Our primary business is to provide asset management and certain corporate governance services to Residential under our asset management agreement with Residential. On
December 21, 2012, which we refer to as the "separation date," we and Residential separated from Altisource and became independent publicly traded companies. Altisource contributed $100 millionof equity capital to Residential and $5 millionof equity capital to us and distributed Residential's and our shares of common stock to the shareholders of Altisource. In October 2013, we applied for and were granted registration by the SECas a registered investment adviser under section 203(c) of the Investment Advisers Act of 1940. We have a capital light operating strategy and will consider using any future profits for share repurchases, although we have no current plans to repurchase shares. Residential is currently our primary source of revenue and will drive our potential future growth. The asset management agreement with Residential entitles us to "incentive management fees," that give us a share of Residential's cash flow available for distribution to its stockholders as Residential grows, as well as reimbursement for certain overhead and operating expenses. Accordingly, our operating results are highly dependent on Residential's ability to achieve positive operating results. We have concluded that Residential is a variable interest entity because Residential's equity holders lack the ability through voting rights to make decisions about Residential's activities that have a significant effect on the success of Residential. We have also concluded that we are the primary beneficiary of Residential's financial condition and results of operations because under the Residential asset management agreement we have the power to direct the activities of Residential that most significantly impact Residential's economic performance including establishing Residential's investment and business strategy. As a result, we consolidate Residential's financial results in our consolidated financial statements. Additionally, we provide management services to NewSource. On December 2, 2013, NewSource became registered as a licensed reinsurer with the BMA. Because we own 100% of voting common stock of NewSource and there are no substantive kick-out rights granted to other equity owners, we consolidate NewSource in our consolidated financial statements. In its first year of operations, we advised Residential and conducted portfolio analysis and the bidding process to facilitate the acquisition and growth of Residential's portfolio of residential mortgage loans as follows: In 2013, Residential acquired portfolios consisting of an aggregate of 8,531 residential mortgage loans, substantially all of which were non-performing, having an aggregate UPB of approximately $2.22 billionand an aggregate market value of underlying properties of $1.80 billionas of the respective cut-off dates for the transactions. The aggregate purchase price for these portfolios was $1.22 billion. 40
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loans with approximately
in aggregate market value of underlying properties pursuant to an agreement that it executed on
December 31, 2013; • On January 28, 2014, Residential consummated the first closing of an acquisition of mortgage loans from HUD, consisting of 66 mortgage loans with $7 millionof UPB and $7 millionin aggregate market value of underlying properties. This represented the first settlement of Residential's agreement with HUD to purchase 164 mortgage loans with approximately $19 millionof UPB and approximately $18 millionin
aggregate market value of underlying properties. We expect Residential to
close the remaining portion of this portfolio in the first quarter of
2014. There can be no assurance that Residential will acquire the
remainder of the HUD portfolio in whole or in part on a timely basis or at
all; • On
January 31, 2014, Residential acquired an additional 3,421 mortgage
loans with approximately
million in aggregate market value of underlying properties. This
acquisition represented the second closing of an agreement with Bank of
America, National Association and its affiliated entities in November
To date, Residential has acquired its non-performing loan portfolios through direct acquisitions from institutions such as banks, HUD and private equity funds.
We believe that Residential qualifies to be taxed as a REIT. We believe that Residential will not be subject to federal income tax on that portion of its income that is distributed to shareholders as long as Residential meets certain asset, income and share ownership tests. If Residential fails to qualify as a REIT, and does not qualify for certain statutory relief provisions, its profits will be subject to income taxes and it may be precluded from qualifying as a REIT for the four tax years following the year it loses its REIT qualification. A portion of Residential's activities are conducted in a TRS, which is subject to corporate federal and state income taxes. Accordingly, Residential has made a provision for income taxes with respect to the operations of its TRS. Our goal is to manage Residential's business to take full advantage of the tax benefits afforded to it as a REIT.
Observations on Current Market Opportunities
We believe there is currently a significant market opportunity to acquire single-family rental properties through the distressed loan channel and expect the supply of non-performing loans, sub-performing loans (defined as loans that are more than 60 days delinquent), properties in foreclosure and REO to increase over the next several years as banks and other mortgage lenders seek to dispose of these distressed inventories which they accumulated during the recent economic crisis. We continue to see substantial volumes of distressed residential mortgage loan sales offered for sale by banks, HUD and private equity funds, among others. We believe Residential is well-positioned to be selected as the buyer of diverse portfolios of such loans since it is not geographically constrained. We believe that this distressed loan channel gives Residential a cost advantage over other acquisition channels such as foreclosure auctions and REO acquisitions because:
• we believe there are fewer participants in the sub-performing and
non-performing loan marketplace than in the foreclosure auction and other
REO acquisition channels due to the large size of portfolios offered for
sale on an "all or none" basis and the required operational infrastructure
involved in servicing loans and managing single-family rental properties
across various states. We believe the relatively lower level of
competition for sub-performing and non-performing loans, combined with
growing supply, provides buyers with the opportunity for a higher discount
rate relative to the foreclosure auction and other REO acquisition
channels and therefore a relatively lower cost to ultimately acquire
single-family rental properties. • we believe that Residential will be able to purchase residential mortgage
loans at a lower price than REO properties because sellers of such loans will be able to avoid paying the costs typically associated with home
sales, such as broker commissions and closing costs of up to 10% of gross
proceeds of the sale. We believe this will motivate the sellers to accept
a lower price for the sub-performing and non-performing loans than they would if selling REO. Use of the distressed loan channel gives Residential multiple resolution methodologies to unlock asset value. Residential's preferred resolution methodology is to modify the sub-performing and non-performing loans. We believe modification followed by refinancing generates near-term cash flows, provides the highest possible economic outcome for Residential and is a socially responsible business strategy because it keeps more families in their homes. We expect a majority of Residential's acquired mortgage loans that are converted to REO to become single-family rental properties that we believe will generate long-term returns for Residential's stockholders. If a REO property meets Residential's rental profile, it determines the extent of renovations that are needed to generate an optimal rent and maintain consistency of renovation specifications for future branding. If we determine that the REO property will not meet Residential's rental profile, Residential lists the property for sale, in many instances after renovations are made to optimize the sale proceeds. 41
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Metrics Affecting Our Consolidated Results
As described above, our operating results depend heavily on Residential's operating results. Residential's results are affected by various factors, some of which are beyond our control, including the following:
Residential's revenues initially primarily consist of the following:
i. Net unrealized gains from the conversion of loans to REO. Upon conversion
of loans to REO, Residential marks the properties to the most recent
market value (less estimated selling costs in the case of REO held for
sale). The difference between the carrying value of asset at the time of
conversion and most recent market value, based on broker price opinions,
is recorded in Residential's statement of operations as net unrealized
gains. We expect the timeline to convert acquired loans into REO will vary
significantly by loan, which could result in fluctuations in Residential's
revenue recognition and operating performance from period to period. The
factors that may affect the timelines to foreclose upon a residential
mortgage loan include, without limitation, state foreclosure timelines and
deferrals associated therewith; unauthorized parties occupying in the
property; federal, state or local legislative action or initiatives
designed to provide homeowners with assistance in avoiding residential
mortgage loan foreclosures and continued declines in real estate values
and/or sustained high levels of unemployment that increase the number of
foreclosures and which place additional pressure and/or delays on the already overburdened judicial and administrative proceedings.
ii. Net unrealized gains from the change in fair value of loans. On a monthly
basis we adjust Residential's loans to fair value by evaluating the fair
value of the underlying property, the expected timeline and probabilities
of loan resolution and expected market yield. We employ various loan resolution methodologies with respect to Residential's residential mortgage loans including loan modification, collateral resolution and collateral disposition. The manner in which a sub-performing or non-performing loan is resolved will impact the amount and timing these
net unrealized gains. We expect the timelines for each of the different
processes to vary significantly, and final resolution could take up to 24 months or longer from the loan acquisition date. The exact nature of resolution will be dependent on a number of factors that are beyond our
control, including borrower willingness, property value, availability of
refinancing, interest rates, conditions in the financial markets, the regulatory environment and other factors.
iii. Net realized gain on mortgage loans. Residential records net realized
gains, including the reclassification of previously accumulated net unrealized gains, upon the liquidation of a loan which may consist of
short sale, third party sale of the underlying property, refinancing or
full debt pay-off of the loan. We expect the timeline to liquidate loans
will vary significantly by loan, which could result in fluctuations in
revenue recognition and operating performance from period to period.
Additionally, the proceeds from loan liquidations may vary significantly
depending on the resolution methodology. Residential generally expects to
collect proceeds of loan liquidations in cash and, thereafter, have no
continuing involvement with the asset.
As a greater number of Residential's REO are renovated and deemed suitable for rental, we expect a greater portion of its revenues will be residential rental revenues. We believe the key variables that will affect Residential's rental revenues over the long term will be average occupancy and rental rates. We anticipate that a majority of Residential's leases of single-family rental properties to tenants will be for a term of two years or less. As these leases permit the residents to leave at the end of the lease term without penalty, we anticipate Residential's rental revenues will be affected by declines in market rents more quickly than if its leases were for longer terms. Short-term leases may result in high turnover, which involves expenses such as renovation costs and marketing costs, or reduced rental revenues. Although we generally seek to lease the REO Residential acquires on foreclosure, we may determine to sell the properties that do not meet Residential's investment criteria. The real estate market and home prices will determine proceeds from any sale of real estate. In addition, while we seek to track real estate price trends and estimate the effects of those trends on the valuations of Residential's portfolios of residential mortgage loans, future real estate values are subject to influences beyond our control. 42
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Residential's expenses primarily consist of loan servicing fees and advances, rental property operating expenses, depreciation and amortization, general and administrative expenses, expense reimbursement, incentive management fees and interest expense. From time to time, expenses also may include impairments of assets. Loan servicing fees and advances are expenses paid to Ocwen to service Residential's acquired loans and for real estate insurance and other corporate advances. Rental property operating expenses are expenses associated with Residential's ownership and operation of rental properties including expenses such as Altisource's inspection, property preservation and renovation fees, property management fees, turnover costs, property taxes, insurance and HOA dues. Depreciation and amortization is a non-cash expense associated with the ownership of real estate and generally remains relatively consistent each year in relation to Residential's asset levels since it depreciate its properties on a straight-line basis over a fixed life. Interest expense consists of the costs to borrow money in connection with Residential's debt financing of our portfolios. General and administrative expenses consist of the costs related to the general operation and overall administration of our business. Expense reimbursement consists primarily of our employee salaries in direct correlation to the services they provide on Residential's behalf and other personnel costs and corporate overhead. We are not reimbursed by Residential for certain general and administrative expenses pertaining to stock-based compensation and our expenditures that are not for the benefit of Residential. The incentive management fees consist of compensation due to us, based on the amount of cash available for distribution to Residential's stockholders for each period. The expense reimbursement and incentive management fee are eliminated in consolidation but increase our net income by reducing the amount of net income attributable to noncontrolling interest.
Other factors affecting our consolidated results
We expect Residential's results of operations to be affected by various additional factors, many of which are beyond our control, including the following:
Residential's operating results will depend on our ability to source sub-performing and non-performing loans. We believe that there is currently a large supply of sub-performing and nonperforming loans available to Residential for acquisition. We believe the available supply provides for a steady acquisition pipeline of assets since we plan on targeting just a small percentage of the population. Generally, we expect that Residential's mortgage loan portfolio may grow at an uneven pace, as opportunities to acquire distressed residential mortgage loans may be irregularly timed and may involve large portfolios of loans, and the timing and extent of our success in acquiring such loans cannot be predicted.
Our ability to grow Residential's business by acquiring sub-performing and non-performing loans is dependent on the availability of adequate financing including additional equity financing, debt financing or both in order to meet Residential's objectives. We intend to leverage Residential's investments with debt, the level of which may vary based upon the particular characteristics of its portfolio and on market conditions. To the extent available at the relevant time, Residential's financing sources may include bank credit facilities, warehouse lines of credit, structured financing arrangements and repurchase agreements, among others. We may also seek to raise additional capital for Residential through public or private offerings of debt or equity securities, depending upon market conditions. To qualify as a REIT under the Code, Residential generally will need to distribute at least 90% of its taxable income each year (subject to certain adjustments) to its stockholders. This distribution requirement limits its ability to retain earnings and thereby replenish or increase capital to support its activities. Residential's taxable income is triggered primarily by material charges in the economic status of loans, such as a sale of the loan, modification of the loan from a non-performing status to a performing status or conversion of the loan to REO. We expect Residential to convert its taxable gains on REO dispositions and loan modifications within a short period to cash gains. The taxable gains on Residential's remaining loans that it expects to convert to rental properties can be funded through a higher advance rate on the increased value when a property becomes rented. 43
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Resolution Activities in 2013
The following table sets forth Residential's resolution activity by asset count for each period during 2013: 2013 First quarter Second quarter Third quarter Fourth quarter Total Mortgage Loans Beginning balance - 673 1,332 5,020 - Acquisitions 684 720 3,783 3,304 8,491 Dispositions (10 ) (28 ) (54 ) (119 ) (211 ) Conversions to REO (1 ) (33 ) (43 ) (151 ) (228 ) Reversions to mortgage loans (1) - - 2 - 2 Ending balance 673 1,332 5,020 8,054 8,054 Modifications - 18 29 54 101 Real Estate Owned Beginning balance - 7 40 114 - Acquisitions 6 - 34 - 40 Dispositions - - (1 ) (3 ) (4 ) Conversions to REO 1 33 43 151 228 Reversions to mortgage loans (1) - - (2 ) - (2 ) Ending balance 7 40 114 262 262 Leased - 1 5 14 14 Renovations complete - - 6 11 11 Renovations in process - 5 3 18 18 Evaluating strategy / held for sale 7 34 100 219 219 7 40 114 262 262
(1) Subsequent to the foreclosure sale, we may be notified that the foreclosure
sale was invalidated for certain reasons including bankruptcy.
The size of Residential's investment portfolio will also be a key revenue driver. Generally, as the size of Residential's investment portfolio grows, the amount of revenue it expects to generate will increase. A growing investment portfolio, however, will drive increased expenses including possibly higher servicing fees to Ocwen and property management fees to Altisource. Residential may also incur additional interest expense if it incurs debt to finance the purchase of its assets.
Summary Management Reporting Information
In addition to evaluating our consolidated financial performance, we also evaluate the operations of AAMC on a stand-alone basis because our financial statements consolidate the results of Residential under U.S. GAAP. We also look at our stand-alone results because the effect of amounts received from Residential are still recognized in net income attributable to our stockholders through the adjustment for net income attributable to noncontrolling interest in Residential. In evaluating our operating performance and managing our business, we consider the incentive management fees and reimbursement of expenses paid to us by Residential under our asset management agreement as well as our stand-alone operating expenses. We maintain our internal management reporting on this basis. The following table presents our consolidating balance sheet and statement of operations which are reconciled to U.S. GAAP. 44
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The following tables include non-GAAP performance measures that we believe are useful to assist investors in gaining an understanding of the trends and operating results for our business. This information should be considered in addition to, and not as a substitute for our financial results determined in accordance with U.S. GAAP. 45
Table of Contents Altisource Asset Management Corporation Consolidating Statement of Operations Year ended December 31, 2013 ($ thousands) NewSource AAMC AAMC Residential stand-alone stand-alone Consolidating consolidated (GAAP) (non-GAAP) (non-GAAP) entries (GAAP) Revenues and net gain on investments: Rental revenues $ 36 $ - $ - $ - $ 36 Net unrealized gain on mortgage loans 61,092 - - - 61,092 Net realized gain on mortgage loans 10,482 - - - 10,482 Incentive management fee - - 4,880 (4,880 ) - Expense reimbursements - - 5,411 (5,411 ) - Total revenues 71,610 - 10,291 (10,291 ) 71,610 Expenses: Residential rental property operating expenses (Note 8) 767 - - - 767 Real estate depreciation and amortization 25 - - - 25 Mortgage loan servicing costs 10,418 - - - 10,418 Interest expense 4,568 - - - 4,568 General and administrative 4,392 77 13,980 - 18,449 Related party general and administrative 12,531 - 1,527 (10,291 ) 3,767 Total expenses 32,701 77 15,507 (10,291 ) 37,994 Other income 687 - - - 687 Net income (loss) 39,596 (77 ) (5,216 ) - 34,303 Net income attributable to noncontrolling interest in consolidated affiliate - - - (39,596 ) (39,596 ) Net income (loss) attributable to common stockholders
$ 39,596$ (77 ) $ (5,216 ) $ (39,596 ) $ (5,293 )46
Table of Contents Altisource Asset Management Corporation Consolidating Statement of Operations March 15, 2012 (inception) to December 31, 2012 ($ in thousands) AAMC AAMC Residential stand-alone Consolidating consolidated (GAAP) (non-GAAP) entries (GAAP) Revenues: Expense reimbursements $ - $ 42 $ (42 ) $ - Total revenues - 42 (42 ) - Expenses: General and administrative 47 88 - 135 Related party general and administrative 42 - (42 ) - Total expenses 89 88 (42 ) 135 Net loss (89 ) (46 ) - (135 ) Net loss attributable to noncontrolling interest in consolidated affiliate - - 89 89 Net loss attributable to common stockholders $ (89 ) $ (46 ) $ 89 $ (46 ) 47
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Altisource Asset Management Corporation Consolidating Balance Sheet December 31, 2013 ($ thousands) NewSource AAMC AAMC Residential stand-alone stand-alone Consolidating consolidated (GAAP) (non-GAAP) (non-GAAP) entries (GAAP) Assets: Real estate assets, net: Land
$ 478$ - $ - $ - $ 478 Rental residential properties, net 3,092 - - - 3,092 Real estate owned 32,332 - - - 32,332 35,902 - - - 35,902 Real estate assets held for sale 1,186 - - - 1,186 Mortgage loans 1,207,163 - - - 1,207,163 Cash and cash equivalents 115,988 19,923 4,089 - 140,000 Restricted cash 5,878 - - - 5,878 Accounts receivable 1,428 - - - 1,428 Related party receivables 9,260 - 4,486 (4,486 ) 9,260 Investment in affiliate 18,000 - 2,000 (20,000 ) - Deferred leasing and financing costs, net 2,293 - - - 2,293 Prepaid expenses and other assets 1,542 - 452 - 1,994 Total assets 1,398,640 19,923 11,027 (24,486 ) 1,405,104 Liabilities: Repurchase agreement 602,382 - - - 602,382 Accounts payable and accrued liabilities 4,952 - 1,920 - 6,872 Related party payables 5,879 - 1,490 (4,486 ) 2,883 Total liabilities 613,213 - 3,410 (4,486 ) 612,137 Commitments and contingencies Equity: Common stock 423 - 24 (423 ) 24 Additional paid-in capital 758,584 20,000 12,855 (778,584 ) 12,855 Retained earnings (accumulated deficit) 26,420 (77 ) (5,262 ) (26,420 ) (5,339 ) Total stockholders' equity 785,427 19,923 7,617 (805,427 ) 7,540 Noncontrolling interest in consolidated affiliate - - - 785,427 785,427 Total equity 785,427 19,923 7,617 (20,000 ) 792,967
Total liabilities and equity
$ (24,486 ) $ 1,405,10448
Table of Contents Altisource Asset Management Corporation Consolidating Balance Sheet December 31, 2012 ($ in thousands) AAMC AAMC Residential stand-alone Consolidating consolidated (GAAP) (non-GAAP) entries (GAAP)
Assets: Cash and cash equivalents
$ 100,005 $ 5,009$ - $ 105,014Related party receivables - 410 (49 ) 361 Prepaid expenses and other assets 6 434 - 440 Total assets 100,011 5,853 (49 ) 105,815 Liabilities: Accounts payable and accrued liabilities 46 360 - 406 Related party payables 54 523 (49 ) 528 Total liabilities 100 883 (49 ) 934 Commitments and contingencies Equity: Common stock 78 23 (78 ) 23 Additional paid-in capital 99,922 4,993 (99,922 ) 4,993 Deficit accumulated during the development stage (89 ) (46 ) 89 (46 ) Total stockholders' equity 99,911 4,970 (99,911 ) 4,970 Noncontrolling interest in consolidated affiliate - - 99,911 99,911 Total equity 99,911 4,970 - 104,881 Total liabilities and equity $ 100,011 $ 5,853$ (49 ) $ 105,815
Primary driver of our stand-alone operating results
As described above under "-Metrics affecting our consolidated results" and "-Other factors affecting our consolidated results," our incentive management fees will be directly linked to the results of Residential which we expect will be affected by various factors including, but not limited to, the number and performance of Residential's mortgage loan acquisitions, its ability to use financing to grow its business, its ability to convert mortgage loans into residential rental properties, its operating expenses, the success of its loan resolution methodologies and the size of its portfolio. The extent to which we are successful in managing these factors for Residential will affect our ability to generate incentive management fees, which currently is our sole source of income other than the reimbursement of our expenses pursuant to the Residential asset management agreement and potential asset management fees that we generate under our asset management agreement with New Source. In the event Residential generates taxable income, our incentive management fees will provide us with an increasing share of Residential's cash available for distribution to its stockholders. If there is a decline in the cash distributable by Residential to its stockholders in any period, or if Residential is unable to make distributions to its stockholders in any period, the amount of our incentive management fees would be adversely affected.
The majority of our expenses are reimbursable by our clients, except for our share-based compensation charges. Our share-based compensation charges are non-cash expenses and are included in our general and administrative expenses.
Results of operations
The following sets forth a discussion of our results of operations for the year ended
December 31, 2013. We had no substantial revenues or expenses for the period from March 15, 2012(inception) to December 31, 2012. Accordingly, we have not presented comparative results for the period from Inception to December 31, 2013. Because the results of Residential are consolidated into our financial statements, the results of operations disclosures set forth below include the results of Residential. We eliminate all intercompany amounts in our consolidated financial statements, including the expense reimbursement and incentive management fees, if any, paid or owed to us by Residential. However, the effect of such amounts received from Residential is still recognized in net income attributable to our stockholders through the adjustment for earnings attributable to noncontrolling interest. 49
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December 31, 2013Residential rental revenues Residential generated a nominal amount of residential rental revenues for the year ended December 31, 2013, as it has rented 14 properties through December 31, 2013. We expect Residential to generate increasing residential rental revenues upon renovating, listing and renting additional residential rental properties. Residential's rental revenues will be dependent primarily on occupancy levels and rental rates for our residential properties. Because Residential's lease terms generally are expected to be one to two years, its occupancy levels and rental rates will be highly dependent on local residential rental markets.
Net unrealized gain on mortgage loans
$61.1 millionof net unrealized gain on mortgage loans for the year ended December 31, 2013, which can be broken down into the following components:
• First, Residential recognized
2013 in unrealized gains driven by a material change in loan status.
During the year ended
December 31, 2013, Residential converted 228 loans to REO status. Upon conversion of these loans to REO, we marked these properties to the most recent market value (less estimated selling costs in the case of REO held for sale); and
• Second, Residential recognized
loans during the period subsequent to acquisition. Adjustments to the fair
value of loans after acquisition represent a change in the expected time
required to complete the foreclosure process, among other factors. The reduction in time required to complete the foreclosure is driven by the
completion of activities in the foreclosure process after Residential
acquired the loans. This reduction in timeline results in reduced carrying
costs and reduced future expenses for the loans, each of which increase
the fair value of the loans. The increase in the value of the loans is
recognized in net unrealized gain on mortgage loans in our consolidated
statements of operations.
Through our acquisitions for Residential, its loan portfolio had grown to 8,054 loans at
December 31, 2013. The fair value of mortgage loans is based on a number of factors which are difficult to predict and may be subject to adverse changes in value depending on the financial condition of borrowers, as well as geographic, economic, market and other conditions. Therefore, Residential may experience unrealized losses on its mortgage loans in the future.
Net realized gain on mortgage loans
$10.5 millionof net realized gains on mortgage loans for the year ended December 31, 2013primarily from disposition of 211 loans, the substantial majority of which were through short sales and foreclosure sales.
Residential rental property operating expenses
$0.8 millionof rental property operating expenses for the year ended December 31, 2013. We expect Residential to incur increasing residential rental property operating expenses upon converting its mortgage loans to and owning residential rental properties. Residential's rental property operating expenses will be dependent primarily on residential property taxes and insurance, property management fees and repair and maintenance expenditures.
Real estate depreciation and amortization
Residential incurred a nominal amount of real estate depreciation and amortization for the year ended
December 31, 2013. We expect Residential to incur increasing real estate depreciation and amortization following the conversion of its mortgage loans to residential rental properties. Real estate depreciation and amortization are non-cash expenditures which generally are not expected to be indicative of the market value or condition of Residential's residential rental properties.
Mortgage loan servicing costs
$10.4 millionof mortgage loan servicing costs primarily for advances of residential property insurance and servicer fees for the year ended December 31, 2013. Residential incurs mortgage loan servicing costs and advances of required payments relating to the loans, such as property insurance and HOA dues that are made to protect its investment in mortgage loans and to continue to service the acquired loans. Therefore, Residential's loan servicing costs could be higher than expected in a given period if the number of non-performing mortgage loans exceeds expected levels. 50
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$4.6 millionof interest expense (including amortization of deferred financing costs) on borrowings under its repurchase agreements for the year ended December 31, 2013. The interest rate on Residential's financing under its repurchase agreements is subject to change with changes to the relevant index. Market interest rates are currently at historically low levels, and any increase in market interest rates will cause Residential's contractual interest expense to increase. We also expect Residential's interest expense to increase as its debt increases to fund and/or leverage its ownership of additional portfolios of sub-performing and non-performing loans and/or rental properties.
Related party general and administrative expenses
Residential and we incurred
General and administrative expenses
Residential and we incurred
Net loss (income) attributable to noncontrolling interest in consolidated affiliate
We have recorded
Incentive management fees and expense reimbursements
We generated incentive management fees of approximately
$4.9 millionfor the year ended December 31, 2013in connection with the cash available for distribution from Residential in 2013. The incentive management fees have been eliminated under U.S. GAAP in consolidation. We generated $5.4 millionof expense reimbursements from Residential for the year ended December 31, 2013that also have been eliminated in consolidation. We are not reimbursed by Residential for certain general and administrative expenses pertaining to stock-based compensation and our expenditures that are not for the benefit of Residential.
Liquidity and capital resources
December 31, 2013, we had stand-alone cash and cash equivalents of $4.1 million. We believe this cash is sufficient to fund our operations since Residential has begun paying the incentive management fees to us as a result of paying cash dividends to its stockholders. Our only stand-alone cash expenditures to date are leasehold improvements and general and administrative expenses, including unreimbursed salaries and professional expenses. On a consolidated basis, our cash and cash equivalents as of December 31, 2013was $140.0 million, of which approximately $116.0 millionwas attributable to Residential. Residential's liquidity reflects its ability to meet its current obligations (including the purchase of residential mortgage loans, its operating expenses and, when applicable, retirement of, and margin calls relating to, its financing arrangements), purchase additional portfolios of sub-performing and non-performing residential mortgage loans and make distributions to its stockholders. Residential generally needs to distribute at least 90% of its taxable income each year (subject to certain adjustments) to its stockholders to qualify as a REIT under the Internal Revenue Code. This distribution requirement limits Residential's ability to retain earnings and thereby replenish or increase capital to support its activities. Our consolidated cash and cash equivalents as of December 31, 2013also include $19.9 millionattributable to NewSource, representing the cash invested by Residential and us into NewSource in October 2013. 51
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Residential was initially funded with
$100.0 millionit received from Altisource in connection with its separation on December 21, 2012. Since its separation, its primary sources of liquidity have been proceeds from equity offerings, borrowings under our repurchase agreements, interest it receives from its portfolio of assets and cash generated from its operating results. Based on Residential's current borrowings and leverage ratio, we believe that these sources of liquidity will be sufficient to enable it to meet anticipated short-term (one year or less) liquidity requirements, including funding its current investment opportunities, paying expenses on its existing loan portfolio, funding distributions to its stockholders, paying fees to us under the asset management agreement and general corporate expenses. To date, under our management, Residential has used the proceeds of its equity offerings and the available funding under its repurchase agreements to finance its acquisition of its portfolio of residential mortgage loans and REO properties. Residential's equity offerings and repurchase facilities are described below.
December 21, 2012, we have facilitated Residential's completion of three public equity offerings with aggregate net proceeds of approximately $1.1 billion. On May 1, 2013, Residential completed a public offering of 17,250,000 shares of its common stock at $18.75per share and received net proceeds of approximately $309.5 million. On October 1, 2013, Residential completed its second public offering of 17,187,000 shares of common stock at $21.00per share and received net proceeds of $349.4 million. On January 22, 2014, Residential completed its third public offering of 14,200,000 shares of common stock at $34.00per share and received $467.6 million.
March 22, 2013, September 12, 2013and September 23, 2013, Residential, through its subsidiaries, entered into three separate repurchase agreements to finance the acquisition and ownership of residential mortgage loans and REO properties. In December 2013, Residential increased the maximum aggregate funding available under its repurchase agreements by an additional $325.0 million. The maximum aggregate funding available to Residential under these repurchase agreements is currently $750.0 million, subject to certain sublimits, eligibility requirements and conditions precedent to each funding. The repurchase agreement dated March 22, 2013has an aggregate funding capacity of $100.0 millionand matures on March 21, 2014. The repurchase agreement dated September 12, 2013, as amended, has an aggregate funding capacity of $250.0 millionand matures on March 11, 2016and provides that provided that beginning in the nineteenth month, Residential will not be able to finance mortgage loans in excess of amounts outstanding under the facility at the end of the eighteenth month. The repurchase agreement dated September 23, 2013, as amended, has an aggregate funding capacity of $400.0 millionand matures on March 23, 2015and provides that provided that beginning in the nineteenth month, Residential will not be able to finance mortgage loans in excess of amounts outstanding under the facility at the end of the eighteenth month. All obligations under the repurchase agreements are fully guaranteed by Residential. As of December 31, 2013, an aggregate of $602.4 millionwas outstanding under Residential's repurchase agreements, and as of February 13, 2014, Residential had $703.1 millionof borrowings outstanding under its repurchase agreements. Under the terms of each repurchase agreement, as collateral for the funds Residential draws thereunder, subject to certain conditions, Residential's operating partnership will sell to the applicable lender equity interests in the Delawarestatutory trust subsidiary that owns the applicable underlying mortgage assets on Residential's behalf, or the trust will sell directly such underlying mortgage assets. In the event the lender determines the value of the collateral has decreased, it has the right to initiate a margin call and require Residential to post additional collateral or to repay a portion of the outstanding borrowings. The price paid by the lender for each underlying mortgage asset Residential finances under the applicable repurchase agreement is subject to agreement between the lender and Residential and is based on a percentage of the market value or, in certain circumstances, the book value of the underlying mortgage asset and depends on its delinquency status. Residential's cost of borrowing under the repurchase agreements generally corresponds to LIBOR, or the lender interest at the lender's cost of funds plus a margin. Residential is also required to pay certain other customary fees, administrative costs and expenses to maintain and administer the repurchase agreements.
The repurchase agreements require Residential to maintain various financial and other covenants, including maintaining positive profitability, a minimum adjusted tangible net worth, a maximum ratio of indebtedness to adjusted tangible net worth and specified levels of unrestricted cash as well as restrictions on net losses in excess of specified amounts. In addition, the repurchase agreements contain customary events of default.
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Residential is currently in compliance with the covenants and other requirements with respect to its repurchase agreements. We monitor Residential's banking partners' ability to perform under the repurchase agreements and have concluded there is currently no reason to doubt that they will continue to perform under the repurchase agreements as contractually obligated. We expect Residential's existing business strategy will require additional debt and/or equity financing. We continues to explore a variety of financing sources to support Residential's growth, including, but not limited to, debt financing through bank warehouse lines of credit, additional and/or amended repurchase agreements, term financing, securitization transactions and additional debt or equity offerings. However, there can be no assurance as to how much additional financing capacity such efforts will produce, what form the financing will take or that such efforts will be successful. If we are unable to renew, replace or expand Residential's sources of financing, its business, financial condition, liquidity and results of operations may be materially and adversely affected.
We report and analyze our cash flows based on operating activities, investing activities and financing activities. The following table sets forth the changes in our consolidated cash flows ($ in thousands): March 15, 2012 For the year ended (inception) to December 31, 2013 December 31, 2012 Change Net cash used in operating activities $ (21,825 ) $ (69 )
$ (21,756 )Net cash used in investing activities (1,188,230 ) - (1,188,230 ) Net cash provided by financing activities 1,245,041 105,083 1,139,958 Total cash flows $ 34,986 $
The change in net cash used in operating activities for the year ended
The change in net cash used in investing activities for the year ended
The change in net cash provided by financing activities for the year ended
Off-balance sheet arrangements
We had no off-balance sheet arrangements as of
The following table sets forth a summary regarding Residential's known contractual obligations, including required interest payments based on the principal outstanding and current interest rates, at
December 31, 2013($ in thousands): Amount due during the year ending December 31, Index Total 2014 2015 2016 Repurchase agreements: Principal (1) $ 602,382 $ 85,364 $ 398,602 $ 118,416Interest (2) 23,379 16,250 6,322 807 $ 625,761 $ 101,614 $ 404,924 $ 119,223
(1) Does not consider contractually available extension options for amounts due
in 2015 and 2016.
(2) Assumes interest rates as of
remaining term of the repurchase agreements. 53
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Residential enters into certain contracts that contain a variety of indemnification obligations. The maximum potential future payment amount Residential could be required to pay under these indemnification obligations is unlimited. Residential has not incurred any costs to defend lawsuits or settle claims related to these indemnification obligations. As a result, the estimated fair value of these agreements is minimal. Accordingly, Residential recorded no liabilities for these agreements as of
December 31, 2013or 2012.
Recent accounting pronouncements
In accordance with ASU 2011-11, Disclosures about Offsetting Assets and Liabilities, beginning in the first quarter of 2013 we were required to provide additional disclosures about the nature of our rights of offset and the related arrangements associated with our financial instruments. As a result, we have included additional disclosures pertaining to the collateral arrangement related to Residential's repurchase agreement in this annual report. In
January 2014, ASU 2014-04, Troubled Debt Restructurings by Creditors, was issued. It provides that a repossession or foreclosure has occurred, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendment requires disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in mortgage loans collateralized by residential real estate property that are in the process of foreclosure. We do not expect this amendment to have a significant effect on our financial position or results of operations since Residential's accounting policies and disclosures are currently consistent with the requirements set forth in the amendment.
Critical accounting judgments
Accounting standards require information in financial statements about the risks and uncertainties inherent in significant estimates, and the application of generally accepted accounting principles involves the exercise of varying degrees of judgment. Certain amounts included in or affecting our financial statements and related disclosures must be estimated requiring us to make certain assumptions with respect to values or conditions that cannot be known with certainty at the time our consolidated financial statements are prepared. These estimates and assumptions affect the amounts we report for our assets and liabilities and our revenues and expenses during the reporting period and our disclosure of contingent assets and liabilities at the date of our consolidated financial statements. Actual results may differ significantly from our estimates and any effects on our business, financial position or results of operations resulting from revisions to these estimates are recorded in the period in which the facts that give rise to the revision become known.
We consider our critical accounting judgments to be those used in the determination of the reported amounts and disclosure related to the following:
The consolidated financial statements include wholly owned subsidiaries and would include those subsidiaries in which we own a majority voting interest with the ability to control operations of the subsidiaries and where no substantive participating rights or substantive kick out rights have been granted to the noncontrolling interests. Additionally, we consolidate partnerships, joint ventures and limited liability companies when we control the major operating and financial policies of the entity through majority ownership, in our capacity as general partner or managing member or by contract. Lastly, we consolidate those entities deemed to be variable interest entities in which we are determined to be the primary beneficiary. While the results of operations of consolidated entities are included in net loss in our consolidated financial statements, net loss attributable to common stockholders does not include the portion attributable to noncontrolling interests. Additionally, noncontrolling interest in consolidated affiliate is recorded in our consolidated balance sheets and our consolidated statements of equity within the equity section but separate from our equity.
Income taxes are provided for using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the consolidated financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted rates expected 54
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to apply to taxable income in the years in which management expects those temporary differences to be recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period in which the change occurs. Subject to our judgment, we reduce a deferred tax asset by a valuation allowance if it is "more likely than not" that some or all of the deferred tax asset will not be realized. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment is required in evaluating tax positions, and we recognize tax benefits only if it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authority. We believe that we have operated Residential in a manner in which Residential has complied and will continue to operate Residential in a manner that will comply with the provisions of the federal income tax code applicable to REITs beginning for the year ended
December 31, 2013and intend to cause Residential to elect REIT status upon filing of its 2013 income tax return. Accordingly, we believe that Residential will not be subject to federal income tax beginning in the year ended December 31, 2013on that portion of Residential's REIT taxable income that is distributed to its stockholders as long as certain asset, income and share ownership tests are met. If Residential fails to qualify as a REIT in any taxable year, it will be subject to federal income tax on its REIT taxable income at regular corporate income tax rates. If after electing to be taxed as a REIT, Residential subsequently fails to qualify as a REIT in any taxable year, it generally will not be permitted to qualify for treatment as a REIT for federal income tax purposes for the four taxable years following the year during which qualification is lost unless the IRSgrants us relief under certain statutory provisions. Such an event could materially adversely affect Residential's net income and net cash available for distribution to stockholders. Its taxable REIT subsidiaries would also be subject to federal and state income taxes. Mortgage loans Upon the acquisition of mortgage loans, Residential records the assets at fair value which is the purchase price it paid for the loans on the acquisition date. Mortgage loans are subsequently accounted for at fair value under the fair value option election with unrealized gains and losses recorded in current period earnings. We have concluded that mortgage loans accounted for at fair value timely reflect the results of Residential's investment performance. We determine the purchase price for Residential's mortgage loans at the time of acquisition by using a discounted cash flow valuation model and considering alternate loan resolution probabilities including modification, liquidation or conversion to rental property. Observable inputs to the model include current interest rates, loan amounts, status of payments and property types. Unobservable inputs to the model include discount rates, forecast of future home prices, alternate loan resolution probabilities, resolution timelines and the value of underlying properties. After mortgage loans are acquired, the fair value of each loan is adjusted in each subsequent reporting period as the loan proceeds to a particular resolution (i.e., modification, or conversion to real estate owned). As a loan approaches resolution, the resolution timeline for that loan decreases and costs embedded in the discounted cash flow model for loan servicing, foreclosure costs and property insurance are incurred and removed from future expenses. The shorter resolution timelines and reduced future expenses each increase the fair value of the loan. The increase in the value of the loan is recognized in net unrealized gain on mortgage loans in Residential's, and therefore, our consolidated statements of operations. Residential also recognizes unrealized gains and losses in the fair value of the loans in each reporting period when its mortgage loans are transferred to real estate owned. The transfer to real estate owned occurs when Residential has obtained title to the property through completion of the foreclosure process. The fair value of these assets at the time of transfer to real estate owned is estimated using BPOs. Our capital markets group determines the fair value of mortgage loans monthly and has developed procedures and controls governing the valuation process relating to these assets. The capital markets group reports to Residential's Investment Committee, which is a committee of Residential's Chief Executive Officer and its Chairman that oversees and approves the valuations. The capital markets group also monitors the valuation model for performance against actual results which is reported to the Investment Committee and used to continuously improve the model. 55
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Real estate impairment
With respect to Residential's rental properties classified as held for use, we perform an impairment analysis using estimated cash flows if events or changes in circumstances indicate that the carrying value may be impaired, such as prolonged vacancy, identification of materially adverse legal or environmental factors, changes in expected ownership period or a decline in market value to an amount less than cost. This analysis is performed at the property level. These cash flows are estimated based on a number of assumptions that are subject to economic and market uncertainties including, among others, demand for rental properties, competition for customers, changes in market rental rates, costs to operate each property and expected ownership periods. If the carrying amount of a held for use asset exceeds the sum of its undiscounted future operating and residual cash flows, an impairment loss is recorded for the difference between estimated fair value of the asset and the carrying amount. Residential generally estimates the fair value of assets held for use by using BPOs. In some instances, appraisal information may be available and is used in addition to BPOs.
Upon the acquisition of real estate, generally through the completion of foreclosure, Residential records the residential property at fair value as of the acquisition date as a component of real estate owned based on information obtained from a broker's price opinion, a full appraisal or the price given in a current contract of sale of the property. After a short evaluation period, Residential performs property renovations to maximize the value of the property for its rental strategy. Such expenditures are part of Residential's initial investment in a property and, therefore, are classified as investing activities in our consolidated statement of cash flows. Subsequently, the residential property, including any renovations that improve or extend the life of the asset, are accounted for at cost. The cost basis is depreciated using the straight-line method over an estimated useful life of three to 27.5 years based on the nature of the components. Interest and other carrying costs incurred during the renovation period are capitalized until the property is ready for its intended use. Expenditures for ordinary maintenance and repairs are charged to expense as incurred. Expenditures directly related to successful leasing efforts such as lease commissions are included in deferred leasing and financing costs, net and are stated at amortized cost. Such expenditures are part of Residential's operations and, therefore, are classified as operating activities in our consolidated statement of cash flows. Capitalized leasing costs are amortized on a straight-line basis over the lease term of the respective leases which generally are from one to two years. Residential properties are classified either as held for use or held for sale. Residential properties are classified as real estate and related assets held for sale when sale of the assets has been formally approved and is expected to occur in the next twelve months. We record residential properties held for sale at the lower of the carrying amount or estimated fair value. Fair value of assets held for sale is equal to the estimated or contracted sales price with a potential buyer less costs to sell. The impairment loss is the amount by which the carrying amount exceeds the estimated fair value.
Residential rental revenues
Minimum contractual rents from leases are recognized on a straight-line basis over the terms of the leases in residential rental revenues. Therefore, actual amounts billed in accordance with the lease during any given period may be higher or lower than the amount of rental revenue recognized for the period. Straight-line rental revenue commences when the customer takes control of the leased premises. Deferred rents receivable, net represents the amount by which straight-line rental revenue exceeds rents currently billed in accordance with lease agreements. Contingent rental revenue is accrued when the contingency is removed. Termination fee income is recognized when the customer has vacated the rental property, the amount of the fee is determinable and collectability is reasonably assured. Rents receivable, net and deferred rents receivable, net will be reduced by an allowance for amounts that become uncollectible. We regularly evaluate the adequacy of Residential's allowance for doubtful accounts. The evaluation takes into consideration the aging of accounts receivable and our analysis of customer data, reviewing past due account balances, our analysis of customer personal profile and review past due account balances. If Residential's assumptions regarding the collectability of receivables prove incorrect, it could experience losses in excess of its allowance for doubtful accounts. Rents receivable, net and deferred rents receivable, net are written-off when Residential has deemed that the amounts are uncollectible. 56
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