a result of the borrower failing to pay debt service. The hotel portfolio appears as real estate owned, net on our consolidated balance sheets and, as of September 30, 2023, was encumbered by a $290.0 million non-recourse securitized senior mortgage assumed by us, which is included as a liability on our consolidated balance sheets.

On June 30, 2023, we acquired legal title to a mixed-use property located in New York, NY and the equity interests therein through an assignment-in-lieu of foreclosure. The mixed-use property contains both office and retail components. Prior to June 30, 2023, the mixed-use property and a pledge of equity interests therein represented the collateral for a senior loan with an unpaid principal balance of $208.8 million. During the fourth quarter of 2022, the borrower defaulted on the loan and in anticipation of the assignment-in-lieu of foreclosure, we recorded a specific CECL reserve of $42.0 million. Upon acquiring legal title of the collateral, we concurrently recorded an additional specific CECL reserve of $24.9 million immediately prior to recording a principal charge-off of $66.9 million, based upon the mixed-use property's $144.0 million estimated fair value as determined by a third-party appraisal and transaction costs of $0.4 million. The fair value was determined using discount rates ranging from 7.3% to 7.5% and market and terminal capitalization rates ranging from 5.0% to 5.5%.

Refer to Note 5 to our consolidated financial statements for additional details.

Asset Management

Our Manager proactively manages the loans in our portfolio from closing to final repayment and our Sponsor has dedicated asset management employees to perform asset management services. Following the closing of an investment, the asset management team rigorously monitors the loan, with an emphasis on ongoing financial, legal, market condition and quantitative analyses. Through the final repayment of a loan, the asset management team maintains regular contact with borrowers, servicers and local market experts monitoring performance of the collateral, anticipating borrower, property and market issues, and enforcing our rights and remedies when appropriate.

From time to time, some of our borrowers may experience delays in the execution of their business plans. As a transitional lender, we work with our borrowers to execute loan modifications which could include additional equity contributions from borrowers, repurposing of reserves, temporary deferrals of interest or principal, or partial deferral of coupon interest as payment-in-kind interest. We have completed a number of loan modifications to date, and we may continue to make additional modifications depending on the business plans, financial condition, liquidity and results of operations of our borrowers.

Our Manager reviews our loan portfolio at least quarterly, undertakes an assessment of the performance of each loan, and assigns it a risk rating between “1” and “5,” from least risk to greatest risk, respectively. The weighted average risk rating of our total loan portfolio based on unpaid principal balance was 3.2 at September 30, 2023.

Current Expected Credit Losses

During the nine months ended September 30, 2023, we recorded a provision for current expected credit losses of $148.4 million, which included a $151.5 million increase in our specific CECL reserve prior to principal charge-offs, and a reversal of $3.1 million of general CECL reserves. The reversal of general CECL reserves was primarily attributable to the seasoning of and a reduction in our loan portfolio, offset by deteriorating macroeconomic conditions. As of September 30, 2023, our total provision for current expected credit losses was $154.9 million.

During the nine months ended September 30, 2022, we recorded a provision for current expected credit losses of $13.0 million, which included a $5.4 million increase in our specific CECL reserve prior to a principal charge-off, resulting in a total current expected credit loss reserve of $75.0 million as of September 30, 2022. The increase in the total current expected credit loss reserve was primarily attributable to an increase in the size of the portfolio and changes in macroeconomic conditions, partially offset by a principal charge-off. As of September 30, 2022, our total provision for current expected credit losses was $75.0 million.

Specific CECL Reserves

During the three months ended September 30, 2023, we recorded a specific CECL reserve of $20.6 million in connection with a senior loan with a borrower that is experiencing financial difficulty. The loan is secured by an office building in San Francisco, CA and a pledge of equity interests therein with an unpaid principal balance and carrying value prior to any specific CECL reserve of $112.4 million and $112.2 million, respectively, and an initial maturity date of February 13, 2024. Effective September 1, 2023, this loan is on non-accrual status.

During the three months ended September 30, 2023, we recorded a specific CECL reserve of $19.8 million in connection with a senior loan with a borrower that is experiencing financial difficulty. The loan is secured by an office building in Atlanta, GA and a pledge of equity interests therein with an unpaid principal balance and carrying value prior to any specific CECL reserve of $71.5 million and $71.1 million, respectively, and an initial maturity date of August 27, 2024. Effective September 1, 2023, this loan is on non-accrual status.

During the three months ended September 30, 2023, we recorded a specific CECL reserve of $30.6 million in connection with a senior loan with a borrower that is experiencing financial difficulty and the loan is in maturity default. The loan is secured by land in Arlington, VA with an unpaid principal balance and carrying value prior to any specific CECL reserve of $150.7 million. Effective January 1, 2023, this loan is on non-accrual status.

During the three months ended June 30, 2023, we recorded a specific CECL reserve of $0.9 million in connection with a subordinate loan with a borrower that is experiencing financial difficulty and the loan is in maturity default. The loan is secured by the equity interests in a retail condo in Brooklyn, NY with an unpaid principal balance and carrying value prior to any specific CECL reserve of $0.9 million. Effective June 30, 2023, the loan is on non-accrual status.

During the three months ended December 31, 2022, we recorded a specific CECL reserve of $42.0 million in connection with a senior loan with a borrower that was experiencing financial difficulty. The loan was secured by a mixed-use building in New York, NY and a pledge of equity interests therein with an unpaid principal balance and carrying value prior to any specific CECL reserve of $208.8 million and an initial maturity date of February 1, 2023. On June 30, 2023, we obtained legal title to the collateral through an assignment-in-lieu of foreclosure and during the three months ended June 30, 2023 recorded an additional specific CECL reserve of $24.9 million prior to a principal charge-off of $66.9 million. Prior to obtaining legal title to the collateral and while the loan was on non-accrual status during 2023, we recognized $8.3 million of interest income. See Note 5 - Real Estate Owned, Net for further detail. As of December 31, 2022 and through the date of the assignment-in-lieu of foreclosure, this loan was on non-accrual status.

During the three months ended December 31, 2022, we recorded a specific CECL reserve of $18.3 million in connection with a senior loan with a borrower that was experiencing financial difficulty. The loan had a then unpaid principal balance of $138.8 million, a carrying value prior to any specific CECL reserve of $138.3 million and an initial maturity date of August 8, 2024. The loan, which was comprised of a portfolio of uncrossed loans, was collateralized by a portfolio of multifamily properties located in San Francisco, CA. During the three months ended June 30, 2023, we recorded an additional specific CECL reserve of $18.8 million due to a revised valuation of the collateral properties. During the three months ended September 30, 2023, we sold the loan and recorded a principal charge-off of $73.0 million following the recognition of an incremental specific CECL reserve of $35.9 million due to a further decline in the value of the collateral properties. As of December 31, 2022 and through the date of the loan sale, the loan was on non-accrual status.

Fair market values used to determine specific CECL reserves are calculated using a discounted cash flow model, a sales comparison approach, or a market capitalization approach. Estimates of fair market values used to determine specific CECL reserves as of September 30, 2023 include assumptions of property specific cash flows over estimated holding periods, discount rates ranging from 7.5% to 9.5%, and market and terminal capitalization rates ranging from 6.0% to 8.3%. These assumptions are based upon the nature of the properties, recent sales and lease comparables, and anticipated real estate and capital market conditions.

Portfolio Financing

Our financing arrangements include repurchase agreements, a term participation facility, asset-specific financings, mortgages on real estate owned, and secured term loan borrowings.

The following table summarizes our loan portfolio financing ($ in thousands):

(1) Weighted average spread over the applicable benchmark is based on unpaid principal balance. SOFR as of September 30, 2023 was 5.32%. Fixed rate loans are presented as a spread over the relevant floating benchmark rates.

Refer to Note 6 to our consolidated financial statements for additional details on our financings.

Repurchase Agreements and Term Participation Facility

We finance certain of our loans using repurchase agreements and a term participation facility. As of September 30, 2023, aggregate borrowings outstanding under our repurchase agreements and the term participation facility totaled $4.2 billion, with a weighted average coupon of SOFR plus 2.74% per annum. All weighted averages are based on unpaid principal balance. As of September 30, 2023, outstanding borrowings under these facilities had a weighted average term to fully extended maturity (assuming conditions to extend are met) of 2.8 years.

Each repurchase agreement contains “margin maintenance” provisions, which are designed to allow the counterparty to require the delivery of cash or other assets to de-lever financings on assets that are determined to have experienced a diminution in value. Since inception through September 30, 2023, we have not received any margin calls under any of our repurchase agreements. As of September 30, 2023, five of our loans were financed under the term participation facility.

Loan Participations Sold

We finance certain of our loans via the sale of a participation in such loans, and we present the loan participations sold as liabilities on our consolidated balance sheet when such arrangements do not qualify as sales under GAAP. In instances where we have multiple loan participations with the same lender, the financings are generally not cross-collateralized. Each of our loan participations sold is generally term-matched to its underlying loan. As of September 30, 2023, three of our loans were financed with loan participations sold.

Notes Payable

We finance certain of our loans via secured financings that are generally non-recourse and are term matched to the related underlying loan. We refer to such financings as notes payable and they are secured by the related loans receivable. As of September 30, 2023, five of our loans were financed with notes payable.

Secured Term Loan

We have a secured term loan of $727.4 million which we originally entered into on August 9, 2019. Our secured term loan is presented net of any original issue discount and transaction expenses which are deferred and recognized as a component of interest expense over the life of the loan using the effective interest method. During the nine months ended September 30, 2023, we purchased and retired $22.0 million of principal of our secured term loan for a price of $19.3 million, recognizing a $2.2 million gain on extinguishment of debt, inclusive of $485,000 of unamortized deferred financing costs. As of September 30, 2023, our secured term loan has an unpaid principal balance of $727.4 million and a carrying value of $713.3 million.

Debt Related to Real Estate Owned

On February 8, 2021 we assumed a $300.0 million securitized senior mortgage in connection with a foreclosure on a portfolio of seven limited service hotels located in New York, New York. The securitized senior mortgage is non-recourse to us. Our debt related to real estate owned as of September 30, 2023 has an unpaid principal balance of $290.0 million, a carrying value of $289.8 million and a stated rate of LIBOR plus 2.83%, subject to a LIBOR floor of 0.75%. Effective July 1, 2023, interest on our debt related to real estate owned is indexed to SOFR. See Derivatives below for further detail of the interest rate cap related to this financing.

Derivatives

As part of the agreement to amend the terms of our debt related to real estate owned in June 2021, we acquired an interest rate cap with a notional amount of $290.0 million, a strike rate of 3.00%, and a maturity date of February 15, 2024 for $275,000. The fair value of the interest rate cap is $2.7 million as of September 30, 2023.

The interest rate cap effectively limits the maximum interest rate of our debt related to real estate owned to 5.83%. Changes in the fair value of our interest rate cap are recorded as an unrealized gain or loss on interest rate cap on our consolidated statements of operations and the fair value is recorded in other assets on our consolidated balance sheets. Proceeds received from our counterparty related to the interest rate cap are recorded as proceeds from interest rate cap on our consolidated statements of operations. During the three months ended September 30, 2023 and 2022, we recognized $1.7 million and $0 of proceeds from interest rate cap. During the nine months ended September 30, 2023 and 2022, we recognized $4.4 million and $0 of proceeds from interest rate cap.

Acquisition Facility

On June 29, 2022, we entered into a full recourse revolving credit facility with $150.0 million in capacity. The facility generally provides interim financing for eligible loans for up to 180 days at an initial advance rate of 75%, which begins to decline after the 90th day. The facility matures on June 29, 2025 and charges interest at a rate of SOFR, plus a 0.10% credit spread adjustment, plus a spread of 2.25%. With the consent of our lenders, and subject to certain conditions, the commitment of the facility may be increased up to $500.0 million. As of September 30, 2023, the outstanding balance of the facility is $0.

Financial Covenants

Our financing agreements generally contain certain financial covenants. For example, our ratio of earnings before interest, taxes, depreciation, and amortization, to interest charges, as defined in the agreements, shall be not less than either 1.4 to 1.0 or 1.5 to 1.0. Further, (i) our tangible net worth, as defined in the agreements, shall not be less than $2.06 billion as of each measurement date plus 75% of proceeds from future equity issuances; (ii) cash liquidity shall not be less than the greater of (x) $50 million or (y) 5% of our recourse indebtedness; and (iii) our indebtedness shall not exceed 77.8% of our total assets. As of September 30, 2023 and December 31, 2022, we are in compliance with all covenants under our financing agreements. The requirements set forth in (i) through (iii) above are based upon the most restrictive financial covenants in place as of the reporting date.

Non-Consolidated Senior Interests Sold and Non-Consolidated Senior Interests Held by Third Parties

In certain instances, we use structural leverage through the non-recourse syndication of a match-term senior loan interest to a third party which qualifies for sale accounting under GAAP, or through the acquisition of a subordinate loan for which a non-recourse senior interest is retained by a third party. In such instances, the senior loan is not included on our consolidated balance sheet.

The following table summarizes our non-consolidated senior interests and related retained subordinate interests as of September 30, 2023 ($ in thousands):

(1) Our non-consolidated senior interest is indexed to SOFR, which was 5.32% at September 30, 2023.

(2) Weighted average is based on unpaid principal balance.

(3) Term to fully extended maturity is determined based on the maximum maturity of each of the corresponding loans, assuming all extension options are exercised by the borrower; provided, however, that our loans may be repaid prior to such date.

Floating and Fixed Rate Portfolio

Our business model seeks to minimize our exposure to changing interest rates by originating floating rate loans and financing them with floating rate liabilities. Further, we seek to match the benchmark index in the floating rate loans we originate with the benchmark index used in the related floating rate financings. Generally, we use SOFR as the benchmark index in both our floating rate loans and floating rate financings. As of September 30, 2023, 98.0% of the unpaid principal balance of our loans were floating rate and indexed to SOFR. The majority of our floating rate loans were financed with floating rate liabilities indexed to SOFR, which resulted in approximately $1.4 billion of net floating rate exposure.

The following table details our net floating rate exposure as of September 30, 2023 ($ in thousands):

(1) SOFR as of September 30, 2023 was 5.32%.

The U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions, has identified the Secured Overnight Financing Rate, or SOFR, a new index calculated using short-term repurchase agreements backed by Treasury securities, as its preferred alternative rate for LIBOR. As of September 30, 2023, all of our floating rate loans and financing arrangements were indexed to SOFR.

On our debt related to real estate owned, we have an interest rate cap with a notional amount of $290.0 million, a strike rate of 3.00%, and a maturity date of February 15, 2024. The interest rate cap effectively limits the maximum interest rate of our debt related to real estate owned to 5.83%. We have not employed other interest rate derivatives (interest rate swaps, caps, collars or floors) to hedge our asset or liability portfolio, but we may do so in the future.

Results of Operations – Three Months Ended September 30, 2023 and June 30, 2023

As previously disclosed, beginning with our Quarterly Report on Form 10-Q for the quarter ended September 30, 2021, and for all subsequent reporting periods, we have elected to present results of operations by comparing to the immediately preceding period, as well as the same year to date period in the prior year. Given the dynamic nature of our business and the sensitivity to the real estate and capital markets, we believe providing analysis of results of operations by comparing to the immediately preceding period is more meaningful to our stockholders in assessing the overall performance of our current business.

Operating Results

The following table sets forth information regarding our consolidated results of operations for the three months ended September 30, 2023, and June 30, 2023 ($ in thousands, except per share data):

Comparison of the three months ended September 30, 2023 and June 30, 2023

Revenue

Revenue decreased $0.4 million during the three months ended September 30, 2023, compared to the three months ended June 30, 2023. The decrease is primarily due to an increase in interest expense of $3.9 million, as a result of increases in SOFR over the three months ended September 30, 2023 and higher average financing balances compared to the prior quarter. The decrease was partially offset by an increase in revenue from real estate owned of $2.3 million primarily due to $1.3 million of revenue generated from the mixed-use property we acquired legal title to on June 30, 2023, and a $1.0 million increase in revenue recognized at the hotel portfolio due to higher occupancy, ADR, and RevPAR levels over the comparative period, as well as an increase in interest income of $1.3 million primarily as a result of SOFR increases over the three months ended September 30, 2023, and accelerated fee revenue recognized upon repayments of loans, partially offset by lower average outstanding loan balances compared to the prior quarter.

Expenses

Expenses are primarily comprised of base management fees payable to our Manager, general and administrative expenses, stock-based compensation expense, operating expenses from real estate owned, interest expense from debt related to real estate owned, and depreciation and amortization on real estate owned and related in-place and other lease values. Expenses increased by $2.1 million during the three months ended September 30, 2023, as compared to the three months ended June 30, 2023, primarily due to:

(i) an increase in operating expenses from real estate owned of $2.4 million during the comparative period, due to expenses incurred at the mixed-use property we acquired legal title to on June 30, 2023, and increased variable operating expenses in connection with higher occupancy levels at the hotel portfolio;

(ii) an increase in depreciation and amortization on real estate owned of $0.5 million primarily as a result of depreciation and amortization of in-place and other lease values at the mixed-use property we acquired title to on June 30, 2023;

(iii) an increase in interest expense on debt related to real estate owned of $0.3 million primarily as a result of SOFR increases over the comparative period;

(iv) partially offset by a decrease in general and administrative expenses of $1.0 million primarily as a result of a decrease in non-recurring charges incurred over the comparative period.

Gain on sale of loan

During the three months ended September 30, 2023, we realized a gain on sale of loan totaling $0.6 million. There were no loans sold during the three months ended June 30, 2023.

Proceeds from interest rate cap

Proceeds from interest rate cap increased $0.2 million during the three months ended September 30, 2023, as compared to the three months ended June 30, 2023, due to increased SOFR rates, which continued to be in excess of our interest rate cap's 3% strike rate.

Unrealized loss on interest rate cap

During the three months ended September 30, 2023, we recognized a $1.7 million unrealized loss on interest rate cap, compared to a $0.3 million unrealized loss on interest rate cap during the three months ended June 30, 2023 driven by the decline in remaining term. The fair value of the interest rate cap increases as interest rates increase, decreases as the interest rate cap approaches maturity, and further fluctuates following shifts in the forward curve.

Loss from equity method investment

During the three months ended September 30, 2023, we recognized a loss from our equity method investment of $0.1 million as a result of the net loss recognized by our investee over the three months ended September 30, 2023. During the three months ended June 30, 2023, we recognized a loss from our equity method investment of $0.9 as a result of the loan held by the equity method investee being placed on non-accrual status effective April 1, 2023.

Gain on extinguishment of debt

During the three months ended June 30, 2023, we recognized a gain on extinguishment of debt of $2.2 million, inclusive of $485,000 of unamortized deferred financing costs, as a result of the retirement of $22.0 million of principal of our secured term loan for a price of $19.3 million.

Provision for current expected credit loss reserve

During the three months ended September 30, 2023, we recorded a provision for current expected credit losses of $110.2 million, primarily attributable to a $71.1 million increase in our specific CECL reserves and a $3.2 million increase in general CECL reserves which was primarily attributable to deteriorating macroeconomic conditions, offset by seasoning of and a reduction in the size of our loan portfolio. During the three months ended June 30, 2023, we recorded provision for of current expected credit losses of $41.5 million, primarily attributable a $19.7 million increase in our specific CECL reserves, and a $3.1 million reversal of general CECL reserves which was primarily attributable to seasoning of and a reduction in the size of our loan portfolio.

Results of Operations – Nine Months Ended September 30, 2023 and September 30, 2022

The following table sets forth information regarding our consolidated results of operations for nine months ended September 30, 2023 and 2022 ($ in thousands, except per share data):

Comparison of the nine months ended September 30, 2023 and September 30, 2022

Revenue

Revenue increased $27.0 million during the nine months ended September 30, 2023, compared to the nine months ended September 30, 2022. The increase is primarily due to an increase in net interest income of $15.9 million for the comparative period, which was driven by an increase in interest income of $210.7 million, primarily as a result of an increased loans receivable balance and reference rate increases, partially offset by an increase in interest expense of $194.9 million as a result of increased borrowing levels and reference rate increases. Further, revenue from real estate owned increased $11.1 million compared to the prior period due to higher occupancy, ADR, and RevPAR levels at the hotel portfolio compared to the nine months ended September 30, 2022 and revenue generated from the mixed-use property we acquired legal title to on June 30, 2023.

Expenses

Expenses are primarily comprised of base management fees payable to our Manager, incentive fees payable to our Manager, general and administrative expenses, stock-based compensation expense, operating expenses from real estate owned, interest expense from debt related to real estate owned, and depreciation and amortization on real estate owned and related in-place and other lease values. Expenses increased by $22.2 million, during the nine months ended September 30, 2023, as compared to the nine months ended September 30, 2022, primarily due to:

(i) an increase in interest expense on debt related to real estate owned of $8.2 million primarily as a result of reference rate increases over the comparative period;

(ii) an increase in stock-based compensation of $8.1 million during the comparative period, due to restricted stock units granted in June 2022 being outstanding for the full period in 2023 and additional awards granted in 2023;

(iii) an increase in operating expenses from real estate owned of $5.3 million during the comparative period, due to increased variable operating expenses in connection with higher occupancy levels at the hotel portfolio during the comparative period and expenses incurred at the mixed-use property we acquired legal title to on June 30, 2023;

(iv) an increase in incentive fees of $1.6 million as a result of core earnings over the trailing four quarters being in excess of a 7% hurdle as of March 31, 2023;

(v) partially offset by a decrease in general and administrative expenses of $0.9 million primarily as a result of a decrease in non-recurring charges incurred compared to the comparative period;

(vi) further offset by a decrease in management fees of $0.8 million as a result of lower stockholders’ equity over the comparative period due to shares repurchased in 2022.

Gain on sale of loan

During the nine months ended September 30, 2022, we realized a gain on sale of loan of $30.1 million compared to a gain on sale of loan of $0.6 million realized during the nine months ended September 30, 2023.

Proceeds from interest rate cap

Proceeds from interest rate cap were $4.4 million higher during the comparative period due to SOFR exceeding our interest rate cap's 3% strike rate during 2023.

Unrealized (loss) gain on interest rate cap

During the nine months ended September 30, 2023, we recognized a $3.3 million unrealized loss on interest rate cap, compared to a $5.6 million unrealized gain on interest rate cap during the nine months ended September 30, 2022. The fair value of the interest rate cap increases as interest rates increase, decreases as the interest rate cap approaches maturity, and further fluctuates following shifts in the forward curve.

Income from equity method investment

During the nine months ended September 30, 2023, we recognized income from equity method investment of $0.6 million compared to $0.9 million recognized during the nine months ended September 30, 2022 as a result of income earned by our investee.

Gain on extinguishment of debt

During the nine months ended September 30, 2023, we recognized a gain on extinguishment of debt of $2.2 million, inclusive of $485,000 of unamortized deferred financing costs, as a result of the retirement of $22.0 million of principal of our secured term loan for a price of $19.3 million.

Provision for current expected credit loss reserve

During the nine months ended September 30, 2023, we recorded a provision for current expected credit losses of $148.4 million, primarily attributable to a $90.7 million increase in our specific CECL reserves, partially offset by a $3.1 million reversal of general CECL reserves which was primarily attributable to seasoning of and a reduction in the size of our loan portfolio. During the nine months ended September 30, 2022, we recorded a provision for current expected credit losses of $13.0 million, primarily attributable to a principal charge off of $11.5 million and an increase in the size of our loan portfolio.

Liquidity and Capital Resources

Capitalization

We have capitalized our business to date primarily through the issuance of shares of our common stock and borrowings under our secured financings and our secured term loan. As of September 30, 2023, we had 138,728,690 shares of our common stock outstanding, representing $2.3 billion of equity and we also had $5.7 billion of outstanding borrowings under our secured financings, our secured term loan, and our debt related to real estate owned. As of September 30, 2023, our secured financings consisted of six repurchase agreements with capacity of $5.1 billion and an outstanding balance of $3.8 billion, a term participation facility with a capacity of $1.0 billion and an outstanding balance of $346.1 million, eight asset-specific financings with capacity of $674.1 million and an outstanding balance of $489.9 million, and an acquisition facility with a capacity of $150.0 million and no outstanding balance. As of September 30, 2023, our secured term loan had an outstanding balance of $727.4 million and our debt related to real estate owned had an outstanding balance of $290.0 million.

Net Debt-to-Equity Ratio and Total Leverage Ratio

Net Debt-to-Equity Ratio and Total Leverage Ratio are non-GAAP measures that we use to evaluate our financial leverage, which in the case of our Total Leverage Ratio, makes certain adjustments that we believe provide a more conservative measure of our financial condition.

Net Debt-to-Equity Ratio is calculated as the ratio of asset specific debt (repurchase agreements, term participation facility, loan participations sold, net, notes payable, net, and debt related to real estate owned, net) and secured term loan, less cash and cash equivalents to total equity.

Total Leverage Ratio is similar to Net Debt-to-Equity Ratio; however, it includes non-consolidated senior interests sold and non-consolidated senior interests held by third parties. Non-consolidated senior interests sold and non-consolidated senior interests held by third parties, as applicable, are secured by the same collateral as our loan and are structurally senior in repayment priority relative to our loan. We believe the inclusion of non-consolidated senior interests sold and non-consolidated senior interests held by third parties provides a meaningful measure of our financial leverage.

The following table presents our Net Debt-to-Equity and Total Leverage Ratios as of September 30, 2023 and December 31, 2022 ($ in thousands):

Sources of Liquidity

Our primary sources of liquidity include cash and cash equivalents, interest income from our loans, loan repayments, available borrowings under our repurchase agreements, identified borrowing capacity related to our notes payable and loan participations sold, proceeds from the issuance of incremental secured term loan or other corporate debt issuances, and proceeds from the issuance of our common stock. As circumstances warrant, we and our subsidiaries may also issue common equity, preferred equity and/or debt or incur other debt, including term loans, from time to time on an opportunistic basis, dependent upon market conditions and available pricing. The following table sets forth, as of September 30, 2023 and December 31, 2022, our sources of available liquidity ($ in thousands):

(1) Represents loan principal payments held in lockboxes or by our third-party loan servicer as of the balance sheet date which were remitted to us during the subsequent remittance cycle, net of the related secured debt balance.

We have $438.0 million unpaid principal balance of unencumbered loans and we have unencumbered real estate owned and net lease intangible assets with a carrying value of $143.6 million at September 30, 2023. Our ability to finance certain of these unencumbered loans, or our real estate owned asset is subject to one or more counterparties' willingness to finance such loans.

Liquidity Needs

In addition to our loan origination and acquisition activity, our primary liquidity needs include future fundings to our borrowers on our unfunded loan commitments, interest and principal payments on outstanding borrowings under our financings, operating expenses and dividend payments to our stockholders necessary to satisfy REIT dividend requirements. Additionally, certain financial covenants in our financing agreements require us to maintain minimum levels of liquidity. We currently maintain, and seek to maintain, cash and liquidity to comply with minimum liquidity requirements under our financings, and we also maintain and seek to maintain excess cash and liquidity to, if necessary, de-lever certain of our secured financings, including our repurchase agreements.

As of September 30, 2023, we had aggregate unfunded loan commitments of $1.3 billion which is comprised of funding for capital expenditures and construction, leasing costs, and interest and carry costs. The timing of these fundings will vary depending on the progress of capital projects, leasing, and cash flows at the properties securing our loans. Therefore, the exact timing and amounts of such future loan fundings are uncertain and will depend on the current and future performance of the underlying collateral assets. We expect to fund our loan commitments over the remaining maximum term of the related loans, which have a weighted-average future funding period of 3.2 years.

We may from time to time use capital to retire, redeem, or repurchase our equity or debt securities, term loans or other debt instruments through open market purchases, privately negotiated transactions or otherwise. The execution of such repurchases, redemptions or retirements, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and/or other factors.

Contractual Obligations and Commitments

Our contractual obligations and commitments as of September 30, 2023 were as follows ($ in thousands):

(1) The estimated allocation of our unfunded loan commitments is based on the earlier of our expected funding date and the commitment expiration date. As of September 30, 2023, we have $642.6 million of expected or in-place financings to fund our remaining commitments, excluding $124.5 million of approved and undrawn credit capacity.

(2) The allocation of our secured financings and term loan agreement is based on the earlier of the fully extended maturity date (assuming conditions to extend are met) of each individual borrowing or the maximum maturity date under the respective agreement, and assumes five loans with aggregate borrowings outstanding of $259.1 million that are in maturity default have a contractual obligation to pay in less than one year.

(3) Amounts include the related future interest payment obligations, which are estimated by assuming the amounts outstanding under our secured financing agreements and SOFR in effect as of September 30, 2023, will remain constant into the future. This is only an estimate, as actual amounts borrowed and rates will vary over time. Our floating rate loans and related liabilities are indexed to SOFR. Totals exclude non-consolidated senior interests.

We are required to pay our Manager, in cash, a base management fee and incentive fees (to the extent earned) on a quarterly basis in arrears. The tables above do not include the amounts payable to our Manager under the Management Agreement as they are not fixed and determinable.

Loans Receivable Maturities

The following table summarizes the future scheduled repayments of principal based on fully extended maturity dates for our loans receivable portfolio as of September 30, 2023 ($ in thousands):

(1) Excludes $261.8 million in principal balance and $261.8 million of commitments of loans which are currently in maturity default and do not have any extension options remaining.

Cash Flows

The following table provides a breakdown of the net change in our cash and cash equivalents and restricted cash for the nine months ended September 30, 2023 and 2022, respectively ($ in thousands):

We experienced a net decrease in cash and cash equivalents and restricted cash of $17.6 million during the nine months ended September 30, 2023, compared to a net decrease of $71.5 million during the nine months ended September 30, 2022.

During the nine months ended September 30, 2023, we made initial fundings of $101.1 million of new loans and $510.9 million of advances on existing loans and made repayments on financings arrangements of $757.1 million. We received $723.9 million of net proceeds from borrowings under our financing arrangements and received $523.3 million from loan repayments.

Income Taxes

We have elected and believe we have qualified to be taxed as a REIT for U.S. federal income tax purposes, commencing with our initial taxable year ended December 31, 2015. We generally must distribute annually at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gain, to maintain our REIT status. To the extent that we satisfy this distribution requirement, but distribute less than 100% of our REIT taxable income, we will be subject to U.S. federal income tax on our undistributed REIT taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay (or are treated as paying) out to our stockholders in a calendar year is less than a minimum amount specified under U.S. federal tax laws. Our real estate owned hotel portfolio is held in a TRS. Our TRS is not consolidated for U.S. federal income tax purposes and is taxed separately as a corporation. For financial reporting purposes, a provision or benefit for current and deferred taxes is established for the portion of earnings or expense recognized by us with respect to our TRS.

Our qualification as a REIT also depends on our ability to meet various other requirements imposed by the Internal Revenue Code, which relate to organizational structure, diversity of stock ownership and certain restrictions with regard to the nature of our assets and the sources of our income. Even if we qualify as a REIT, we may be subject to certain U.S. federal income and excise taxes and state and local taxes on our income and assets. If we fail to maintain our qualification as a REIT for any taxable year, we may be subject to material penalties as well as federal, state and local income tax on our REIT taxable income at regular corporate rates and we would not be able to qualify as a REIT for the subsequent four full taxable years. As of September 30, 2023, we were in compliance with all REIT requirements.

Refer to Note 13 to our consolidated financial statements for additional information about our income taxes.

Off-Balance Sheet Arrangements

As of September 30, 2023, we had no off-balance sheet arrangements aside from those discussed in Note 3 - Loans Portfolio, Note 4 - Equity Method Investment, and Note 14 - Commitments and Contingencies.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires our Manager to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. We believe that all of the decisions and estimates are reasonable, based upon the information available to us. We believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our financial statements.

Refer to Note 2 to our consolidated financial statements for a description of our significant accounting policies.

Current Expected Credit Losses

The CECL reserve required under ASU 2016-13 “Financial Instruments – Credit Losses – Measurement of Credit Losses on Financial Instruments (Topic 326)” (“ASU 2016-13”), reflects our current estimate of potential credit losses related to our loan portfolio.

Changes to the CECL reserve are recognized through a provision for or reversal of current expected credit loss reserve on our consolidated statements of operations. ASU 2016-13 specifies the reserve should be based on relevant information about past events, including historical loss experience, current portfolio, market conditions and reasonable and supportable macroeconomic forecasts for the duration of each loan.

For our loan portfolio, we perform a quantitative assessment of the impact of CECL using the Weighted Average Remaining Maturity, or WARM, method. The application of the WARM method to estimate a general CECL reserve requires judgment, including the appropriate historical loan loss reference data, the expected timing and amount of future loan fundings and repayments, the current credit quality of our portfolio, and our expectations of performance and market conditions over the relevant time period.

The WARM method requires us to reference historical loan loss data from a comparable data set and apply such loss rate to each of our loans over their expected remaining term, taking into consideration expected economic conditions over the forecasted timeframe. Our general CECL reserve reflects our forecast of the current and future macroeconomic conditions that may impact the performance of the commercial real estate assets securing our loans and the borrower's ultimate ability to repay. These estimates include unemployment rates, price indices for commercial properties, and market liquidity, all of which may influence the likelihood and magnitude of potential credit losses for our loans during their anticipated term. Additionally, further adjustments may be made based upon loan positions senior to ours, the risk rating of a loan, whether a loan is a construction loan, or the economic conditions specific to the property type of a loan's underlying collateral.

To estimate an annual historical loss rate, we obtained historical loss rate data for loans most comparable to our loan portfolio from a commercial mortgage-backed securities database licensed by a third party, Trepp, LLC, which contains historical loss data from January 1, 1999 through September 30, 2023.

When evaluating the current and future macroeconomic environment, we consider the aforementioned macroeconomic factors. Historical data for each metric is compared to historical commercial real estate loan losses in order to determine the relationship between the two variables. We use projections of each macroeconomic factor, obtained from a third party, to approximate the impact the macroeconomic outlook may have on our loss rate. Selections of these economic forecasts require judgement about future events that, while based on the information available to us as of the balance sheet date, are ultimately unknowable with certainty, and the actual economic conditions could vary significantly from the estimates we made. Following a reasonable and supportable forecast period, we use a straight-line method of reverting to the historical loss rate. Additionally, we assess the obligation to extend credit through our unfunded loan commitments over each loan’s contractual period, adjusted for projected fundings from interest reserves, if applicable, which is considered in the estimate of the general CECL reserve. For both the funded and unfunded portions of our loans, we consider our internal risk rating of each loan as the primary credit quality indicator underlying our assessment.

In certain circumstances we may determine that a loan is no longer suited for the WARM method due to its unique risk characteristics or where we have deemed the borrower/sponsor to be experiencing financial difficulty and the repayment of the loan’s principal is collateral-dependent. We may instead elect to employ different methods to estimate loan losses that also conform to ASU 2016-13 and related guidance.

For such loan we would separately measure the specific reserve for each loan by using the fair value of the loan's collateral. If the fair value of the loan's collateral is less than the carrying value of the loan, an asset-specific reserve is created as a component of our overall current expected credit loss reserve. Specific reserves are equal to the excess of a loan’s carrying value to the fair value of the collateral, less estimated costs to sell, if recovery of our investment is expected from the sale of the collateral.

If we have determined that a loan or a portion of a loan is uncollectible, we will write-off such portion of the loan through an adjustment to our current expected credit loss reserve. Significant judgment is required in determining impairment and in estimating the resulting credit loss reserve, and actual losses, if any, could materially differ from those estimates.

Real estate owned, net

We may assume legal title or physical possession of the underlying collateral property of a defaulted loan through foreclosure, a deed-in-lieu of foreclosure, or an assignment-in-lieu of foreclosure. If we intend to hold, operate or develop the property for a period of at least 12 months, the asset is classified as real estate owned, net. If we intend to market the property for sale in the near subsequent term, the asset is classified as real estate held for sale. Real estate owned is initially recorded at estimated fair value and is subsequently presented net of accumulated depreciation. Depreciation is computed using a straight-line method over estimated useful lives ranging from 5 to 40 years and is recognized in depreciation and amortization expense on our consolidated statement of operations.

We account for acquisitions of real estate, including foreclosures, deed-in-lieu of foreclosures, or assignment-in-lieu of foreclosures, in accordance with ASC 805, Business Combinations, which first requires that we determine if the real estate investment is the acquisition of an asset or a business combination. Under this model, we identify and determine the fair value of any assets acquired and liabilities assumed. This generally results in the allocation of the purchase price to the assets acquired and liabilities assumed based on the relative fair values of each respective asset and liability. Debt related to real estate owned is non-recourse to us and is initially recorded at its estimated fair value at the time of foreclosure, deed-in-lieu of foreclosure, or assignment-in-lieu of foreclosure.

Assets acquired and liabilities assumed generally may include land, building, building improvements, tenant improvements, furniture, fixtures and equipment, mortgages payable, and identified intangible assets and liabilities, which generally consists of above or below market lease values, in-place lease values, and other lease-related values. In estimating fair values for allocating the purchase price of our real estate owned, we may utilize various methods, including a market approach, which considers recent sales of similar properties, adjusted for differences in location and state of the physical asset, or a replacement cost approach, which considers the composition of physical assets acquired, adjusted based on industry standard information and the remaining useful life of the acquired property. In estimating fair values of intangible assets acquired or liabilities assumed, we consider the estimated cost of leasing our real estate owned assuming the property was vacant, the value of the current lease agreements relative to market-rate leases, and the estimation of total lease-up time including lost rents. In-place, above market, and other lease values, net are included within other assets on our consolidated balance sheets. Below market lease values, net, are included within other liabilities on our consolidated balance sheets. Amortization of in-place and other lease values is recognized in depreciation and amortization expense on our consolidated statement of operations. Amortization of above and below market lease values is recognized in revenue from real estate owned on our consolidated statement of operations.

Real estate assets are evaluated for indicators of impairment on a quarterly basis. Factors that we may consider in our impairment analysis include, among others: (1) significant underperformance relative to historical or anticipated operating results; (2) significant negative industry or economic trends; (3) costs necessary to extend the life or improve the real estate asset; (4) significant increase in competition; and (5) ability to hold and dispose of the real estate asset in the ordinary course of business. A real estate asset is considered impaired when the sum of estimated future undiscounted cash flows expected to be generated by the real estate asset over the estimated remaining holding period is less than the carrying amount of such real estate asset. Cash flows include operating cash flows and anticipated capital proceeds generated by the real estate asset. If the sum of such estimated undiscounted cash flows is less than the carrying amount of the real estate asset, an impairment charge is recorded equal to the excess of the carrying value of the real estate asset over the fair value.

When determining the fair value of a real estate asset, we make certain assumptions including, but not limited to, consideration of projected operating cash flows, comparable selling prices and projected cash flows from the eventual disposition of the real estate asset based upon our estimate of a capitalization rate and discount rate.

Interest Rate Risk

In early 2022, the Federal Reserve began a campaign to combat inflation by increasing interest rates. By the end of 2022, the Federal Reserve had raised interest rates by a total of 4.25%. During the nine months ended September 30, 2023, the Federal Reserve raised rates another 1.00% and signaled the potential for further increases in coming quarters to the extent necessary to tame inflation. Higher interest rates imposed by the Federal Reserve may continue to increase our interest expense, negatively impact the ability of our borrowers to service their debt, and reduce the value of the CRE collateral underlying our loans.

Rising interest rates will generally increase our net interest income, while declining interest rates will generally decrease our net interest income.

The following table illustrates as of September 30, 2023 the impact on our interest income and interest expense for the twelve-month period following September 30, 2023 assuming a decrease in SOFR of 50 and 100 basis points and an increase in SOFR of 50 and 100 basis points in the applicable interest rate benchmark (based on SOFR of 5.32% as of September 30, 2023) ($ in thousands):

Risks related to fluctuations in cash flows and asset values associated with movements in interest rates may also contribute to the risk of nonperformance on floating rate assets. In the case of a significant increase in interest rates, the cash flows of the collateral real estate assets to our loans may be insufficient to pay debt service due, which may contribute to nonperformance of, or in severe cases default on, our loans. We seek to manage this risk by, among other things, generally requiring our borrowers to acquire interest rate caps from an unaffiliated third-party.

Credit Risk

Our loans and other investments are also subject to credit risk, including the risk of default. In particular, changes in general economic conditions, including interest rates, will affect the creditworthiness of borrowers and/or the value of underlying real estate collateral relating to our investments. By its very nature, our investment strategy emphasizes prudent risk management and capital preservation by primarily originating senior loans utilizing underwriting techniques requiring relatively conservative loan-to-value ratio levels to insulate us from loan losses absent a significant diminution in collateral value. In addition, we seek to manage credit risk by performing extensive due diligence on our collateral, borrower and guarantors, as applicable, evaluating, among other things, title, environmental and physical condition of collateral, comparable sales and leasing analysis of similar collateral, the quality of and alternative uses for the real estate collateral being underwritten, submarket trends, our borrower’s track record and the reasonableness of the borrower’s projections prior to originating a loan. Subsequent to origination, we also manage credit risk by proactively monitoring our investments and, whenever possible, limiting our own leverage to partial recourse or non-recourse, match-funding financing. Notwithstanding these efforts, there can be no assurance that we will be able to avoid losses in all circumstances. The performance and value of our loans and investments depend upon the borrower’s ability to improve and operate the properties that serve as our collateral so that they produce cash flows adequate to pay interest and principal due to us. To monitor this risk, our Sponsor’s asset management team monitors the performance of our loan portfolio and our Sponsor’s asset management and origination teams maintain regular contact with borrowers, co-lenders and local market experts to monitor the performance of the underlying loan collateral, anticipate borrower, property and market issues and, to the extent necessary or appropriate, enforce our rights as the lender.

In addition, we are exposed to the risks generally associated with the CRE market, including variances in occupancy rates, capitalization rates, absorption rates and other macroeconomic factors (including interest rates) beyond our control. We seek to manage these risks through our underwriting, loan structuring, financing structuring, and asset management processes.

In the event that we are forced to foreclose, our broader Sponsor platform includes professionals experienced in CRE development, ownership, property management, and asset management which enables us to execute the workout of a troubled loan and protect investors’ capital in a way that we believe many non-traditional lenders cannot.

Capital Markets Risks

We are exposed to risks related to the equity and debt capital markets which impact our related ability to raise capital through the issuance of our common stock or other debt or equity-related instruments. As a REIT, we are required to distribute a significant portion of our REIT taxable income annually, which constrains our ability to retain and accumulate operating earnings and therefore requires us to utilize debt or equity capital to finance the growth of our business. We seek to mitigate these risks by constantly monitoring the debt and equity capital markets, the maturity profile of our in-place loan portfolio and financings, and future funding requirements on our loan portfolio to inform our decisions on the amount, timing, and terms of any capital we may raise.

Each of our repurchase agreements contain “margin maintenance” provisions, which allow the lender to require the delivery of cash or other assets to reduce the financing amount against loans that have been deemed to have experienced a diminution in value. A substantial deterioration in the commercial real estate capital markets may negatively impact the value of assets financed with lenders that have margin maintenance provisions in their facilities. Certain of our repurchase agreements permit valuation adjustments solely as a result of collateral-specific credit events, while other repurchase agreements contain provisions also allowing our lenders to make margin calls upon the occurrence of adverse changes in the capital markets or as a result of interest rate or spread fluctuations, subject to minimum thresholds, among other factors. As of September 30, 2023, we have not received any margin calls under any of our repurchase agreements.

During 2023, there was significant volatility in the banking sector resulting from several bank failures. While we neither maintained nor maintain any accounts at these failed banks, substantially all of our cash and cash equivalents currently on deposit with major financial institutions exceed insured limits. Such deposits are redeemable upon demand and are maintained with financial institutions with strong credit profiles and we therefore believe bear minimal risk. Further, we do not and have not had any financing relationships with any of the banks that have recently failed, and thus none of our future fundings are subject to the risk that one of the failed banks will not fund.

Prepayment Risk

Prepayment risk is the risk that principal will be repaid prior to initial maturity, which may require us to identify new investment opportunities to deploy such capital at a similar rate of return in order to avoid an overall reduction in our net interest income. We may structure our loans with spread maintenance, minimum multiples and make-whole provisions to protect against early repayment. Typically, investments are structured with the equivalent of 12 to 24 months’ spread maintenance or a minimum level of income that an investment is contractually obligated to return. In general, an increase in prepayment rates accelerates the accretion of deferred income, including origination fees and exit fees, which increases interest income earned on the asset during the period of repayment. Conversely, if capital that is repaid is not subsequently redeployed into investment opportunities generating a similar return, future periods may experience reduced net interest income.

Repayment / Extension Risk

Loans are expected to be repaid at maturity, unless the borrower repays early or meets contractual conditions to qualify for a maturity extension. However, in the case of a loan maturity extension, we are often entitled to extension fees, principal paydowns and/or spread increases. Our Manager computes the projected weighted average life of our assets based on the initial and fully extended scheduled maturity dates of loans in our portfolio. Higher interest rates imposed by the Federal Reserve may lead to an increase in the number of our borrowers who exercise or request additional extension options. The granting of these extensions may cause a loan’s term to extend beyond the term of its related secured financing. Higher interest rates may also increase the number of our borrowers who may default because, among other things, they may not be able to find replacement financing for our loan. This could have a negative impact on our results of operations, and in some situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses.

Counterparty Risk

The nature of our business requires us to hold cash and cash equivalents with various financial institutions, as well as obtain financing from various financial institutions. This exposes us to the risk that these financial institutions may not fulfill their obligations to us under various contractual arrangements. We mitigate this exposure by depositing our cash and cash equivalents and entering into financing agreements with high credit-quality institutions.

Our relationships with our lenders subject us to counterparty risks including the risk that a counterparty is unable to fund undrawn credit capacity, particularly if such counterparty enters bankruptcy. We seek to manage this risk by diversifying our financing sources across counterparties and financing types and generally obtaining financing from high credit quality institutions.

The nature of our loans and other investments also exposes us to the risk that our borrowers are unable to execute their business plans, and as a result do not make required interest and principal payments on scheduled due dates, as well as the impact of our borrowers’ tenants not making scheduled rent payments when contractually due. We seek to manage this risk through a comprehensive credit analysis prior to making an investment and rigorous monitoring of our borrowers’ progress in executing their business plans as well as market conditions that may affect the underlying collateral, through our asset management process. Each loan is structured with various lender protections that are designed to prevent fraudulent behavior and other bad acts by borrowers, as well as require borrowers to adhere to their stated business plans while the loan is outstanding. Such protections may include, without limitation: cash management accounts, “bad boy” carveout guarantees, completion guarantees, guarantor minimum net worth and liquidity requirements, approval rights over major decisions, and performance tests throughout the loan term.

Currency Risk

To date, we have made no loans and hold no assets or liabilities denominated or payable in foreign currencies, although we may do so in the future.

We may in the future hold assets denominated or payable in foreign currencies, which would expose us to foreign currency risk. As a result, a change in foreign currency exchange rates may have a positive or an adverse impact on the valuation of our assets, as well as our income and dividends. Any such changes in foreign currency exchange rates may impact the measurement of such assets or income for the purposes of our REIT tests and may affect the amounts available for payment of dividends to our stockholders.

Although not required, if applicable, we may hedge any currency exposures. However, such currency hedging strategies may not eliminate all of our currency risk due to, among other things, uncertainties in the timing and/or amount of payments received on the related investments and/or unequal, inaccurate or unavailability of hedges to perfectly offset changes in future exchange rates. Additionally, we may be required under certain circumstances to collateralize our currency hedges for the benefit of the hedge counterparty, which could adversely affect our liquidity.

Real Estate Risk

The market values of loans secured directly or indirectly by CRE assets are subject to volatility and may be adversely affected by a number of factors, including, but not limited to, the interest rate environment; persistent inflation; increases in remote work trends; COVID-19 pandemic; national, regional, local and foreign economic conditions (which may be adversely affected by industry slowdowns and other factors); changes in social conditions; regional or local real estate conditions; geopolitical volatility, changes or continued weakness in specific industry segments; construction quality, age and design; demographic factors; changes to building or similar codes and regulatory requirements (such as rent control); and changes in real property tax rates. In addition, decreases in property values reduce the value of the loan collateral and the potential proceeds available to a borrower to repay the underlying loans, which could also cause us to suffer losses. We seek to manage these risks through our underwriting, loan structuring, financing structuring and asset management processes.

Financing Risk

We finance our business through a variety of means, including the syndication of non-consolidated senior interests, notes payable, borrowings under our repurchase and participation facilities, the syndication of pari passu portions of our loans, the syndication of senior participations in our originated senior loans, and our secured term loan. Over time, as market conditions change, we may use other forms of financing in addition to these methods of financing. Weakness or volatility in the debt capital markets, the CRE and mortgage markets, changes in regulatory requirements, and the economy generally, in particular as a result of the COVID-19 pandemic, geopolitical volatility, and recent rapid increase in interest rates and the resulting market disruptions therefrom could adversely affect one or more of our lenders or potential lenders and could cause one or more of our lenders or potential lenders to be unwilling or unable to provide us with financing or to increase the costs of that financing or otherwise offer unattractive terms for that financing. In addition, we may seek to finance our business through the issuance of our common stock or other equity or equity-related instruments, though there is no assurance that such financing will be available on a timely basis with attractive terms, or at all.

Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to provide reasonable assurance that information required to be disclosed in our reports filed or submitted with the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act of 1934) during the three months ended September 30, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

As of September 30, 2023, an evaluation was performed under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) under the Securities Exchange Act of 1934). Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of September 30, 2023.

For a discussion of our potential risks and uncertainties, see the information under the heading “Risk Factors” in the Prospectus. There have been no material changes to our principal risks that we believe are material to our business, results of operations, and financial condition from the risk factors disclosed in our Annual Report file on Form 10-K, which is accessible on the SEC’s website at www.sec.gov (http://www.sec.gov).