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NRF > SEC Filings for NRF > Form 10-Q on 8-Nov-2012All Recent SEC Filings




Quarterly Report

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our unaudited consolidated financial statements and notes thereto included in this report. References to "N-Star," "we," "us" or "our" refer to NorthStar Realty Finance Corp. and its subsidiaries unless the context specifically requires otherwise.


NorthStar Realty Finance Corp. is a diversified commercial real estate, or CRE, investment and asset management company. We are an internally-managed real estate investment trust, or REIT, and were formed in October 2003. We conduct substantially all of our operations and make our investments through NorthStar Realty Finance Limited Partnership, or our Operating Partnership, including its subsidiaries. Our primary business lines are as follows:

Commercial Real Estate Debt-Our CRE debt business is focused on originating, structuring, acquiring and managing senior and subordinate debt investments secured primarily by commercial and multifamily properties and includes first mortgage loans, subordinate mortgage interests, mezzanine loans, credit tenant loans and other loans, including preferred equity interests. We directly underwrote and originated approximately 74% of the debt investments in our current portfolio (excluding debt originally owned in the CSE RE 2006-A CDO, or CSE CDO, and CapLease 2005-1 CDO, or CapLease CDO, that we consolidate as a result of acquiring the equity interests in 2010 and 2011, respectively, see also "-Sources of Operating Revenues and Cash Flows"). Our CRE debt portfolio represents approximately 39.1% of our assets under management as of September 30, 2012.

Commercial Real Estate Securities-Our CRE securities business is focused on investing in and managing a wide range of CRE securities, including commercial mortgage backed securities, or CMBS, unsecured REIT debt and collateralized debt obligation, or CDO, notes backed primarily by CRE securities and CRE debt. Our CRE securities portfolio represents approximately 38.7% of our assets under management as of September 30, 2012.

Net Lease Properties-Our net lease properties business is focused on acquiring commercial real estate located throughout the United States that are typically leased under net leases to corporate tenants and healthcare operators. Our core net lease business invests primarily in office, industrial and retail properties. We also own, manage and invest in a portfolio of healthcare properties focused on mid-acuity facilities (i.e., skilled nursing and assisted living), with the highest concentration in assisted living facilities. Our net lease properties portfolio represents approximately 13.6% of our assets under management as of September 30, 2012.

Asset Management and Other-Our asset management and other activities relate to real estate and real estate finance, including managing our CDO financing transactions on a fee basis and sponsoring and advising on a fee basis, non-traded REITs, or Sponsored REITs (i.e., NorthStar Real Estate Income Trust, Inc., or NorthStar Income, and NorthStar Healthcare Income, Inc., or NorthStar Healthcare). Our asset management segment represents approximately 8.6% of our assets under management as of September 30, 2012.

We believe that these businesses are complementary to each other due to their overlapping sources of investment opportunities, common reliance on real estate fundamentals and ability to utilize secured borrowings to finance assets and enhance returns. We seek to match fund our CRE debt and security investments primarily by issuing term financing and other forms of secured term financing.

Liquidity and access to capital returned to the commercial real estate finance markets in the first quarter of 2012. During the nine months ended September 30, 2012, we raised net proceeds of $206 million from the issuance of common equity, $142 million from the issuance of preferred stock (including pursuant to our at-the-market equity offering program) and $79 million from the issuance of

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exchangeable senior notes. Subsequent to quarter end, we raised an additional $121 million from the issuance of preferred stock. Total capital raised year to date is $548 million.

Our financing strategy focuses on match funding our assets and liabilities by having similar maturities and like-kind interest rate benchmarks (fixed or floating) to manage refinancing and interest rate risk. Our legacy CRE debt and security portfolios are predominantly financed through long-term, non-recourse CDOs. Our net lease properties are predominantly financed with non-recourse mortgage notes. Given the nature of our current financing arrangements, we expect to maintain our borrowing at or near our current levels for our existing investments. Borrowing levels may change for new investments depending upon the nature of the assets and the related financing.

In terms of new investment-level financing, we pursue a variety of financing arrangements such as credit facilities, securitized arrangements and other term borrowings. The amount of our borrowings will depend upon the nature and credit quality of our assets, the structure of our financings and where possible, we will seek to limit our reliance on recourse borrowings. In late 2011, we began using secured term credit facilities provided by major financial institutions to partially finance new investments. The credit facilities provide up to an aggregate of $140 million to finance loan originations and $100 million to make investments in CMBS. In October 2012, we priced a CMBS financing transaction, or the NorthStar CMBS Financing Transaction, that provides long-term, non-recourse, non-mark-to-market financing for the debt investments we will contribute to the transaction. The debt investments that will be contributed to the NorthStar CMBS Financing Transaction are currently financed on our credit facilities.

We are also focused on raising capital in alternate channels. Beginning in the second half of 2011, we started to see capital raising velocity increase in NorthStar Income. Total capital raised for the nine months ended September 30, 2012 was $297 million, with $452 million raised from inception through September 30, 2012. NorthStar Realty Securities, LLC, or NorthStar Realty Securities, our wholly-owned broker-dealer subsidiary, has executed selling agreements with broker-dealers covering more than 60,000 registered representatives as of September 30, 2012. Additionally, NorthStar Healthcare's registration statement on Form S-11 was declared effective by the Securities and Exchange Commission, or SEC, in the third quarter 2012 and subsequently retained NorthStar Realty Securities to serve as its dealer manager.

Our Investments

The following describes the major CRE asset classes in which we invest and continue to actively manage to maximize stockholder value and to preserve our capital. The following table presents our

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assets under management as of September 30, 2012 based on principal amount of CRE debt and security investments and the cost basis of net lease properties (dollars in thousands):

                                                Amount       Percentage
             CRE Debt
             First mortgage loans             $ 1,644,207           23.2 %
             Mezzanine loans                      442,850            6.2 %
             Credit tenant and other loans        232,491            3.3 %
             Subordinate mortgage interests       131,062            1.8 %
             Other(1)                             324,012            4.6 %

             Total CRE debt                     2,774,622           39.1 %
             CRE Securities
             CMBS                               2,373,496           33.4 %
             Third-party CDO notes                225,959            3.2 %
             Other securities                     148,905            2.1 %

             Total CRE securities               2,748,360           38.7 %
             Net Lease
             Core net lease                       404,532            5.7 %
             Healthcare net lease                 562,476            7.9 %

             Total net lease                      967,008           13.6 %
             Subtotal NorthStar                 6,489,990           91.4 %

             Sponsored REIT
             NorthStar Income(2)                  607,971            8.6 %

             Grand total                      $ 7,097,961          100.0 %

Relates to real estate owned (either directly or through a joint venture) as a result of taking title to a property through foreclosure, deed in lieu or otherwise ("taking title to a property"), presented at the principal amount of such loan at time of taking title.

Based on consolidated total assets.

Commercial Real Estate Debt

Our Portfolio

As of September 30, 2012, $2.8 billion, or 39.1%, of our assets under management were invested in CRE debt, which includes $0.3 million principal amount of loans related to certain investments accounted for as joint ventures and real estate owned. As of September 30, 2012, our $2.5 billion CRE debt portfolio consisted of 158 investments with an average investment size of $16 million.

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The portfolio's diversity across property type and geographic location is summarized as follows, based on outstanding principal amount:

     Loan Portfolio by Property Type   Loan Portfolio by Geographic Location
       [[Image Removed: GRAPHIC]]           [[Image Removed: GRAPHIC]]

Commercial Real Estate Securities

Our Portfolio

    As of September 30, 2012, $2.7 billion, or 38.7%, of our assets under
management were invested in a portfolio of CRE securities. Our CRE securities
portfolio consisted of 584 investments with an average investment size of
$5 million. CMBS represents $2.4 billion, or 86.4%, of our CRE securities
portfolio. The CMBS portfolio had an average credit rating of CCC+/Caa1. The
following summarizes our CRE securities by type and CMBS by vintage, based on
outstanding principal amount:

                 Securities by Type           CMBS by Vintage(1)
             [[Image Removed: GRAPHIC]]   [[Image Removed: GRAPHIC]]


2006 and 2007 vintages were purchased at a weighted average discount of approximately 58%.

Net Lease Properties

Core Net Lease Properties

As of September 30, 2012, $405 million, or 5.7%, of our total assets under management were invested in our 24 core net lease properties, consisting of a portfolio of office, retail and industrial facilities totaling 3.2 million square feet. As of September 30, 2012, our core net lease properties had a weighted average remaining lease term of 5.9 years and were 96% leased.

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The following summarizes our core net lease portfolio's diversity across property type and geographic location as of September 30, 2012, based on purchase price, or cost.

Core Net Lease by Property Type Core Net Lease by Geographic Location
[[Image Removed: GRAPHIC]] [[Image Removed: GRAPHIC]]

Healthcare Net Lease Properties

As of September 30, 2012, $562 million, or 7.9%, of our assets under management were invested in our healthcare net lease properties, with a focus on the senior housing sector which includes assisted living, skilled nursing and independent living facilities. Our portfolio was comprised of 42 assisted living facilities (ALF), 31 skilled nursing facilities (SNF), three life science buildings (LSB), six independent living facilities (ILF) and one medical office building (MOB). As of September 30, 2012, 100% of our net lease healthcare portfolio was leased to third-party operators with weighted average lease coverage of 1.3x and a 7.2 year weighted average remaining lease term.

The following summarizes our healthcare portfolio by property type and geographic location as of September 30, 2012, based on purchase price:

Healthcare Net Lease by Property Type Healthcare Net Lease by Property Type
[[Image Removed: GRAPHIC]] [[Image Removed: GRAPHIC]]

Asset Management and Other

Our asset management and other activities are focused on:

Managing CDO financing transactions on a fee basis.

We manage eleven CDOs representing $5.5 billion of assets based on principal amount, nine of which were sponsored by us, or the N-Star CDOs. In addition, we acquired the equity interests of two CDOs that have been integrated into our platform, the CSE CDO and the CapLease CDO, which we herein collectively refer to as our acquired CDOs. In the case of the CSE CDO, we were delegated the collateral management and special servicing rights and for the CapLease CDO, we acquired the collateral management rights. Five of the CDOs are primarily collateralized by CRE debt and six are primarily collateralized by CRE securities.

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We consolidate these CDO financing transactions under accounting principles generally accepted in the United States, or U.S. GAAP. As a result, the collateral management fees we earn and receive in cash are eliminated in consolidation in the statements of operations.

Sponsoring and advising on a fee basis, our Sponsored REITs.

In connection with our current public Sponsored REIT, NorthStar Income, we manage the day-to-day affairs including identifying, originating, acquiring and managing investments on its behalf, and we earn advisory and other fees for these services, which vary based on the amount of assets under management, investment activity and investment performance.

In addition, NorthStar Realty Securities distributes equity for our Sponsored REITs. NorthStar Realty Securities is currently raising equity capital for NorthStar Income and will raise equity capital for NorthStar Healthcare. In addition, we expect that NorthStar Realty Securities will assist us in the future in accessing diverse sources of capital for other companies that may be sponsored and managed by us.

Other Opportunistic Investments

We also pursue other opportunistic investments that we expect will generate attractive risk-adjusted returns, such as repurchasing our CDO bonds at a significant discount to principal amount as well as other real estate-related investments. These CDO bonds typically have significant credit support and, when we repurchase a CDO bond, we generally expect the CDO bonds will be repaid at par.

As of November 2, 2012, the principal proceeds we could receive from CDO bonds we owned was $805 million, of which $655 million was repurchased at an average price of 37% in the secondary market and had a weighted average original credit rating of A+/A1. Because our CDO financing transactions are consolidated under U.S. GAAP, these CDO bonds are generally not presented as an investment but rather are eliminated in our consolidated financial statements. We will generate cash flows in future periods through the interest payable on these bonds, as well as realizing (in cash) the discount as the bonds repay. If realized, this $416 million discount will generally not be reported as a gain and the interest will not be recorded as income under U.S. GAAP.

Sources of Operating Revenues and Cash Flows

We primarily generate revenues from net interest income on our CRE debt and security portfolios, rental income from the net lease properties and fee income from the asset management and other related activities. Our income is primarily derived through the difference between revenues and the cost at which we are able to finance our assets. We may also acquire investments which generate attractive returns without any leverage.

Our legacy CRE debt and security investments are predominantly financed in CDOs. We consolidate the CDO financing transactions under U.S. GAAP regardless of whether we retain the equity interests for our sponsored CDOs or acquire the equity interests of other CDOs. However, we generate cash flows based on the equity interests that we retain/acquire. As a result, the cash flows may be different from the income (loss) generated for U.S. GAAP purposes.

In this Quarterly Report on Form 10-Q, we refer to certain CDOs that we consolidate on our balance sheet as "our CDOs." Our CDOs are financing transactions that we consolidate on our balance sheet in accordance with U.S. GAAP, as we own the equity interests in such CDOs. We do not, however, own undivided interests in any of the assets within our CDOs and all senior and junior bondholders of the CDOs have economic interests that are senior to our equity interests. A more detailed discussion of our CDO financing transactions is provided in this section under "-Liquidity and Capital Resources."

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Profitability and Performance Metrics

We calculate several metrics to evaluate the profitability and performance of our business.

Adjusted funds from operations, or AFFO (see "-Non-GAAP Financial Measures-Funds from Operations and Adjusted Funds from Operations" for a description of this metric).

Credit losses are a measure of performance and can be used to compare the credit performance of our assets to our competitors and other finance companies.

Assets under management growth is a driver of our ability to grow our income especially related to our Sponsored REITs, but we believe it is of lesser importance than other metrics such as AFFO.

Cash from our investments is a driver of our ability to maintain and/or grow our distributions to our stockholders.

Outlook and Recent Trends

In the first half of 2011, liquidity began to return to the commercial real estate finance markets and capital started to become available to the stronger sponsors. Wall Street and commercial banks began to more actively provide credit to real estate borrowers. A proxy of the easing of credit and restarting of the capital markets for CRE debt is the approximately $30 billion in non-agency CMBS issuance that were completed in 2011. Credit started to contract in mid-2011 as the European debt woes began to unfold resulting in severe market volatility.

Global financial markets continue to be strained in 2012 and we expect that the commercial real estate finance markets will continue to be volatile in the near term due to anemic United States economic growth, continued high levels of unemployment and global market instability, along with the risk of maturing CRE debt that will have difficulties being refinanced. There was a coordinated effort to stimulate growth by several of the world's largest central banks through massive injections of stimulus in the financial markets in September 2012 which will also have the likely impact of keeping interest rates low for the near and intermediate term.

It is currently estimated that $1.3 trillion of CRE debt will mature in the next three years and $2.1 trillion will mature through 2017. While there is increased demand among lenders to provide such financing, we still anticipate that many of these loans will not be able to be refinanced, exacerbating growth and potentially leading to contracting credit. The capital markets are opening up as evidenced by our recent NorthStar CMBS Financing Transaction. Refer to "Financing Strategy" for additional details. The recent stimulus in the United States helped to increase demand for new CMBS, even though current new issue is still well below historic levels. Through September 30, 2012, there has been $31 billion in non-agency CMBS issuance. We expect the second half of 2012 to be better than the first half. Originally $35 billion of total non-agency CMBS issuance was projected for 2012 and now many industry experts are predicting that to be $40 to $45 billion.

Virtually all commercial real estate property types were adversely impacted by the credit crisis, including core property types such as hotel, retail, office, industrial and multifamily properties. Land, condominium and other commercial property types were more severely impacted. As a result, cash flows and values associated with properties serving as collateral for our loans are generally weaker than expected when we originated the loans. Despite the difficult United States and global economic conditions, investor interest has been returning to commercial real estate especially in urban areas having high concentrations of institutional quality real estate and especially in certain asset types such as apartments. The degree to which commercial real estate values improve or erode in 2012 in the markets in which our real estate collateral is located, will impact the performance of our asset base and the related level of loan losses.

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Our CRE debt and securities investments are negatively impacted by weaker real estate market and economic conditions. Slow economic conditions reduce a tenant's ability to make rent payments in accordance with the terms of their leases and for companies to lease new space. To the extent that market rental and occupancy rates are reduced, property-level cash flows are negatively affected as existing leases renew at lower rates and over longer periods of time impact the value of underlying properties and the borrowers' ability to service their outstanding loans.

Many of our legacy CRE debt investments bear interest based on a spread to one-month LIBOR, a floating-rate index based on rates that banks charge each other to borrow. One-month LIBOR as of September 30, 2012 was 0.21%, well below its 0.99% average over the past five years. Lower LIBOR means lower debt service costs for our borrowers. This dynamic has partially offset decreasing cash flows caused by the challenging economic conditions and may also result in extending the life of interest reserves for those debt investments that require interest reserves to service debt. However, many of our new CRE loan originations have a LIBOR floor that is in excess of current LIBOR. The degree in which rates will remain low is driven in a significant part by the actions of the Federal Reserve. Our current expectation is that rates will remain low into 2014.

CRE security values are also influenced by credit ratings assigned by the rating agencies. Beginning in 2009 and continuing into late 2011, the rating agencies dramatically changed their ratings methodologies for all securitized asset classes, including commercial real estate. Combined with challenging economic conditions, their reviews have resulted in large amounts of rating downgrade actions for CMBS, negatively impacting market values of CMBS and in many cases negatively impacting the CDO financing structures used by us and others to finance these assets. To some extent, we took advantage of the rating agency downgrades by purchasing $1.2 billion of CMBS in our CDOs in 2009 and 2010 at a weighted average discount to par of approximately 60%.

Our net lease properties are also adversely impacted by a weaker economy. Corporate space needs contracted resulting in lower lease renewal rates and longer releasing periods when leases are not renewed. Poor economic conditions may negatively impact the creditworthiness of our tenants/operators, which could result in their inability to meet the terms of their leases. Further, our healthcare net lease portfolio is also subject to impact from regulatory changes which are also impacted by a weak economy, such as changes to the Medicaid and Medicare programs that could negatively affect property values. Although we cannot make assurances that our cash flow will not be impacted by changes to these programs, a majority of our assets do not derive revenues from these government programs and we believe assets dependent on these programs have adequate lease coverage to support the rent of our operators.

Our Strategy

Our primary business objectives are to make commercial real estate-related investments in order to produce attractive risk-adjusted returns and engage in asset management activity in order to generate stable cash flows for distribution to our stockholders and build long-term franchise value. When we observed deteriorating market conditions, we responded by decreasing investment activity and preserving capital. At the same time, we focused on raising capital in alternative channels, such as the non-traded REIT market.

We currently anticipate that most of our investment activity and uses of available unrestricted cash liquidity will be focused on our businesses of originating new loans and investing in securities, as well as opportunistic investments, including discounted repurchases of our previously-issued CDO bonds and other opportunistic real estate-related investments that we believe will be beneficial to us. Availability and cost of capital will impact our profitability and earnings since we must raise new capital to fund a majority of this growth. As a result, we also remain focused on the growth of our asset management business and in particular, our Sponsored REITs.

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As liquidity was becoming more available and commercial real estate fundamentals were beginning to stabilize in 2011 and 2012, we took advantage of this dynamic in terms of both capital raising and investment activity. We raised $232 million of capital in the first half of 2011 and $548 million of capital in 2012 through October 2012. In addition, we entered into two $100 million term credit facilities in the fourth quarter 2011 to finance the origination of CRE first mortgage loans and the purchase of AAA-rated CMBS investments. In July 2012, we entered into an additional credit facility that provides up to $40 million on a non-recourse basis, subject to certain exceptions, to finance first mortgage loans and senior loan participations secured by commercial real estate. In October 2012, we priced the NorthStar CMBS Financing Transaction to permanently finance debt investments on a non-recourse, non-mark to market basis that had previously been financed on our credit facilities.

Throughout 2012, we have been actively investing across our businesses. Year to date through November 2, 2012, we originated seven loans and acquired three loans with an aggregate principal amount of $227 million (including two interests owned through joint ventures). The weighted average expected return on invested equity of these debt investments is approximately 18%, including the impact of the NorthStar CMBS Financing Transaction. Also, as the advisor of NorthStar Income, we originated eleven loans with a principal amount of $308 million during the same period. The principal proceeds we could receive from CDO bonds acquired through November 2, 2012 is $326 million, which were . . .

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