UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2014 |
OR
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
COMMISSION FILE NUMBER: 000-54809
Altisource Asset Management Corporation
(Exact name of registrant as specified in its charter)
UNITED STATES VIRGIN ISLANDS | 66-0783125 |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
402 Strand Street
Frederiksted, United States Virgin Islands 00840-3531
(Address of principal executive office)
(340) 692-1055
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
(Title of Each Class) | (Name of exchange on which registered) |
Common stock, par value $0.01 per share | NYSE MKT |
Securities registered pursuant to Section 12(g) of the Act:
None.
Indicate by check if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ Nox
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large Accelerated Filer | x | Accelerated Filer | ¨ | |
Non-Accelerated Filer | ¨ | (Do not check if a smaller reporting company) | Smaller Reporting Company | ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate market value of common stock held by non-affiliates of the registrant was $921.7 million, based on the closing share price as reported on the New York Stock Exchange on June 30, 2014 and the assumption that all directors and executive officers of the registrant and their families are affiliates. This determination of affiliate status is not necessarily a conclusive determination for any other purpose.
As of February 19, 2015, 2,206,577 shares of our common stock were outstanding (excluding 264,131 shares held as treasury stock).
Altisource Asset Management Corporation
December 31, 2014
Table of Contents
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References in this report to "we," "our," "us," or the "Company" refer to Altisource Asset Management Corporation and its consolidated subsidiaries, unless otherwise indicated. References in this report to “Residential” refer to Altisource Residential Corporation, unless otherwise indicated. References in this report to “Altisource” refer to Altisource Portfolio Solutions S.A. and its consolidated subsidiaries, unless otherwise indicated. References in this report to “Ocwen” refer to Ocwen Financial Corporation and its consolidated subsidiaries, unless otherwise indicated.
Special note on forward-looking statements
Our disclosure and analysis in this Annual Report on Form 10-K contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, which we refer to as the “Securities Act,” and Section 21E of the Securities Exchange Act of 1934, as amended, which we refer to as the “Exchange Act.” In some cases, you can identify forward-looking statements by the use of forward-looking terminology such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” or “potential” or the negative of these words and phrases or similar words or phrases which are predictions of or indicate future events or trends and which do not relate solely to historical matters. You can also identify forward-looking statements by discussions of strategy, plans or intentions.
The forward-looking statements contained in this report reflect our current views about future events and are subject to numerous known and unknown risks, uncertainties, assumptions and changes in circumstances that may cause our actual results to differ significantly from those expressed in any forward-looking statement. Factors that may materially affect such forward-looking statements include, but are not limited to:
• | our ability to implement our business strategy and the business strategy of Residential; |
• | our ability to retain Residential as a client; |
• | our ability to retain and maintain our strategic relationships with related parties; |
• | the ability of Residential to generate cash available for distribution to its stockholders under our management; |
• | our ability to effectively compete with our competitors; |
• | Residential's ability to complete future or pending transactions; |
• | the failure of Altisource to effectively perform its obligations under their agreements with us and Residential; |
• | the failure of Residential’s servicers to effectively perform their services to Residential; |
• | general economic and market conditions; and |
• | governmental regulations, taxes and policies. |
While forward-looking statements reflect our good faith beliefs, assumptions and expectations, they are not guarantees of future performance. Such forward-looking statements speak only as of their respective dates, and we assume no obligation to update them to reflect changes in underlying assumptions or factors, new information or otherwise. For a further discussion of these and other factors that could cause our future results to differ materially from any forward-looking statements contained herein, please refer to the section “Item 1A. Risk factors.”
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Part I
Item 1. Business
Overview
We were incorporated in the United States Virgin Islands on March 15, 2012, which we refer to as "inception." On December 21, 2012, we became a stand-alone publicly traded company with an initial capital contribution of $5 million. Our primary business is to provide asset management and certain corporate governance services to institutional investors. Our primary client currently is Altisource Residential Corporation, which we refer to as “Residential,” under a 15-year asset management agreement, which we refer to as the “asset management agreement.” Residential is a public real estate investment trust, or "REIT," that acquires and manages single-family rental properties by acquiring sub-performing and non-performing mortgage loans throughout the United States. In October 2013, we applied for and were granted registration by the SEC as a registered investment adviser under section 203(c) of the Investment Advisers Act of 1940.
We have a capital light operating strategy with profits available for share repurchases and dividends. Initially, Residential is our primary source of revenue and will drive our potential future growth. The asset management agreement with Residential entitles us to incentive fees, which we refer to as our “incentive management fee,” that will give us a share of Residential's cash flow available for distribution to its shareholders 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 ("VIE") 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 because, under the 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 in our consolidated financial statements.
In addition to the services we provide to Residential, we provide management services to NewSource Reinsurance Company Ltd., which we refer to as “NewSource,” a Bermuda title insurance and reinsurance company. In October 2013, we invested $2.0 million in NewSource and received 100% of the common stock of NewSource, representing 2,000,000 shares. Simultaneously, Residential invested $18.0 million in NewSource and received 100% of the non-voting preferred stock of NewSource. 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. On December 2, 2013, NewSource became registered as a licensed reinsurer with the Bermuda Monetary Authority (“BMA”).
Our Business Strategy
Our business strategy is to:
• | provide asset management services to Residential to generate a growing stream of cash available for distribution to its shareholders and thereby growing our earnings; and |
• | develop additional scalable investment strategies and vehicles by leveraging the expertise of our management team. |
Our Expertise
Our senior management team includes individuals with significant experience in the real estate, mortgage, housing and asset management markets. Throughout their careers, our executives have managed various real estate-related businesses and executed structured real estate and financing transactions through multiple market cycles. We have also internally developed a valuation model that uses proprietary historical data to evaluate and project the performance of residential mortgage loans. We believe that our asset evaluation process and the experience and judgment of our executive management team in identifying, assessing, valuing and acquiring new residential mortgage loans will help Residential to appropriately value the portfolios at the time of purchase.
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Asset Management Agreement
Under our asset management agreement with Residential we are responsible for, among other duties: (1) performing and administering Residential's day-to-day operations, (2) defining investment criteria in cooperation with Residential's Board of Directors, (3) sourcing, analyzing and executing asset acquisitions for Residential, including its acquisition of sub-performing and non-performing residential mortgage loan portfolios and related financing activities, (4) analyzing sales of properties, (5) overseeing servicing of Residential's residential mortgage loan portfolios, (6) overseeing Altisource’s renovation, leasing and property management of Residential's single-family rental properties, (7) performing asset management duties and (8) performing corporate governance and other management functions, including financial, accounting and tax management services. We provide Residential with a management team and appropriate support personnel who have substantial sub-performing and non-performing loan portfolio experience. Our management also has significant corporate governance experience that enables Residential to manage its business and organizational structure efficiently. We have agreed not to provide the same or substantially similar services to any other party so long as Residential and its operating partnership have on hand an average of $50,000,000 in capital available for investment over the previous two fiscal quarters.
Incentive Management Fee
Under the asset management agreement with Residential, we earn quarterly incentive management fees as follows:
i. | 2% of all cash available for distribution by Residential to its stockholders and to us as incentive management fees, which we refer to as “available cash,” until the aggregate amount per share of available cash for the quarter (based on the average number of shares of Residential's common stock outstanding during the quarter), which we refer to as the “quarterly per share distribution amount,” exceeds $0.161, then |
ii. | 15% of all additional available cash for the quarter until the quarterly per share distribution amount exceeds $0.193, then |
iii. | 25% of all additional available cash for distribution by Residential for the quarter until the quarterly per share distribution amount exceeds $0.257, and thereafter |
iv. | 50% of all additional available cash for distribution by Residential for the quarter; |
in each case set forth in clauses (i) through (iv), as such amounts may be appropriately adjusted from time to time to take into account the effect of any stock split, reverse stock split or stock dividend.
Residential will distribute any quarterly distribution to its stockholders after the application of the incentive management fee payable to us.
Expense Reimbursement
Pursuant to the asset management agreement, we are reimbursed by Residential on a monthly basis for the (i) direct and indirect expenses we incur or payments we make on Residential's behalf, including, but not limited to, the allocable compensation and routine overhead expenses of all our employees and staff for activities they conduct for Residential and (ii) all other reasonable operating and overhead expenses we incur related to the asset management services we provide to Residential. We are not reimbursed by Residential for any compensation paid to our Directors.
Termination
Residential may terminate the asset management agreement without cause upon the determination of at least two-thirds of its independent directors that (i) there has been unsatisfactory performance by us that is materially detrimental to Residential, or (ii) the compensation payable to us under the asset management agreement is unreasonable, unless we agree to amend our compensation by an amount or in a manner that at least two-thirds of Residential's independent directors determine is reasonable.
We may terminate the asset management agreement without cause by providing written notice to Residential no later than 180 days prior to December 21 of any year during the initial term or a renewal term, and the asset management agreement will terminate on the December 21 following the delivery of such notice.
Residential will be required to pay us a termination fee in the event that the asset management agreement is terminated as a result of (i) a termination by Residential without cause, (ii) a termination by us as a result of Residential's becoming regulated
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as an “investment company” under the Investment Company Act, or (iii) a termination by us if Residential defaults in the performance of any material term of the asset management agreement (subject to a notice and cure period).
The termination fee will be equal to three times the average annual incentive management fee earned by us during the prior 24-month period immediately preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination.
If the asset management agreement were terminated by Residential, even if a termination fee is payable to us, our financial position and future prospects for revenues and growth would be materially adversely affected.
Residential's Business Strategy
Overview
We believe that Residential's business model provides it with operating capabilities that are difficult to replicate and positions it to capitalize on substantial single-family rental and non-performing loan market opportunities. Specifically, we believe that Residential's differentiated acquisition strategy, which is focused on purchasing sub-performing and non-performing mortgage loans, provides it with multifaceted loan resolution methodologies through Residential's mortgage loan servicers and access to an established, nationwide renovation and property management infrastructure. We believe this provides Residential with multiple avenues of value creation that will help it to achieve its business objective of generating attractive risk-adjusted returns for its stockholders.
Acquisition Strategy
We expect that Residential will continue to acquire single-family rental properties primarily through the acquisition of sub-performing and non-performing mortgage loan portfolios. Based on the experience of our management team, we believe that the 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 throughout the United States. We believe the relatively lower level of competition for sub-performing and non-performing loans, provides buyers with the opportunity for a relatively lower cost to ultimately acquire single-family rental properties relative to foreclosure auctions or other REO acquisition channels; and |
• | 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 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. |
Multifaceted Loan Resolution Methodologies
Through its mortgage servicers, including Ocwen, Residential seeks to employ various loan resolution methodologies with respect to its residential mortgage loans, including loan modification, collateral resolution and collateral disposition. To help Residential achieve its business objective, we intend to focus on (1) converting a portion of Residential's sub-performing and non-performing loans to performing status and (2) managing the foreclosure process and timelines with respect to the remainder of those loans.
Residential's preferred resolution methodology is to modify the sub-performing and non-performing loans. Once successfully modified, we expect that certain borrowers will refinance their loans with other lenders or we will sell the modified loans after establishing a payment history at or near the estimated value of the underlying property, potentially generating attractive returns for Residential. We believe modification followed by refinancing or sale generates near-term cash flows for Residential, 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 significant portion of Residential’s mortgage loans will enter into foreclosure or result in Residential's acquisition of the property via alternative resolution such as deed-in-lieu of foreclosure, ultimately becoming REO that it can convert into single-family rental properties which we believe will generate long-term returns for Residential's stockholders. If an REO property does not meet Residential's rental investment criteria, we expect Residential to engage in REO liquidation to dispose of the property and generate cash for reinvestment in other acquisitions and dividend
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distributions. We believe that the optionality provided by this multifaceted resolution approach enables Residential to bid on large portfolios in an effective manner as all loans may not be amenable to a single resolution strategy.
Access to Established Nationwide Property Management Infrastructure
We believe that Residential's 15-year master services agreement with Altisource allows Residential to operate and manage single-family rental properties with efficiency and predictability. This efficiency and predictability is driven by Altisource’s technology and global workforce. Altisource has developed a nationwide operating infrastructure enabled by technology and standardized and centrally managed processes. It also has a global back office organization that qualifies vendors, solicits the appropriate vendors to perform requested work, assigns the work to the vendor with the best possible combination of cost and delivery capabilities, verifies that the vendor’s work is complete and pays the vendor. This technology and organizational infrastructure allows Altisource to provide services which we believe provide Residential with the following competitive advantages:
• | the management of single-family rental properties using Altisource’s nationwide vendor network is not dependent upon scale; accordingly, unlike many of Residential's competitors, it does not require a critical size of single-family rental properties in a geographic area to attain operating efficiencies; |
• | sub-performing and non-performing loan portfolios typically contain properties that are geographically dispersed, requiring a cost-effective nationwide property management system; we believe Residential is positioned to bid effectively on portfolios with large geographic dispersion; |
• | Altisource’s rental marketing strategy is specifically designed to advertise listings across popular industry-focused websites, utilizing their high organic and paid search rankings to generate large volumes of prospective tenants; |
• | Residential's contracted relationships with nationwide manufacturers and material suppliers, who are also used by Altisource, enable Residential to manage the ordering and delivery of flooring, appliances, paint, fixtures and lighting for all renovation and unit turn work (i.e. work associated with turnover from one tenant to the next); |
• | We have direct access to Altisource's inspection and estimating application which is utilized by the third-party general contracting vendors to identify required renovation work and prepare detailed scopes of work to provide a consistent end product. In addition, this application catalogs major HVAC systems, appliances and construction materials, which can enable more accurate forecasting of long term maintenance requirements; and |
• | Ongoing tenant management services are coordinated through an internal “24x7” customer service center. |
We work directly with Altisource’s vendor management team on Residential's behalf, and our construction management team often interfaces with the general contractors and vendors to maintain relationships with the vendor network. Through our team, Residential coordinates with Altisource and its personnel as well as the vendor network to establish a collective approach to the renovation management, maintenance, repair and materials supply chain to create a unified look and feel for the REO properties that Residential rents, owns or acquires upon resolution of its mortgage loans. We believe our experience and these coordinated efforts with Altisource provide us with the capabilities to replicate Altisource’s vendor network, if necessary, which competitors may not be able to do without substantial efforts and expense.
Although Residential's master services agreement and other support agreements with Altisource are not exclusive arrangements, we believe that these relationships and our direct access to a large vendor network through Altisource provides Residential with significant competitive advantages over third parties with respect to acquiring and maintaining sub-performing and non-performing loans and single-family rental properties. We expect Residential to hold single-family rental property assets over the long-term with a focus on developing brand and franchise value.
We also believe that the forecasted growth for the single-family rental marketplace, in combination with our projected asset management and acquisition costs for Residential and its ability to acquire assets nationwide, provides Residential with a significant opportunity to establish it as a leading, externally-managed residential REIT.
Existing Portfolio
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 2014, Residential completed the acquisition of an aggregate of 7,326 residential mortgage loans, substantially all of which were non-performing, and 237 REO properties having an aggregate unpaid principal balance (“UPB”) of approximately $1.9 billion and an aggregate market value of underlying properties of $1.8 billion. The aggregate purchase price for these acquisitions was $1.2 billion. In 2013, Residential completed the acquisition of an aggregate of 8,491 residential mortgage loans, substantially all of which were non-performing, and 40 REO properties having an aggregate UPB of approximately $2.2
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billion and an aggregate market value of underlying properties of $1.8 billion. The aggregate purchase price for these acquisitions was $1.2 billion.
During the years ended December 31, 2014 and 2013, Residential completed the acquisition of the following portfolios of non-performing residential mortgage loans.
Portfolios Acquired | |||||||||
Date acquired | Number of loans acquired | Fair value of underlying property (in millions) | UPB (in millions) | ||||||
Year ended December 31, 2013 | 8,531 | $ | 1,795.2 | $ | 2,219.3 | ||||
January 2, 2014 | 650 | 93.6 | 120.8 | ||||||
January 28, 2014 | 66 | 7.0 | 7.3 | ||||||
January 31, 2014 | 3,421 | 791.7 | 987.8 | ||||||
February 28, 2014 | 70 | 8.2 | 8.0 | ||||||
May 1, 2014 | 664 | 126.6 | 153.0 | ||||||
June 27, 2014 | 1,116 | 375.3 | 328.2 | ||||||
July 10, 2014 | 46 | 5.0 | 6.9 | ||||||
July 31, 2014 | 1,243 | 315.7 | 260.3 | ||||||
October 24, 2014 | 159 | 31.6 | 42.9 | ||||||
December 23, 2014 | 127 | 15.1 | 16.0 | ||||||
Totals | 16,093 | (1) | $ | 3,565.0 | $ | 4,150.5 | |||
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(1) | Includes 40 REOs purchased in 2013, 190 REOs purchased in May 2014, and 46 REOs purchased in October 2014. Excludes the portfolio of 879 re-performing loans acquired in June 2014, the majority of which were subsequently sold in October 2014. |
Throughout this report, all unpaid principal balance and market value amounts for the portfolios Residential has acquired are provided as of the applicable “cut-off” date for each transaction unless otherwise indicated. We refer to the assets underlying Residential's completed acquisitions as its “Existing Portfolio.” The Existing Portfolio does not include assets acquired as REO. As defined in this report, Residential's “Existing Portfolio” does not include the 102 re-performing mortgage loans having an aggregate UPB of approximately $18.4 million and an aggregate market value of underlying properties of approximately $22.5 million as of December 31, 2014, which are considered “Mortgage loans held for sale.”
Residential’s sub-performing and non-performing mortgage loans become REO properties when it has obtained legal title to the property upon completion of the foreclosure. Additionally, some of the portfolios Residential purchases may, from time to time, contain a small number of residential mortgage loans that have already been converted to REO.
As of December 31, 2014, Residential had 3,960 REO properties, consisting of 3,349 REO properties held for use and 611 held for sale. Of the 3,349 REO properties held for use, 336 properties had been rented, 197 were being listed for rent and 254 were in varying stages of renovation in preparation for rent. With respect to the remaining 2,562 REO properties held for use, Residential will make a final determination whether each property meets its rental profile after (a) applicable state redemption periods have expired, (b) the foreclosure sale has been ratified, (c) Residential has recorded the deed for the property, (d) utilities have been activated and (e) Residential has secured access for interior inspection. A majority of the REO properties are subject to state regulations which require Residential to await the expiration of a redemption period before a foreclosure can be finalized. Residential includes these redemption periods in its pricing which generally reduces the price Residential pays for the mortgage loans. Once the redemption period expires, Residential immediately proceeds to record the new deed, take possession of the property, activate utilities, and start the inspection process in order to make a final determination on whether to rent or liquidate the property. If an REO property meets Residential’s rental investment criteria, Residential determines the extent of renovations that are needed to generate an optimal rent and maintain consistency of renovation specifications for future branding. If it is determined that the REO property will not meet Residential’s rental investment criteria, the property is listed for sale, in some instances after renovations are made to optimize the sale proceeds. As of December 31, 2013, Residential had 246 REO properties held for use. Of these properties, 14 had been rented, 11 were being listed for rent and 18 were in various stages of renovation. With respect to the remaining 203 REO properties at December 31, 2013, Residential was in the process of determining whether these properties would meet its rental profile. Additionally, 16 REO properties owned as of December 31, 2013 were held for sale.
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The remainder of Residential’s Existing Portfolio consists of a diversified pool of sub-performing and non-performing residential mortgage loans with the underlying properties located across the United States. The aggregate purchase price of Residential’s Existing Portfolio for acquisitions completed through December 31, 2014 was 67% of the aggregate market value, as determined by the most recent BPO provided by the applicable seller for each property in the respective portfolio as of its cut-off date. We cannot assure you that the BPOs accurately reflected the actual market value of the related property at the purported time or accurately reflect such market value today.
As of December 31, 2014 the aggregate carrying value of Residential's Existing Portfolio was $2.0 billion (which does not include the carrying value of Residential's REO properties of an additional $624.6 million). The carrying value of mortgage loans is based on our proprietary pricing model. The significant unobservable inputs used in the fair value measurement of Residential's mortgage loans are discount rates, forecasts of future home prices, alternate resolution probabilities and foreclosure timelines. Significant changes in any of these inputs in isolation could result in a significant change to the fair value measurement. For a more complete description of the fair value measurements and the factors that may significantly affect the carrying value of Residential's assets, please see Note 4 to our consolidated financial statements.
The table below provides a summary of the sub-performing and non-performing residential mortgage loans in Residential’s Existing Portfolio based on the respective UPB and respective market values of underlying properties as of December 31, 2014 ($ in thousands):
Location | Loan count | UPB | Market value of underlying properties (1) | Weighted average market LTV (2) | ||||||
Alabama | 58 | $ | 8,479 | $ | 7,404 | 174.4 | % | |||
Alaska | 3 | 672 | 1,011 | 68.8 | % | |||||
Arizona | 152 | 41,668 | 37,939 | 121.8 | % | |||||
Arkansas | 54 | 4,409 | 5,088 | 108.3 | % | |||||
California | 1302 | 615,067 | 643,059 | 108.5 | % | |||||
Colorado | 58 | 17,051 | 16,834 | 109.0 | % | |||||
Connecticut | 139 | 41,462 | 37,664 | 139.8 | % | |||||
Delaware | 59 | 11,254 | 10,030 | 128.9 | % | |||||
Dist. of Columbia | 67 | 17,735 | 20,726 | 109.2 | % | |||||
Florida | 2160 | 524,716 | 424,259 | 145.3 | % | |||||
Georgia | 262 | 48,882 | 43,594 | 136.6 | % | |||||
Hawaii | 53 | 27,840 | 28,230 | 106.1 | % | |||||
Idaho | 33 | 7,829 | 7,177 | 132.2 | % | |||||
Illinois | 384 | 96,036 | 74,762 | 189.8 | % | |||||
Indiana | 260 | 32,532 | 29,420 | 123.5 | % | |||||
Iowa | 26 | 2,252 | 2,340 | 108.1 | % | |||||
Kansas | 26 | 2,801 | 3,120 | 114.5 | % | |||||
Kentucky | 53 | 6,212 | 5,713 | 118.0 | % | |||||
Louisiana | 38 | 6,503 | 7,101 | 103.2 | % | |||||
Maine | 38 | 7,097 | 6,763 | 118.8 | % | |||||
Maryland | 633 | 169,408 | 137,391 | 145.8 | % | |||||
Massachusetts | 278 | 75,893 | 75,426 | 118.1 | % | |||||
Michigan | 98 | 15,324 | 14,290 | 165.2 | % | |||||
Minnesota | 42 | 9,486 | 8,756 | 127.3 | % | |||||
Mississippi | 27 | 3,150 | 3,029 | 124.7 | % | |||||
Missouri | 80 | 8,162 | 6,864 | 166.2 | % | |||||
Montana | 4 | 1,121 | 1,266 | 89.3 | % | |||||
Nebraska | 7 | 730 | 682 | 111.1 | % | |||||
Nevada | 233 | 73,771 | 56,805 | 146.3 | % | |||||
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New Hampshire | 13 | 3,319 | 3,403 | 103.4 | % | |||||
New Jersey | 1071 | 319,960 | 250,254 | 158.6 | % | |||||
New Mexico | 125 | 17,614 | 17,709 | 110.6 | % | |||||
New York | 732 | 251,483 | 255,943 | 116.0 | % | |||||
North Carolina | 238 | 32,958 | 29,870 | 128.8 | % | |||||
North Dakota | 1 | 123 | 140 | 87.9 | % | |||||
Ohio | 128 | 19,036 | 16,362 | 148.5 | % | |||||
Oklahoma | 34 | 4,377 | 4,466 | 134.8 | % | |||||
Oregon | 106 | 31,002 | 28,906 | 116.2 | % | |||||
Pennsylvania | 288 | 51,698 | 43,952 | 139.6 | % | |||||
Puerto Rico | 2 | 219 | 293 | 76.3 | % | |||||
Rhode Island | 58 | 13,716 | 7,447 | 229.3 | % | |||||
South Carolina | 216 | 39,907 | 34,301 | 128.7 | % | |||||
South Dakota | 3 | 396 | 325 | 132.0 | % | |||||
Tennessee | 83 | 12,257 | 12,695 | 117.7 | % | |||||
Texas | 459 | 53,508 | 71,055 | 88.2 | % | |||||
Utah | 66 | 15,399 | 15,804 | 103.3 | % | |||||
Vermont | 9 | 1,452 | 1,336 | 133.4 | % | |||||
Virginia | 149 | 47,771 | 46,745 | 113.4 | % | |||||
Washington | 482 | 131,475 | 127,470 | 115.8 | % | |||||
West Virginia | 8 | 1,009 | 827 | 135.2 | % | |||||
Wisconsin | 65 | 9,740 | 7,479 | 160.0 | % | |||||
Total mortgage loans | 10,963 | $ | 2,935,961 | $ | 2,693,525 | 131.6 | % | |||
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(1) | Market value is based on the most recent BPO provided to Residential by the applicable seller for each property in the respective portfolio as of its cut-off date or an updated BPO received since the acquisition was completed. Although Residential performed diligence on a representative sample of the properties to confirm the accuracy of the BPOs provided by the sellers, we cannot assure you that the BPOs set forth in this table accurately reflected the actual market value of the related property at the purported time or accurately reflect such market value today. |
(2) | Weighted average loan to value (LTV) is based on the loan to value weighted by unpaid principal balance for each state. |
As of December 31, 2014, the 15 states with the highest concentration of loans accounted for 8,724 loans (80% of our Existing Portfolio), with an aggregate UPB of $2.5 billion (87% of our Existing Portfolio) as of the respective cut-off dates, with the remainder dispersed among 34 other states, one territory and the District of Columbia.
As set forth in the chart below, approximately 93% of the residential mortgage loans in Residential's Existing Portfolio were 60 days or more delinquent as of December 31, 2014.
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Residential's Strengths
Depth of Management Experience in Mortgage Servicing
We believe the experience of our management team allows Residential to capitalize on the servicing capabilities of third party servicers to cost effectively service Residential's acquired residential mortgage loan portfolios. We have directed and will continue to direct Residential's mortgage servicers to employ various loan resolution methodologies with respect to Residential's mortgage loans, including loan modification, collateral resolution and collateral disposition. To help Residential achieve its business objective, we instruct the mortgage servicers to focus on (1) converting a portion of Residential's sub-performing and non-performing loans to performing status and (2) managing the foreclosure process and timelines with respect to the remainder of those loans.
Importantly, by modifying as many loans as possible, we seek to keep more families in their homes because of our efforts.
Through 2014, Residential had exclusively engaged Ocwen to service the residential mortgage loans in its portfolio. Given the recent challenges and regulatory scrutiny faced by Ocwen, through our connections and experience, Residential has engaged additional alternate servicers to service Residential’s loans. Residential has begun to move certain loans to these new servicers to diversify its servicing options. However, a substantial number of the loans Residential owns continue to be serviced by Ocwen. It is possible, even as Residential transfers all or a portion of its mortgage loan portfolio to such other servicers, the alternate servicers may not be able to service our loans or resolve our non-performing loans as well as Ocwen has serviced our portfolio. In any event, if for any reason Residential's mortgage servicers, including Ocwen, are unable to service these loans at the level and/or the cost that Residential anticipates, or if Residential fails to pay or otherwise defaults under the servicing agreements, causing one or more mortgage servicers cease to act as its servicer, alternate qualified servicers may not be readily available on favorable terms, or at all, which could have a material adverse effect on Residential.
Relationship with Altisource and its Nationwide Property Management Infrastructure
We believe that Residential is strategically positioned to operate single-family rental properties across the United States at an attractive cost structure, with the support of Altisource’s nationwide vendor network, which provides services in 208 major markets across the United States.
In 2014, Altisource's vendor network completed an average of approximately 400,000 inspection, maintenance and repair orders per month. This vendor network infrastructure has been developed over many years and we believe this infrastructure would be difficult and expensive for our competitors and/or new market participants to replicate. We believe, therefore, that Residential's existing relationships with Altisource and its vendor network, as described above in “-Access to Established Nationwide Property Management Infrastructure,” gives it a distinct advantage as it allows us to bid on large attractive portfolios regardless of geography at an attractive cost structure. We also believe that our established relationships with the Altisource network management team and our ongoing experience with the service providers in Altisource’s vendor network who know our renovation, maintenance and repair standards would likely provide us with an advantage over others in replicating and/or acquiring this nationwide property management infrastructure for Residential, if necessary.
Other Services Provided by Altisource
In addition to the Altisource master services agreement, Residential also has a trademark license agreement with Altisource that provides it with a non-exclusive, non-transferable, non-sublicensable, royalty free license to use the name “Altisource.” Residential also has a support services agreement with Altisource to provide services to it in such areas as human resources, vendor management operations, corporate services, risk management, quality assurance, consumer psychology, treasury, finance and accounting, legal, tax and compliance. Although the support services agreement has enabled us to grow Residential's and our respective businesses, we are in the process of internalizing the support services that had been provided to us by Altisource through our direct employment of the 26 employees that currently are providing these services to us through the support services agreement.
Residential's Investment Process
The underwriting analysis for acquiring sub-performing and non-performing loan portfolios on a national basis relies on extensive analysis of the target portfolio’s characteristics and the use of our proprietary model in determining future cash flows and returns from various resolution methodologies. We estimate Residential's resolution timelines using advanced modeling techniques. We use regression-based models to determine the expected probabilities of different loan resolutions, including
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modification, rental and liquidation. We also use an extensive due diligence process to validate data accuracy, compliance with laws, and enforceability of liens among other factors.
The following graphic outlines the process for assessing sub-performing and non-performing portfolio investment opportunities:
Residential's Financing Strategy
Residential intends to continue to finance its investments with leverage, 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 facilitate Residential's capital raising activities through public or private offerings of Residential's debt or equity securities, depending upon market conditions. For additional information on Residential's financing arrangements, see “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations–Liquidity and Capital Resources.”
Investment Committee and Investment Policy
We conduct substantially all of the investment activities on behalf of Residential pursuant to the asset management agreement.
Residential’s Board of Directors has adopted a broad investment policy designed to facilitate our management of Residential’s capital and assets and our maintenance of an investment portfolio profile that meets Residential’s objectives. We report to Residential’s investment committee, whose role is to act in accordance with the investment policy and guidelines approved by Residential’s Board of Directors for the investment of its capital. As part of an overall investment portfolio strategy, the investment policy provides that we can facilitate Residential’s purchase or sale of non-performing or sub-performing residential mortgage loans, residential mortgage backed securities and real estate owned assets. We are also authorized, on behalf of Residential, to offer leases on acquired single-family residential real estate. The investment policy may be modified by Residential’s Board of Directors without the approval of our stockholders.
The objective of Residential’s investment policy is to oversee our efforts to achieve a return on assets consistent with Residential’s business objective and to maintain adequate liquidity to meet Residential’s financial covenants and regular cash requirements.
The investment committee is authorized to approve the financing of Residential’s investment positions through repurchase agreements, warehouse lines of credit, securitized debt and other financing arrangements provided such agreements are negotiated with counterparties approved by the investment committee. We are also permitted to hedge Residential’s interest rate exposure on its financing activities through the use of interest rate swaps, forwards, futures and options, subject to prior approval from Residential’s investment committee.
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Investment Committee Approval of Counterparties
Residential’s investment committee is authorized to consider and approve, based on our recommendations:
• | the financial soundness of institutions with which Residential plans to transact business and recommendations with respect thereto; |
• | Residential’s risk exposure limits with respect to the dollar amounts of total exposure with a given institution; and |
• | investment accounts and trading accounts to be opened with banks, broker-dealers and financial institutions. |
Investment Committee Guidelines
The activities of Residential’s investment committee are subject to the following guidelines, which we must follow in making recommendations to the investment committee:
• | no investment will be made that would cause Residential or any of its subsidiaries to fail to qualify as a REIT for U.S. federal income tax purposes; |
• | no investment will be made that would cause Residential to be required to register as an investment company under the Investment Company Act of 1940; and |
• | until appropriate investments can be identified, Residential may invest available cash in interest-bearing and short-term investments that are consistent with (a) Residential’s intention to qualify as a REIT and (b) Residential’s exemption from registration as an investment company under the Investment Company Act of 1940. |
Broad Investment Policy Risks
Residential's investment policy is very broad and, therefore, its investment committee and we have great latitude in determining the types of assets that are proper investment for Residential, as well as the individual investment decisions. In the future, we may make investments with lower rates of return than those anticipated under current market conditions and/or may make investments with greater risks to achieve those anticipated returns. Residential's Board of Directors will periodically review its investment policy and its investment portfolio but will not review or approve each proposed investment made by us unless it falls outside our previously approved investment policy or constitutes a related party transaction.
In addition, in conducting periodic reviews, Residential's Board of Directors will rely primarily on information provided to it by us. Furthermore, we may use complex strategies. Transactions entered into by us on behalf of Residential may be costly, difficult or impossible to unwind by the time they are reviewed by Residential's Board of Directors. Changes in Residential's investment strategy, investment policy and targeted asset classes may increase its exposure to interest rate risk, counterparty risk, default risk and real estate market fluctuations, which could materially and adversely affect Residential and, in turn, could adversely affect the incentive management fees we earn under our asset management agreement.
NewSource Investment
On December 21, 2012, we entered into a subscription agreement to invest $2.0 million in 100% of the voting common stock of NewSource Reinsurance Company Ltd., which we refer to as “NewSource,” an insurance and reinsurance company focused on real estate related insurance products in Bermuda. Residential simultaneously entered into a subscription agreement to invest $18.0 million to acquire non-voting preferred stock of NewSource. On October 17, 2013, we and Residential invested the full amount of our respective subscriptions in NewSource, and on December 2, 2013, NewSource became registered as a licensed reinsurer with the Bermuda Monetary Authority (“BMA”).
Additionally, on November 18, 2013, NewSource entered into a management agreement with us to provide asset management and corporate governance services for an aggregate annual management fee of $840,000, and in November 2013, NewSource entered into a management agreement with Marsh IAS Management Services (Bermuda) Ltd. to administer its day-to-day business activities and operations.
NewSource commenced reinsurance activities during the second quarter of 2014, and generated approximately $5.0 million of title reinsurance premiums during 2014. However, in December 2014, NewSource determined that the economics of the initial business activities did not warrant the continuation of its initial reinsurance quota share agreement with an unrelated third party. NewSource therefore transferred all of the risk of claims and future losses underwritten to an unrelated third party for a price of $3.2 million.
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NewSource is continuing to evaluate its real estate related insurance and reinsurance strategy and considering related opportunities. There is no assurance that NewSource will be able to develop or grow its business strategy or operations, or engage in insurance and reinsurance activities at all..
Employees
As of December 31, 2014, we had nine full time employees and had an additional 26 dedicated support personnel provided to us by Altisource through its support services agreement with us. Our executive officers are also officers of Residential.
Service Providers
We have entered into a support services agreement with Altisource, which we refer to as the “Altisource support services agreements,” to provide, as necessary, services to us in such areas as human resources, vendor management operations, corporate services, risk management and six sigma, quality assurance, consumer psychology, treasury, finance and accounting, legal, tax, compliance and other support services. In addition, we have entered into trademark license agreements with Altisource that provides us with non-exclusive, non-transferable, non-sublicensable, royalty free license to use the name “Altisource.” We also entered into a technology services agreement with Altisource pursuant to which Altisource provides us with technology support services for network management and telephony.
Our Competition
We are in a highly competitive market and are competing with other asset managers. Our competitors may have greater resources, more personnel, more clients, more sources of revenue and more capital than we do. Our clients may not perform as well as the clients of our competitors. Some of our competitors' clients may have significant amounts of capital, lower cost of capital or access to funding sources not available to our client. Additionally, our competitors and competitors' clients may have higher risk tolerances or may be willing to accept lower returns on investment. Some of our competitors may have better expertise or be regarded by potential clients as having better expertise to specific assets.
Residential's Competition
Residential faces competition from various sources for the acquisition of sub-performing and non-performing residential mortgage loans. Its competition includes other REITs, hedge funds, private equity funds and partnerships. To effectively compete, Residential will rely upon our management team and their substantial industry expertise which we believe provides Residential with a competitive advantage and helps it assess the investment risks and determine appropriate pricing. We expect Residential's integrated approach of acquiring sub-performing and non-performing residential mortgage loans and converting them to rental properties will enable it to compete more effectively for attractive investment opportunities. However, we cannot assure you that Residential will be able to achieve its business goals or expectations due to the competitive, pricing and other risks that it faces. Residential's competitors may have greater resources and access to capital and higher risk tolerances than it has, may be able to pay higher prices for sub-performing and non-performing residential mortgage loans than it can or may be willing to accept lower returns on investment. As the inventory of available sub-performing and non-performing residential mortgage loans and REO will fluctuate, the competition for assets and financing may increase.
Residential also faces significant competition in the single-family rental market from other real-estate companies, including REITs, investment companies, partnerships and developers. To effectively manage rental yield and occupancy levels, Residential will rely upon the ability of our management team to supervise the renovation, yield management, and property management services on its acquired properties. Despite these efforts, some of Residential's competitors' single-family rental properties may be of better quality, or in more desirable locations than its properties or have leasing terms more favorable than it offers. In addition, Residential's ability to compete and meet its return objectives depends upon, among other factors, trends of the national and local economies, the financial condition and liquidity of current and prospective tenants, availability and cost of capital, taxes and governmental regulations. Given the significant competition, complexity of the market, changing financial and economic conditions and evolving single-family tenant demographics and demands, we cannot assure you that Residential will be successful in acquiring or managing single-family rental properties that satisfy its return objectives.
Environmental Matters
As an owner of real estate, Residential is subject to various federal, state and local environmental laws, regulations and ordinances and also could be liable to third parties resulting from environmental contamination or noncompliance with
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environmental laws at its properties. We are tasked with monitoring these laws, regulations and ordinances for Residential. Environmental laws can impose liability on an owner or operator of real property for the investigation and remediation of contamination at or migrating from such real property without regard to whether the owner or operator knew of or was responsible for the presence of the contaminants. The costs of any required investigation or cleanup of these substances could be substantial. The liability is generally not limited under such laws and could exceed the property's value and the aggregate assets of the liable party. The presence of contamination or the failure to remediate contamination at Residential's properties also may expose it to third-party liability for personal injury or property damage or adversely affect Residential's ability to sell, lease or renovate the real estate or to borrow using the real estate as collateral. These and other risks related to environmental matters are described in more detail in “Item 1A. Risk Factors.”
Government Approval
Outside of routine business filings, we do not believe it is necessary to obtain any government approval to operate our business.
Governmental Regulations
We do not believe there are any governmental regulations that will materially affect the conduct of our business.
Available Information
We file Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and other information with the Securities and Exchange Commission which we refer to as the “SEC.” These filings are available to the public over the Internet at the SEC's website at http://www.sec.gov. You may also read and copy any document we file at the SEC's public reference room located at 100 F Street, N.E., Washington, DC 20549. Please call the SEC at 1 800-SEC-0330 for further information on the public reference room.
Our principal Internet address is http://www.altisourceamc.com, and we encourage investors to use it as a way of easily finding information about us. We promptly make available on this website, free of charge, the reports that we file with or furnish to the SEC along with corporate governance information including our Corporate Governance Guidelines, our Code of Business Conduct and Ethics and select press releases. The contents of our website are available for informational purposes only and shall not be deemed incorporated by reference in this report.
Item 1A. Risk Factors
The following risk factors and other information included in this Annual Report on Form 10-K should be carefully considered. We consider the risks faced by Residential to be our risks because we rely on the performance of Residential to determine our incentive management fee payments and result of operations. If any of the following risks actually occur, our business, operating results and financial condition could be materially adversely affected.
Risks Related to Our Business
We have a limited operating history. If we are unable to implement our business strategy as planned, we will be materially and adversely affected.
We commenced operations approximately two years ago, and our business model is relatively untested and evolving. Businesses like ours that have a limited operating history present substantial business and financial risks and may suffer significant losses. As a result we cannot predict our results of operations, financial condition and cash flows. Our results for prior periods are not necessarily indicative of our results for any future period, and we may not have sufficient additional capital to implement our business model. There can be no assurance that our business will remain profitable or that it will be sustainable. The earnings potential of our proposed business is unproven, and the absence of an operating history makes it difficult to evaluate our prospects. We may not be able to implement our business strategy as planned, which could materially and adversely affect us.
Residential is our primary client and we are primarily reliant on Residential to generate our revenues. A loss of Residential as a client and/or our inability to obtain or develop new clients would materially adversely affect us.
Residential currently is our primary customer. The loss of this key customer or its failure to pay us would adversely affect our revenues, results of operations and financial condition. Despite Residential’s or our efforts, Residential may fail to substantially
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grow or have adverse financial performance for a number of reasons including, without limitation, failure to maintain adequate liquidity, an inability to grow through equity offerings and/or debt facilities, generation if poor or inadequate returns, or an inability to, or substantial delays in growing or monetizing its portfolio. Residential is entitled to terminate the asset management agreement without cause upon the determination of at least two-thirds of its independent directors that (i) there has been unsatisfactory performance by us that is materially detrimental to Residential, or (ii) the compensation payable to us under the asset management agreement is unreasonable, unless we agree to amend our compensation by an amount or in a manner that at least two-thirds of Residential's independent directors determine is reasonable. If the asset management agreement were terminated by Residential, even if a termination fee is payable to us (see “Item 1. Business. Asset Management Agreement-Termination”), our financial position and future prospects for revenues and growth would be materially adversely affected.
We may not be able to obtain or develop additional clients on acceptable terms or at all. Our ability to attract, develop and/or maintain additional clients may depend, in large part, on the success of Residential under our management and our ability to continue to develop and implement Residential’s business plan profitably and enable Residential to maintain and grow its shareholder returns and dividends. We may be unable to reduce our reliance on Residential for incentive management fees and our failure to do so could materially adversely affect our results of operation and financial condition and could adversely affect our ability to attract additional clients and the sustainability of our business model.
The success of our business is dependent on Residential and its ongoing access to sufficient and cost-effective sources of capital.
Residential commenced operations approximately two years ago and may require additional working capital to implement its investment strategies. Residential may need to utilize a variety of funding sources to provide sufficient capital to effectively carry out its business plan over the long-term. We will have significant responsibilities in advising Residential on its capital raising activities. Our success is dependent on Residential's ability to obtain such capital. Residential utilizes various sources of liquidity including without limitation accessing the capital markets to issue debt or equity securities, engaging in collateralized or other borrowings including repurchase agreements and warehouse facilities from third party banks or entering into securitization transactions, all or any of which may not be available or have terms that are not cost-effective, therefore having an adverse impact on Residential's financial performance. Residential currently is our primary customer. The loss of this key customer or its failure to pay us would adversely affect our revenues, results of operation, financial condition. We may not be able to obtain additional clients on acceptable terms or at all. Therefore, we may be unable to reduce our reliance on Residential for incentive management fees.
The asset management business is intensely competitive.
The asset management business is intensely competitive, driven by a variety of factors including asset performance, the quality of service provided to clients, brand recognition and business reputation. Our asset management business competes with a number of other asset managers. A number of factors serve to increase our competitive risks:
• | a number of our competitors may have greater financial, technical, marketing and other resources and more personnel than we do; |
• | our clients may not perform as well as the clients of our competitors; |
• | several of our competitors and their clients have significant amounts of capital and many of them have similar management objectives to ours which may create additional competition for management opportunities; |
• | some of these competitors' clients may also have a lower cost of capital and access to funding sources that are not available to our clients which may create competitive disadvantages for us with respect to funding opportunities; |
• | some of our competitors' clients may have higher risk tolerances, different risk assessments or lower return thresholds which could allow them to facilitate the acquisition and management by their clients of a wider variety of assets and allow them to advise their clients to bid more aggressively than our clients for assets on which we would advise our clients to bid; |
• | there are relatively few barriers to entry impeding new asset management firms, and the successful efforts of new entrants into the asset management business is expected to continue to result in increased competition; |
• | some of our competitors may have better expertise or be regarded by potential clients as having better expertise with regard to specific assets and |
• | other industry participants will from time to time seek to recruit members of our management team and other employees away from us. |
Our accounting and other management systems and resources may not be adequately prepared to meet the financial reporting and other requirements to which we will be subject following the separation date.
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We are directly subject to reporting and other obligations under the Exchange Act. Under the Sarbanes-Oxley Act, we are required to maintain effective disclosure controls and procedures. To comply with these requirements, we may need to implement additional financial and management controls, reporting systems and procedures and hire additional accounting and finance staff. We have and expect to incur additional annual expenses for the purpose of addressing these requirements, and these expenses may be significant. If we are unable to implement additional controls, reporting systems, information technology systems and procedures in a timely and effective fashion, our ability to comply with our financial reporting requirements and other rules that apply to reporting companies under the Exchange Act could be impaired. Any failure to achieve and maintain effective internal controls could have a material adverse effect on our financial condition, results of operations or cash flows. In the future, we may also be required to comply with Section 404 of the Sarbanes-Oxley Act which will require annual management assessments of the effectiveness of our internal controls over financial reporting and will require a report by our independent registered public accounting firm addressing these assessments. These reporting and other obligations may place significant demands on our management, administrative and operational resources, including accounting systems and resources.
Our success depends on our senior management team, and if we are not able to retain them, it could have a material adverse effect on us.
We are highly dependent upon the continued services and experience of our senior management team. We depend on the services of members of our senior management team to, among other things, continue the development and implementation of our growth strategies and maintain and develop our client relationships. In the event that, for any reason, we are unable to retain our key personnel, it may be difficult for us to secure suitable replacements on acceptable terms. This would adversely impact the development and implementation of our growth strategies.
The continuing unpredictability of the credit markets may restrict our access to capital and may make it difficult or impossible for us to obtain any required additional financing.
The domestic and international credit markets continue to be unpredictable. In the event that we need additional capital for our business, we may have a difficult time obtaining it and/or the terms upon which we can obtain it would have an adverse impact on our financial performance.
Our business could be significantly impacted if we suffer failure or disruptions of our information systems.
We rely heavily on communications, data processing and other information processing systems to conduct our business and support our day-to-day activities, most services of which are provided through Altisource. Thus, our business requires the continued operation of Altisource's sophisticated information technology systems and network infrastructure. These systems are vulnerable to interruption by fire, loss, system malfunction and other events which are beyond our control. Systems interruptions could reduce our ability to provide our services and could have an adverse effect on our operations and financial performance.
Failure to retain the tax benefits provided by the United States Virgin Islands would adversely affect our financial performance.
We are incorporated under the laws of the United States Virgin Islands and are headquartered in Frederiksted, in the United States Virgin Islands. The United States Virgin Islands has an Economic Development Commission, which we refer to as the “EDC,” that provides benefits, which we refer to as “EDC Benefits,” to certain qualified businesses in Frederiksted that enable us to avail ourselves of significant tax benefits for a thirty year period. We received our certificate to operate as a company that qualifies for EDC Benefits as of February 1, 2013, which provides us with a 90% credit on our taxes so long as we comply with the requirements of the EDC and our certificate of benefits. It is possible that we may not be able to retain our qualifications for the EDC Benefits or that changes in U.S. federal, state, local, territorial or United States Virgin Islands taxation statutes or applicable regulations may cause a reduction in or an elimination of the EDC Benefits, all of which could result in a significant increase to our tax expense, and, therefore, adversely affect our financial condition and results of operations.
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We may be subject to United States federal income taxation.
We are incorporated under the laws of the United States Virgin Islands and intend to operate in a manner that will cause us to be treated as not engaging in a trade or business within the United States which will cause us to be exempt from current United States federal income taxation on our net income. However, because there are no definitive standards provided by the Code, regulations or court decisions as to the specific activities that constitute being engaged in the conduct of a trade or business within the United States, and as any such determination is essentially factual in nature, we cannot assure you that the IRS will not successfully assert that we are engaged in a trade or business within the United States.
If the IRS were to successfully assert that we have been engaged in a trade or business within the United States in any taxable year, various adverse tax consequences could result including the following:
• | we may become subject to current United States federal income taxation on our net income from sources within the United States; |
• | we may be subject to United States federal income tax on a portion of our net investment income, regardless of its source; |
• | we may not be entitled to deduct certain expenses that would otherwise be deductible from the income subject to United States taxation and |
• | we may be subject to United States branch profits tax on profits deemed to have been distributed out of the United States. |
United States persons who own shares may be subject to United States federal income taxation on our undistributed earnings and may recognize ordinary income upon disposition of shares.
Significant potential adverse United States federal income tax consequences generally apply to any United States person who owns shares in a passive foreign investment company which we refer to as a “PFIC.” We cannot provide assurance that we will not be a PFIC in any future taxable year.
In general, we would be a PFIC for a taxable year if either (i) 75% or more of its income constitutes “passive income” or (ii) 50% or more of our assets produce “passive income.” Passive income generally includes interest, dividends and other investment income. We believe that we are currently operating and intend to continue operating our business in a way that should not cause us to be a deemed PFIC, although we cannot assure you the IRS will not successfully challenge this conclusion.
United States persons who, directly or indirectly or through attribution rules, own 10% or more of our shares which we refer to as United States 10% shareholders, may be subject to the controlled foreign corporation, which we refer to as “CFC,” rules. Under the CFC rules, each United States 10% shareholder must annually include his pro rata share of the CFC's “subpart F income,” even if no distributions are made. In general, with respect to insurance revenues related to NewSource, we will be treated as a CFC only if United States 10% shareholders collectively own more than 25% of the total combined voting power or total value of our shares for an uninterrupted period of 30 days or more during any year. With respect to all other revenues, we will be treated as a CFC only if United States 10% shareholders collectively own more than 50% of the total combined voting power or total value of our shares for an uninterrupted period of 30 days or more during any year. We believe that the dispersion of our ordinary shares among holders will generally prevent shareholders who acquire shares from being United States 10% shareholders. We cannot assure you, however, that these rules will not apply to you. If you are a United States person, we strongly urge you to consult your own tax adviser concerning the CFC rules.
United States tax-exempt organizations who own shares may recognize unrelated business taxable income.
If you are a United States tax-exempt organization you may recognize unrelated business taxable income with respect to our insurance-related income if a portion of our subpart F income is allocated to you. In general, subpart F income will be allocated to you if we are a CFC and you are a United States 10% shareholder and certain exceptions do not apply. In general, with respect to insurance revenues related to NewSource, we will be treated as a CFC only if United States 10% shareholders collectively own more than 25% of the total combined voting power or total value of our shares for an uninterrupted period of 30 days or more during any year. Although we do not believe that any United States persons will be allocated subpart F income, we cannot assure you that this will be the case. If you are a United States tax-exempt organization, we advise you to consult your own tax adviser regarding the risk of recognizing unrelated business taxable income.
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Change in United States tax laws may be retroactive and could subject us, and/or United States persons who own shares to United States income taxation on our undistributed earnings.
The tax laws and interpretations regarding whether we are engaged in a United States trade or business, are a CFC or a PFIC are subject to change, possibly on a retroactive basis. New regulations or pronouncements interpreting or clarifying such rules may be forthcoming from the IRS. We are not able to predict if, when or in what form such guidance will be provided and whether such guidance will have a retroactive effect.
The impact of the initiative of the Organization for Economic Cooperation and Development to eliminate harmful tax practices is uncertain and could adversely affect our tax status in the United States Virgin Islands.
The Organization for Economic Cooperation and Development has published reports and launched a global dialogue among member and non-member countries on measures to limit harmful tax competition. These measures are largely directed at counteracting the effects of tax havens and preferential tax regimes in countries around the world. While the United States Virgin Islands is currently a jurisdiction that has substantially implemented internationally agreed tax standards, we are not able to predict if additional requirements will be imposed and if so whether changes arising from such additional requirements will subject us to additional taxes.
Risks to Us Related to Residential’s Business Risks and Operating Performance
Initially, Residential is our primary source of revenue and will drive our potential future growth. Any risk associated with Residential's business that would adversely affect its ability to generate revenue and pay distributions to its shareholders is a risk to our business, as our revenues, results of operations and financial condition significantly depend upon the incentive management fees paid to us as a percentage of Residential's cash available for distribution to its shareholders. Any risk that ultimately adversely affects Residential would adversely affect the revenues we can generate, as well as our results of operations and financial condition. The risks related to Residential’s business are provided below.
Residential has a limited operating history. If Residential is unable to implement its business strategy as planned, it will be materially and adversely affected.
Residential commenced operations approximately two years ago and its business model is relatively untested. Businesses like Residential’s that have a limited operating history present substantial business and financial risks and may suffer significant losses. As a result we cannot predict Residential’s results of operations, financial condition and cash flows that would be generated in incentive management fees. Residential generated a nominal amount of residential rental revenue for the year ended December 31, 2013. Residential’s results for prior periods are not necessarily indicative of its results for any future period. In addition, we may not have sufficient additional capital to implement our business model. Moreover, we expect that it will take time to determine success from Residential’s loan resolution efforts and it could take as long as 24 months, and in some cases longer, for a significant portion of loans in any given portfolio to be converted into single-family rental properties or an underlying property to be liquidated or sold. Accordingly, if Residential is not able to generate sufficient cash flows from its loan modification and refinancing or other activities, it may not have cash available for distribution to its stockholders for an extended period of time, which would limit or prevent us from earning incentive management fees. There can be no assurance that Residential’s business will remain profitable or that its profitability will be sustainable. The earnings potential of Residential’s business is unproven, and its limited operating history makes it difficult to evaluate its prospects. Residential may not be able to implement its business strategy as planned, which could materially and adversely affect both Residential and us.
Residential is an early entrant in an emerging industry, and the long-term viability of its investment strategy on an institutional scale is unproven.
Large-scale institutional investment in single-family residential homes for rent is a relatively recent phenomenon that has emerged out of the mortgage and housing crisis that began in late 2007. Prior to that time, single-family rental homes were generally not viewed as viable assets for investment on a large scale by institutional investors. Consequently, the long-term viability of the single-family rental property investment strategy on an institutional scale has not yet been proven. As an early entrant in this emerging industry, Residential is subject to the risk that single-family rental properties may not prove to be a viable long-term investment strategy for a permanent capital vehicle on an institutional scale. If it turns out that this investment strategy is not a viable one, Residential would be materially and adversely affected and may not be able to sustain the growth of its assets and operations that it seeks, which could materially and adversely affect our results of operations and financial condition.
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Residential's failure to raise equity capital and/or obtain adequate debt financing could adversely affect its ability to increase its portfolio, manage its existing assets and generate shareholder returns.
Residential's success has been, and will be, largely dependent on its ability to raise equity capital and obtain debt financing to increase its portfolio, manage its existing assets and generate attractive shareholder returns. Residential requires significant financial resources to maintain its obligations under its debt facilities and to continue to acquire portfolios of mortgage loans and REO properties. If Residential is unable to continue to raise equity capital, or leverage its portfolio through repurchase facilities and/or securitizations, its current portfolio and cash from operations may become inadequate to meet its financial obligations.
Residential uses leverage as a component of its financing strategy in an effort to enhance its returns. We can provide no assurance that Residential will be able to timely access all funds available under its financing arrangements or obtain other debt or equity financing on favorable terms or at all. To qualify as a REIT, Residential will be required to distribute at least 90% of its REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gain, each year to its stockholders. As a result, Residential's ability to retain earnings to fund acquisitions, property renovations or other capital expenditures will be limited.
Limited availability of credit may have an adverse effect on Residential's ability to obtain financing on favorable terms, thereby increasing financing costs and/or requiring Residential to accept financing with increasing restrictions. Residential's long-term ability to grow through additional investments will be limited if it cannot obtain additional debt or equity financing, which could materially and adversely affect our ability to generate incentive management fees.
Residential may not be able to successfully operate its business or generate sufficient operating cash flows to make or sustain distributions to its stockholders.
There can be no assurance that Residential will be able to successfully operate its business or generate sufficient cash to make distributions to its stockholders. Residential's ability to make or sustain distributions to its stockholders depends on many factors, including the availability of attractive risk-adjusted investment opportunities that satisfy its investment strategy and its success in identifying and consummating such opportunities on favorable terms, the success of its loan resolution efforts, the ability of borrowers to refinance its loans with other lenders, its ability to sell modified loans on favorable terms, the availability of short-term and long-term financing on favorable terms, the length of time required to convert a distressed loan into a single-family rental property, the level and expected movement of home prices, the occupancy rates and rent levels of properties, the restoration, maintenance, marketing and other operating costs, the level and volatility of interest rates, conditions in the financial, real estate, housing and mortgage markets and the economy, as to which no assurance can be given. We cannot assure you that Residential will be able to make investments with attractive risk-adjusted returns or will not seek investments with greater risk to obtain the same level of returns or that the value of its investments in the future will not decline substantially. Existing and future government regulations may result in additional costs or delays, which could adversely affect the implementation of Residential's investment strategy, which could materially and adversely affect our results of operations and financial condition.
Residential has leveraged its investments and expects to continue to do so, which may materially and adversely affect its return on investments and may reduce cash available for distribution to Residential's stockholders.
To the extent available, we intend to continue to leverage Residential's investments through borrowings, the level of which may vary based on the particular characteristics of Residential's investment portfolio and on market conditions. We have leveraged certain of Residential's investments to date through its repurchase agreements. When Residential enters into any repurchase agreement, it sells securities or residential mortgage loans to lenders (i.e., repurchase agreement counterparties) and receives cash from the lenders. The lenders are obligated to resell the same assets back to Residential at the end of the term of the transaction. Because the cash Residential receives from the lender when it initially sells the assets to the lender is less than the value of those assets, if the lender defaults on its obligation to resell the same assets back to Residential, it could incur a loss on the transaction. In addition, repurchase agreements generally allow the counterparties, to varying degrees, to determine a new market value of the collateral to reflect current market conditions or for other reasons. If such counterparty determines that the value of the collateral has decreased, it may initiate a margin call and require Residential to either post additional collateral to cover such decrease or repay a portion of the outstanding borrowing. Should this occur, in order to obtain cash to satisfy a margin call, Residential may be required to liquidate assets at a disadvantageous time, which could cause it to incur further losses. In the event Residential is unable to satisfy a margin call, its counterparty may sell the collateral, which may result in significant losses to Residential. Residential's repurchase agreements generally require it to comply with various financial covenants, including those relating to tangible net worth, profitability and its ratio of total liabilities to tangible net worth, and
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to maintain minimum amounts of cash or cash equivalents sufficient to maintain a specified liquidity position. We expect any future repurchase agreements or other financing arrangements will have similar provisions. In the event that Residential is unable to satisfy these requirements, it could be forced to sell additional investments at a loss which could materially and adversely affect Residential.
Residential's repurchase agreements to finance sub-performing and non-performing loans are complex and difficult to manage. In part, this is due to the fact that the residential mortgage loan portfolios and single-family rental properties that will collateralize these repurchase agreements do not produce consistent cash flows and require specific activities to be performed at specific points in time in order to preserve value. Residential's inability to comply with the terms and conditions of these agreements could materially and adversely impact it. In addition, Residential's outstanding repurchase agreements contain, and we expect any future repurchase agreements will contain, events of default, including payment defaults, breaches of financial and other covenants and/or certain representations and warranties, cross-defaults, servicer termination events, guarantor defaults, bankruptcy or insolvency proceedings and other events of default customary for these types of agreements. The remedies for such events of default are also customary for these types of agreements and include the acceleration of the outstanding principal amount, requirements that Residential repurchase loans collateralizing the financing, the liquidation by the lender of the assets then subject to the agreements and the avoidance of other repurchase transactions with Residential. Because Residential's financing agreements will typically contain cross-default provisions, a default that occurs under any one agreement could allow the lenders under its other agreements to also declare a default. Any losses Residential incurs on its repurchase agreements could materially and adversely affect Residential.
Residential has utilized repurchase facilities and securitization transactions to finance its portfolio and may in the future utilize other sources of borrowings, including bank credit facilities, warehouse lines of credit and structured financing arrangements, among others, each of which has similar risks to repurchase agreement financing and securitizations, including, but not limited to, covenant compliance, events of default, acceleration and margin calls. The percentage of leverage Residential employs, which could increase substantially in the future, varies depending on assets in its portfolios, its available capital, its ability to obtain and access financing arrangements with lenders and the lenders’ and rating agencies’ estimate of the stability of its investment portfolio’s cash flow. There can be no assurance that new sources of financing will be available to Residential in the future or that existing sources of financing will continue to be available to it. Residential's governing documents contain no limitation on the amount of debt it may incur. Residential's return on investments and cash available for distribution to its stockholders may be reduced to the extent that changes in market conditions increase the cost of its financing relative to the income that can be derived from the investments acquired. Residential's debt service payments will reduce cash flow available for distribution to stockholders. Residential may not be able to meet its debt service obligations and, to the extent that it cannot, it risks the loss of some or all of its assets to foreclosure or sale to satisfy the obligations.
If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
If and when non-recourse long-term financing structures become available to Residential and are utilized, such structures expose it to risks which could result in losses to Residential.
Residential may use securitization and other non-recourse long-term financing for its investments if, and to the extent, available. In such structures, Residential's lenders typically have only a claim against the assets included in the securitizations rather than a general claim against Residential as an entity. Prior to any such financing, Residential seeks to finance its investments with relatively short-term facilities until a sufficient portfolio is accumulated. Conditions in the capital markets may make the issuance of any such securitization less attractive to Residential. While Residential intends to retain the unrated equity component of securitizations and, therefore, still have exposure to any investments included in such securitizations, its inability to enter into such securitizations may increase its overall exposure to risks associated with direct ownership of such investments, including the risk of default.
Residential's inability to refinance any short-term facilities would also increase its risk because borrowings thereunder would likely be recourse to it as an entity. If Residential is unable to obtain and renew short-term facilities or to consummate securitizations to finance its investments on a long-term basis, it may be required to seek other forms of potentially less attractive financing or to liquidate assets at an inopportune time or price, which could materially and adversely affect our ability to generate incentive management fees.
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Failure of Altisource to effectively perform its obligations under various agreements with Residential and us, including the master services agreement, could materially and adversely affect Residential.
Both Residential and we have engaged Altisource to provide services. If for any reason Altisource is unable to perform the services described under these agreements at the level and/or the cost that we anticipate, qualified alternate service providers may not be readily available on favorable terms, or at all, which could adversely affect our performance under the Residential asset management agreement. Altisource’s failure to perform the services under these agreements with Residential or us or our inability to retain qualified alternate service providers to replace and/or supplement Altisource could have a material adverse effect on us.
Failure of our third party mortgage servicers, including Ocwen, to effectively perform their servicing obligations under our servicing agreements could have an adverse effect on Residential.
Residential is contractually obligated to service the residential mortgage loans that it acquires. Residential does not have any employees, servicing platform, licenses or technical resources necessary to service its acquired loans. Consequently, Residential has engaged mortgage servicers to service the non-performing and sub-performing and non-performing loans it acquires. Through 2014, Residential had exclusively engaged Ocwen to service the residential mortgage loans in its portfolio.
Ocwen has been and is subject to a number of pending regulatory investigations, inquiries, requests for information and legal proceedings that could result in adverse regulatory or other actions against Ocwen. As a result of these various difficulties faced by Ocwen, its debt and servicer ratings have been downgraded. Given the recent challenges and regulatory scrutiny faced by Ocwen, through our connections and experience, Residential has engaged additional alternate servicers to service Residential’s loans. Residential has begun to move certain loans to these new servicers to diversify its servicing service providers. However, a substantial number of the loans Residential owns continue to be serviced by Ocwen. It is possible, even as Residential transfers all or a portion of its mortgage loan portfolio to such other servicers, the alternate servicers may not be able to service our loans or resolve our non-performing loans. If for any reason Residential's mortgage servicers, including Ocwen, are unable to service these loans at the level and/or the cost that Residential anticipates, or if Residential fails to pay or otherwise defaults under the servicing agreements, causing one or more mortgage servicers cease to act as its servicers, alternate servicers may not be readily available on favorable terms, or at all, which could have a material adverse effect on Residential.
Residential may incur significant costs in renovating its properties, and it may underestimate the costs or amount of time necessary to complete restorations.
Before renting a property, we perform a detailed assessment, with an on-site review of the property, to identify the scope of renovation to be completed. Beyond customary repairs, Residential may undertake improvements designed to optimize overall property appeal and increase the value of the property. We expect that nearly all of Residential's rental properties will require some level of renovation immediately upon their acquisition or in the future following expiration of a lease or otherwise. Residential may acquire properties that we plan to extensively renovate and restore. In addition, in order to reposition properties in the rental market, Residential will be required to make ongoing capital improvements and may need to perform significant renovations and repairs from time to time. Consequently, Residential is exposed to the risks inherent in property renovation, including potential cost overruns, increases in labor and materials costs, delays by contractors in completing work, delays in the timing of receiving necessary work permits and certificates of occupancy and poor workmanship. If our assumptions regarding the cost or timing of renovations across Residential's properties prove to be materially inaccurate, it may be more difficult or take significantly more time than anticipated to develop and grow its single-family rental portfolio, which could materially and adversely affect Residential. This could, in turn, materially and adversely affect our ability to generate incentive management fees.
Difficulties in selling REO properties and/or single-family rental properties could limit Residential's flexibility and/or harm its liquidity.
Federal tax laws may limit Residential's ability to earn a gain on the sale of its properties if it is found to have held or acquired the properties with the intent to resell, and this limitation may adversely affect its willingness to sell single-family rental properties under favorable conditions or if necessary for funding purposes. Residential typically contributes properties that will not meet its rental profile to its taxable REIT subsidiary in order to sell and generate gains or losses at the taxable REIT subsidiary upon such sales. In addition, Residential's REO properties that it intends to sell can at times be difficult to dispose of quickly or at favorable prices. These potential difficulties in selling real estate in Residential's markets may limit its ability to either sell properties that it deems unsuitable for rental or change or reduce the single-family rental properties in its portfolio
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promptly in response to changes in economic or other conditions. Residential's failure to sell or delays in selling its REO properties could potentially cause a strain on its liquidity, and it may be forced to reduce prices and/or continue to hold such REO properties without leverage, which could materially and adversely affect our ability to generate incentive management fees.
A significant portion of the residential mortgage loans that Residential acquires are, or may become, sub-performing or non-performing loans, which increases its risk of loss.
Residential acquires distressed residential mortgage loans where the borrower has failed to make timely payments of principal and/or interest. As part of the residential mortgage loan portfolios Residential purchases, it also may acquire performing loans that are or subsequently become sub-performing or non-performing. Under current market conditions, it is likely that many of these loans will have current loan-to-value ratios in excess of 100%, meaning the amount owed on the loan exceeds the value of the underlying real estate. Further, the borrowers on such loans may be in economic distress and/or may have become unemployed, bankrupt or otherwise unable or unwilling to make payments when due. Even though Residential typically pays less than the amount owed on these loans to acquire them, if actual results are different from its assumptions in determining the price for such loans, it may incur significant losses. There are no limits on the percentage of sub-performing or non-performing loans Residential may hold. Any loss Residential incurs may be significant and could materially and adversely affect it, which could materially and adversely affect our results of operations and financial condition.
Many of Residential's assets may be illiquid, and this lack of liquidity could significantly impede its ability to vary its portfolio in response to changes in economic and other conditions or to realize the value at which such assets are carried if it is required to dispose of them.
The distressed residential mortgage loans Residential acquires are generally illiquid. Illiquidity may result from the absence of an established market for the distressed residential mortgage loans, as well as legal or contractual restrictions on their resale, refinancing or other disposition. Such restrictions would interfere with subsequent sales of such loans or adversely affect the terms that could be obtained upon any disposition thereof, which could materially and adversely affect our results of operations and financial condition.
Residential mortgage loan modification and refinance programs, future legislative action, and other actions and changes may materially and adversely affect the supply of, value of and the returns on sub-performing and non-performing loans.
Residential's business model is dependent on the acquisition of a steady supply of sub-performing and nonperforming loans, the success of its loan modification and other resolution efforts and the conversion of a significant portion of those loans to REO. The number of sub-performing and non-performing loans available for purchase may be reduced by uncertainty in the lending industry and the governmental sector and/or as a result of general economic improvement. Lenders may choose to delay foreclosure proceedings, renegotiate interest rates or refinance loans for borrowers who face foreclosure. In recent years, the federal government has instituted a number of programs aimed at assisting at-risk homeowners and reducing the number of properties going into foreclosure or going into non-performing status.
For example, the U.S. Government, through the Federal Reserve, the Federal Housing Administration or “FHA” and the Federal Deposit Insurance Corporation or “FDIC” has implemented a number of federal programs designed to assist homeowners, including (i) the Home Affordable Modification Program or “HAMP”, which provides homeowners with assistance in avoiding defaults on residential mortgage loans, (ii) the Hope for Homeowners Program or “H4H Program”, which allows certain distressed borrowers to refinance their residential mortgage loans into FHA-insured loans in order to avoid residential mortgage loan foreclosures and (iii) the Home Affordable Refinance Program which allows borrowers who are current on their mortgage payments to refinance and reduce their monthly mortgage payments without new mortgage insurance, up to an unlimited loan-to-value ratio for fixed-rate mortgages. HAMP, the H4H Program and other loss mitigation programs may involve, among other things, the modification of residential mortgage loans to reduce the principal amount of the loans (through forbearance and/or forgiveness) and/or the rate of interest payable on the loans and/or to extend the payment terms of the loans. These loan modification programs, future legislative or regulatory actions including possible amendments to the bankruptcy laws which result in the modification of outstanding residential mortgage loans as well as changes in the requirements necessary to qualify for refinancing residential mortgage loans, may materially and adversely affect the value of, and the returns on, Residential's portfolio of sub-performing and non-performing loans.
Other governmental actions may affect Residential's business by hindering the pace of foreclosures. In recent periods, there has been a backlog of foreclosures, due to a combination of volume constraints and legal actions, including those brought by the U.S. Department of Justice, or the “DOJ,” HUD, State Attorneys General, the office of the Comptroller of the Currency, or the
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“OCC,” and the Federal Reserve Board against mortgage servicers alleging wrongful foreclosure practices. Financial institutions have also been subjected to regulatory restrictions and limitations on foreclosure activity by the FDIC. Legal claims brought or threatened by the DOJ, HUD and 49 State Attorneys General against residential mortgage servicers and an enforcement action threatened by the OCC against residential mortgage servicers have both produced large settlements. A portion of the funds from each settlement will be directed to homeowners seeking to avoid foreclosure through mortgage modifications, and servicers are required to adopt specified measures to reduce mortgage obligations in certain situations. It is expected that the settlements will help many homeowners avoid foreclosures that would otherwise have occurred in the near-term. It is also possible that other residential mortgage servicers will agree to similar settlements. These developments will reduce the number of homes in the process of foreclosure and decrease the supply of properties that meet Residential's investment criteria.
In addition, the U.S. Congress and numerous state legislatures have considered, proposed or adopted legislation to constrain foreclosures, or may do so in the future. The Dodd-Frank Act also created the Consumer Financial Protection Bureau, or “CFPB,” which supervises and enforces federal consumer protection laws as they apply to banks, credit unions and other financial companies, including mortgage servicers. It remains uncertain as to whether any of these CFPB or other related
measures will have a significant impact on foreclosure volumes or what the timing or extent of that impact would be. If foreclosure volumes were to decline significantly, Residential may experience difficulty in finding target assets at attractive prices, which would materially and adversely affect Residential. Also, the number of families seeking rental housing might be reduced by such legislation, reducing rental housing demand for properties in Residential's markets.
Residential may be, or may become, subject to the regulation of various states, including licensing requirements and consumer protection statutes. Residential's failure to comply with any such laws, if applicable to it, would adversely affect its ability to implement its business strategy, which could materially and adversely affect Residential. If these risks are realized by Residential, our ability to generate incentive management fees would be harmed and our results of operations and financial condition could be materially and adversely affected.
Certain jurisdictions require licenses to purchase, hold, enforce or sell residential mortgage loans. In the event that any such licensing requirement is applicable and Residential is not able to obtain such licenses in a timely manner or at all, its ability to implement its business strategy could be adversely affected, which could materially and adversely affect Residential.
Certain jurisdictions require a license to purchase, hold, enforce or sell residential mortgage loans. Residential currently owns its loans in Delaware statutory trusts with a nationally-chartered bank as the trustee. Therefore, it does not hold any such licenses. Because Residential has contributed its acquired sub-performing and non-performing residential mortgage loans to wholly-owned trusts whose trustee is a nationally-chartered bank, it may be exempt from state licensing requirements. However, there is no assurance that Residential will ever seek or be required to obtain such licenses or, if obtained, that it will be able to maintain them. Residential's failure to obtain or maintain such licenses could restrict its ability to invest in loans in these jurisdictions if such licensing requirements become applicable. If Residential's subsidiaries obtain the required licenses, any trust holding loans in the applicable jurisdictions may transfer such loans to such subsidiaries, resulting in these loans being held by a state-licensed entity. There can be no assurance that Residential will be able to obtain the requisite licenses in a timely manner or at all or in all necessary jurisdictions, or that the use of the trusts will reduce the requirement for licensing, any of which could limit its ability to invest in residential mortgage loans in the future and have a material adverse effect on Residential. If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
The supply of sub-performing and non-performing loans may decline over time as a result of higher credit standards for new loans and/or general economic improvement and the prices for sub-performing and non-performing loans may increase, which could materially and adversely affect Residential.
Over the last several years, there has been an increase in supply of sub-performing and non-performing loans available for sale. However, in response to the economic crisis, the origination of jumbo, subprime, Alt-A and second lien residential mortgage loans has dramatically declined as lenders have increased their standards of credit-worthiness in originating new loans and fewer homeowners may go into sub-performing or non-performing status on their residential mortgage loans. In addition, the prices at which sub-performing and non-performing loans can be acquired may increase from time to time, or permanently, due to the entry of new participants into the distressed loan marketplace or a lower supply of sub-performing and non-performing loans in the marketplace. For these reasons, along with the general improvement in the economy, the supply of sub-performing and non-performing residential mortgage loans that Residential may acquire may decline over time and could materially and
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adversely affect Residential. If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
Competition in identifying and acquiring non-performing loans could adversely affect Residential's ability to implement its business strategy, which could materially and adversely affect Residential.
Residential faces competition from various sources for investment opportunities in sub-performing and non-performing loans including REITs, hedge funds, private equity funds, partnerships and developers. Some third-party competitors have substantially greater financial resources and access to capital than Residential does and may be able to accept more risk than Residential can. Competition from these companies may reduce the number of attractive sub-performing and non-performing loan investment opportunities available to Residential or increase the bargaining power of asset owners seeking to sell, which would increase the prices for sub-performing and non-performing loans. If such events occur, Residential's ability to implement its business strategy could be adversely affected, which could materially and adversely affect Residential. Given the existing competition, complexity of the market and requisite time needed to make such investments, no assurance can be given that Residential will be successful in acquiring investments that generate attractive risk-adjusted returns. Furthermore, there is no assurance that such investments, once acquired, will perform as expected. If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
Residential's inability to promptly foreclose upon defaulted residential mortgage loans could increase its costs and/or diminish its expected return on investments.
Residential's ability seek alternative resolutions for the underlying properties and, in certain cases, where appropriate, to promptly foreclose upon defaulted residential mortgage loans plays a critical role in our valuation of the assets in which it invests and its expected return on those investments. We expect the timeline to convert acquired loans into single-family rental properties will vary significantly by loan. Certain of Residential's acquired loans may already be in foreclosure proceedings, in which case conversion could be as soon as three to six months following acquisition, but in other cases conversion could take up to 24 months or longer. There are a variety of factors that may inhibit Residential's ability, through its mortgage servicers, to foreclose upon a residential mortgage loan and get access to the real property within the timelines modeled as part of our valuation process. These factors include, without limitation: state foreclosure timelines and deferrals associated therewith (including with respect to litigation, bankruptcy and statute of limitations); unauthorized occupants living in the property; federal, state or local legislative action or initiatives designed to provide homeowners with assistance in avoiding residential mortgage loan foreclosures and that serve to delay the foreclosure process; HAMP and similar programs that require specific procedures to be followed to explore the refinancing of a residential mortgage loan prior to the commencement of a foreclosure proceeding; and continued declines in real estate values and sustained high levels of unemployment that increase the number of foreclosures and place additional pressure on the already overburdened judicial and administrative systems.
In addition, certain issues, including “robo-signing,” have been identified throughout the mortgage industry that relate to affidavits used in connection with the residential mortgage loan foreclosure process. A substantial portion of Residential's investments are, and in the future may be, sub-performing and non-performing residential mortgage loans, many of which are already subject to foreclosure proceedings at the time of purchase. There can be no assurance that similar practices have not been followed in connection with residential mortgage loans that are already subject to foreclosure proceedings at the time of purchase. To the extent we determine that any of the loans Residential acquires are impacted by these issues, Residential may be required to re-commence the foreclosure proceedings relating to such loans, thereby resulting in additional delay that could have the effect of increasing its costs and/or diminishing its expected return on its investments. The uncertainty surrounding these issues could also result in legal, regulatory or industry changes to the foreclosure process as a whole, any or all of which could lengthen the foreclosure process and negatively impact Residential's business.
If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
Residential may be materially and adversely affected by risks affecting borrowers or the single-family rental properties in which its investments may be concentrated at any given time, as well as from unfavorable changes in the related geographic regions.
Residential's assets are not subject to any geographic diversification or concentration limitations. Entities that sell distressed mortgage loan portfolios may group the portfolios by location or other metrics that could result in a concentration of Residential's portfolio by geography, single-family rental property characteristics and/or borrower demographics. Such
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concentration could increase the risk of loss to Residential if the particular concentration in its portfolio is subject to greater risks or undergoing adverse developments. In addition, adverse conditions in the areas where the properties securing Residential's investments are located (including business layoffs or downsizing, industry slowdowns, changing demographics, oversupply, reduced demand and other factors) may have an adverse effect on the value of its investments. As of December 31, 2014, approximately 21% of Residential's portfolio by UPB was concentrated in California and approximately 18% of Residential's portfolio by UPB was concentrated in Florida. A material decline in the demand for single-family housing or rentals in these or other areas where Residential owns assets may materially and adversely affect Residential. Lack of diversification can increase the correlation of non-performance and foreclosure risks among Residential's investments. If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
Short-term leases of residential property expose Residential more quickly to the effects of declining market rents.
We anticipate that a majority of Residential's leases to tenants of single-family rental properties 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, resulting in additional cost to renovate and maintain the property and lower occupancy levels. Because Residential has a limited operating history, its tenant turnover rate and related cost estimates may be less accurate than if we had more operating data upon which to base these estimates.
Residential may be unable to secure funds for future tenant or other capital improvements, which could limit its ability to attract or replace tenants.
When Residential acquires or otherwise takes title to single-family properties or when tenants fail to renew their leases or otherwise vacate their space, Residential generally will be required to expend funds for property restoration and leasing commissions in order to lease the property. If Residential has not established reserves or set aside sufficient funds for such expenditures, it may have to obtain financing from other sources, as to which no assurance can be given. Residential may also have future financing needs for other capital improvements to restore its properties. If Residential needs to secure financing for capital improvements in the future but are unable to secure such financing on favorable terms or at all, Residential may be unable or unwilling to make capital improvements or it may be required or may choose to defer such improvements. If this happens, Residential's properties may suffer from a greater risk of obsolescence or a decline in value, or a greater risk of decreased cash flow as a result of fewer potential tenants being attracted to the property or existing tenants not renewing their leases. If Residential does not have access to sufficient funding in the future, it may not be able to make necessary capital improvements to its properties, and its properties’ ability to generate revenue may be significantly impaired. If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
Residential's revenue and expenses are not directly correlated, and, because a large percentage of its costs and expenses are fixed and some variable expenses may not decrease over time, it may not be able to adapt its cost structure to offset any declines in its revenue.
Many of the expenses associated with Residential's business, such as acquisition costs, restoration and maintenance costs, home owners’ association, or “HOA,” fees, personal and real property taxes, insurance, compensation and other general expenses are fixed and would not necessarily decrease proportionally with any decrease in revenue. Residential's assets also will likely require a significant amount of ongoing capital expenditure. Residential's expenses, including capital expenditures, will be affected by, among other things, any inflationary increases, and cost increases may exceed the rate of inflation in any given period. Certain expenses, such as HOA fees, taxes, insurance and maintenance costs are recurring in nature and may not decrease on a per-unit basis as Residential's portfolio grows through additional property acquisitions. By contrast, Residential's revenue is affected by many factors beyond our control, such as the availability and price of alternative rental housing and economic conditions in its markets. As a result, Residential may not be able to fully, or even partially, offset any increase in its expenses with a corresponding increase in its revenues. In addition, state and local regulations may require Residential to maintain its properties, even if the cost of maintenance is greater than the potential benefit. If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
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Fair values of Residential's mortgage loans are imprecise and may materially and adversely affect its operating results and credit availability, which, in turn, would materially and adversely affect Residential.
The values of Residential's mortgage loans may not be readily determinable. We measure the fair value of Residential's mortgage loans monthly, but the fair value at which Residential's mortgage loans are recorded may not be an indication of their realizable value. Ultimate realization of the value of a mortgage loan depends to a great extent on economic and other conditions that are beyond our control. Further, fair value is only an estimate based on good faith judgment of the price at which a mortgage loan can be sold since market prices of mortgage loans can only be determined by negotiation between a willing buyer and seller. In certain cases, our estimation of the fair value of Residential's mortgage loans includes inputs provided by third-party dealers and pricing services, and valuations of certain securities or other assets in which we invest are often difficult to obtain and are subject to judgments that may vary among market participants. Changes in the estimated fair values of Residential's mortgage loans are directly charged or credited to earnings for the period. If Residential were to liquidate a particular mortgage loan, the realized value may be more than or less than the amount at which such mortgage loan was recorded. We could be materially and adversely affected by negative determinations that reduce the fair value of Residential's mortgage loans, and such valuations may fluctuate over short periods of time.
We value the properties underlying Residential's mortgage loans and recognize unrealized gains in each period when Residential's mortgage loans are transferred to real estate owned. The fair value of residential properties is estimated using broker price opinions, or “BPOs,” provided by third-party brokers. BPOs are subject to the judgments of the particular broker formed by visiting the property, assessing general home values in the area, reviewing comparable listings and reviewing comparable completed sales. These judgments may vary among brokers and may fluctuate over time based on housing market activities and the influx of additional comparable listings and sales. Residential's results could be materially and adversely affected if the judgments used by the brokers prove to be incorrect or inaccurate.
If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
Challenges to the MERS® System could materially and adversely affect Residential.
MERSCORP, Inc. is a privately held company that maintains an electronic registry, referred to as the MERS System, which tracks servicing rights and ownership of loans in the United States. Mortgage Electronic Registration Systems, Inc., or “MERS,” a wholly owned subsidiary of MERSCORP, Inc., can serve as a nominee for the owner of a residential mortgage loan and in that role initiate foreclosures and/or become the mortgagee of record for the loan in local land records. We may choose to use MERS as a nominee. The MERS System is widely used by participants in the mortgage finance industry. Several legal challenges have been made disputing MERS’s legal standing to initiate foreclosures and/or act as nominee in local land records. These challenges could negatively affect MERS’s ability to serve as the mortgagee of record in some jurisdictions. In addition, where MERS is the mortgagee of record, it must execute assignments of mortgages, affidavits and other legal documents in connection with foreclosure proceedings. As a result, investigations by governmental authorities and others into the servicer foreclosure process deficiencies described under “–Residential's inability to promptly foreclose upon defaulted residential mortgage loans could increase its cost of doing business and/or diminish its expected return on investments” may impact
MERS. Failures by MERS to apply prudent and effective process controls and to comply with legal and other requirements in the foreclosure process could pose operational, reputational and legal risks that may materially and adversely affect Residential, which could materially and adversely affect our results of operations and financial condition.
We utilize analytical models and data in connection with the valuation of Residential's investments, and any incorrect, misleading or incomplete information used in connection therewith would subject Residential to potential risks.
Given the complexity of Residential's investments and strategies, we must rely heavily on models and data, including analytical models (both proprietary models developed by us and those supplied by third parties) and information and data supplied by third parties. Models and data are used to value investments or potential investments and also in connection with performing due diligence on Residential's investments. In the event models and data prove to be incorrect, misleading or incomplete, any decisions made in reliance thereon expose us to potential risks. For example, by relying on incorrect models and data, especially valuation models, Residential may be induced to buy certain investments at prices that are too high, to sell certain other investments at prices that are too low or to miss favorable opportunities altogether, all of which could adversely affect our ability to generate incentive management fees.
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Our accounting and other management systems and resources may not be adequately prepared to meet the financial reporting and other requirements we are subject to as a stand-alone reporting public company.
We are subject to reporting and other obligations under the Exchange Act, as amended. Under the Sarbanes-Oxley Act of 2002, or the “Sarbanes-Oxley Act,” we are required to maintain effective disclosure controls and procedures. To comply with these requirements, we may need to implement additional financial and management controls, reporting systems and procedures. We have incurred, and expect to incur, additional annual expenses for the purpose of addressing these requirements, and these expenses may be significant. If we are unable to implement additional controls, reporting systems, information technology systems and procedures in a timely and effective fashion, our ability to comply with our financial reporting requirements and other rules that apply to reporting companies under the Exchange Act could be impaired. Any failure to achieve and maintain effective internal controls could have a material adverse effect on us. We are also be required to comply with Section 404 of the Sarbanes-Oxley Act which requires annual management assessments of the effectiveness of our internal control over financial reporting and a report thereon by our independent registered public accounting firm. These reporting and other obligations may place significant demands on our management, administrative and operational resources, including accounting systems and resources.
Changes in global economic and capital market conditions, including periods of generally deteriorating occupancy and real estate industry fundamentals may materially and adversely affect Residential.
There are risks to the ownership of real estate and real estate related assets, including decreases in residential property values, changes in global, national, regional or local economic, demographic and real estate market conditions as well as other factors particular to the locations of Residential's investments. A prolonged recession and a slow recovery could materially and adversely affect Residential as a result of, among other items, the following:
• | joblessness or unemployment rates that adversely affect the local economy; |
• | an oversupply of or a reduced demand for single-family rental properties for rent; |
• | a decline in employment or lack of employment growth; |
• | the inability or unwillingness of residents to pay rent increases or fulfill their lease obligations; |
• | a decline in rental rate which may be accentuated since we expect Residential to have rent terms of two years or less; |
• | rent control or rent stabilization laws or other laws regulating housing that could prevent us from raising rents to offset increases in operating costs; |
• | changes in interest rates, availability and terms of debt financing; and |
• | economic conditions that could cause an increase in Residential's operating expenses such as increases in property taxes, utilities and routine maintenance. |
These conditions could also adversely impact the financial condition and liquidity of the renters that will occupy Residential's real estate properties and, as a result, their ability to pay rent to Residential.
Suboptimal economics of real estate related insurance activities, or a failure to commence and/or grow the business of NewSource could adversely impact our investment in NewSource.
Residential invested $18.0 million in the non-voting preferred stock of NewSource. We invested $2.0 million in 100% of the common stock of NewSource. Despite the commencement in 2014 of NewSource’s title reinsurance business operations, NewSource determined that the economics of the initial business activities did not warrant the continuation of its initial reinsurance quota share agreement with an unrelated third party. NewSource therefore transferred all of the risk of claims and future losses underwritten to an unrelated third party for a price of $3.2 million.
NewSource is continuing to evaluate its real estate related insurance and reinsurance strategy and considering related opportunities. There is no assurance that NewSource will be able to develop or grow its business strategy or operations, or engage in insurance and reinsurance activities at all. In any such event, the business model for NewSource would become challenged or the growth of NewSource would become hampered, which would adversely affect the economics of our investment in NewSource and/or NewSource’s ability to pay its preferred dividend to Residential and /or generate shareholder returns to us.
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Inflation or deflation may adversely affect Residential's results of operations and cash flows.
Increased inflation could have an adverse impact on interest rates, property management expenses and general and administrative expenses, as these costs could increase at a rate higher than Residential's rental and other revenue. Conversely, deflation could lead to downward pressure on rents and other sources of income without an accompanying reduction in Residential's expenses. Accordingly, inflation or deflation may adversely affect Residential's results of operations and cash flows, which could materially and adversely affect our ability to generate incentive management fees.
Changes in applicable laws or noncompliance with applicable law could materially and adversely affect Residential.
As an owner of real estate, Residential is required to comply with numerous federal, state and local laws and regulations, some of which may conflict with one another or be subject to limited judicial or regulatory interpretations. These laws and regulations may include zoning laws, building codes, landlord-tenant laws and other laws generally applicable to business operations. Noncompliance with laws or regulations could expose Residential to liability.
Lower revenue growth or significant unanticipated expenditures may result from Residential's need to comply with changes in (i) laws imposing remediation requirements and potential liability for environmental conditions existing on properties or the restrictions on discharges or other conditions, (ii) rent control or rent stabilization laws or other residential landlord-tenant laws or (iii) other governmental rules and regulations or enforcement policies affecting the rehabilitation, use and operation of Residential's single-family rental properties including changes to building codes and fire and life-safety codes. If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
In addition, NewSource has registered as a Class 3A Bermuda insurance company and is subject to regulation and supervision in Bermuda by the BMA. Changes in Bermuda insurance statutes, regulations and policies could result in restrictions on NewSource’s ability to pursue its business plans, issue reinsurance policies, distribute funds and execute its investment strategy. In addition, NewSource may become subject to regulation and supervision by insurance authorities in any other jurisdictions in which it operates. Failure to comply with or to obtain appropriate authorizations and/or exemptions under any applicable laws could result in restrictions on NewSource’s ability to do business or certain activities that are regulated in one or more of the jurisdictions in which it operates and could subject NewSource to fines and other sanctions, which could have a material adverse effect on NewSource’s business and its ability to pay the dividend on Residential's preferred stock. As a result, the value of Residential’s and our investment in NewSource could decline.
Competition could limit Residential's ability to lease single-family rental properties or increase or maintain rents.
Residential's single-family rental properties, when acquired, will compete with other housing alternatives to attract residents, including rental apartments, condominiums and other single-family homes available for rent as well as new and existing condominiums and single-family homes for sale. Residential's competitors’ single-family rental properties may be better quality, in a more desirable location or have leasing terms more favorable than Residential can provide. In addition, Residential's ability to compete and generate favorable returns depends upon, among other factors, trends of the national and local economies, the financial condition and liquidity of current and prospective renters, availability and cost of capital, taxes and governmental regulations. Given Residential's significant competition, we cannot assure you that it will be successful in acquiring or managing single-family rental properties that generate favorable returns, which would materially and adversely affect our ability to generate incentive management fees.
If rents in Residential's markets do not increase sufficiently to keep pace with rising costs of operations, its operating results and cash available for distribution will decline.
The success of Residential's business model will substantially depend on conditions in the single-family rental property market in its geographic markets. Residential's asset acquisitions are premised on assumptions about, among other things, occupancy and rent levels. If those assumptions prove to be inaccurate, Residential's operating results and cash available for distribution will be lower than expected, potentially materially. This, in turn, could materially and adversely affect our ability to generate incentive management fees. Rental rates and occupancy levels have benefited in recent periods from macroeconomic trends affecting the U.S. economy and residential real estate and mortgage markets in particular, including:
• | a tightening of credit that has made it more difficult to finance a home purchase, combined with efforts by consumers generally to reduce their exposure to credit; |
• | economic and employment conditions that have increased foreclosure rates; and |
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• | reduced real estate values that challenged the traditional notion that homeownership is a stable investment. |
If the current trend favoring renting rather than homeownership reverses, the single-family rental market could decline.
The single-family rental market is currently significantly larger than in historical periods. We do not expect the favorable trends in the single-family rental market to continue indefinitely. Eventually, a strengthening of the U.S. economy and job growth, together with the large supply of foreclosed single-family rental properties, the current availability of low residential mortgage rates and government sponsored programs promoting home ownership, may contribute to a stabilization or reversal of the current trend that favors renting rather than homeownership. In addition, we expect that as investors increasingly seek to capitalize on opportunities to purchase undervalued housing properties and convert them to productive uses, the supply of single-family rental properties will decrease and the competition for tenants will intensify. A softening of the rental property market in Residential's markets would adversely affect its operating results and cash available for distribution, potentially materially. This, in turn, could materially and adversely affect our ability to generate incentive management fees.
Single-family rental properties that are subject to foreclosure or short-sales are subject to risks of theft, vandalism or other damage that could impair their value.
When a single-family rental property is subject to foreclosure, it is possible that the homeowner may cease to maintain the property adequately, or that the property may be abandoned by the homeowner and become susceptible to theft or vandalism. Lack of maintenance, theft and vandalism can substantially impair the value of the property. To the extent Residential initiates foreclosure proceedings, some of its properties could be impaired.
Contingent or unknown liabilities could materially and adversely affect Residential.
Residential's acquisition activities are subject to many risks. Residential may acquire properties that are subject to unknown or contingent liabilities, including liabilities for or with respect to liens attached to properties, unpaid real estate taxes, utilities or HOA charges for which a prior owner remains liable, clean-up or remediation of environmental conditions or code violations, claims of vendors or other persons dealing with the acquired properties and tax liabilities, among other things. In each case, Residential's acquisition may be without any, or with only limited, recourse with respect to unknown or contingent liabilities or conditions. As a result, if any such liability were to arise relating to Residential's properties, or if any adverse condition exists with respect to Residential's properties that is in excess of its insurance coverage, Residential might have to pay substantial sums to settle or cure it, which could materially and adversely affect Residential. The properties Residential acquires may also be subject to covenants, conditions or restrictions that restrict the use or ownership of such properties, including prohibitions on leasing or requirements to obtain the approval of HOAs prior to leasing. We may not discover such restrictions during the acquisition process and such restrictions may adversely affect Residential's ability to operate such properties as it intends. This, in turn, could materially and adversely affect our ability to generate incentive management fees.
The costs and amount of time necessary to secure possession and control of a newly acquired property may exceed our assumptions, which would delay Residential's receipt of revenue from, and return on, the property.
Upon acquiring a property, Residential may have to evict occupants who are in unlawful possession before it can secure possession and control of the property. The holdover occupants may be the former owners or tenants of a property, or they may be squatters or others who are illegally in possession. Securing control and possession from these occupants can be both costly and time-consuming. If these costs and delays exceed our expectations, Residential's and our financial performance may suffer because of the increased expenses incurred or the unexpected delays in turning the properties into revenue-producing rental properties.
Poor tenant selection and defaults by Residential's tenants may materially and adversely affect Residential.
Residential's success will depend, in large part, upon its ability to attract and retain qualified tenants for its properties. This will depend, in turn, upon Residential's ability to screen applicants, identify good tenants and avoid tenants who may default. Residential will inevitably make mistakes in its selection of tenants, and it may rent to tenants whose default on its leases or failure to comply with the terms of the lease or HOA regulations could materially and adversely affect Residential. For example, tenants may default on payment of rent, make unreasonable and repeated demands for service or improvements, make unsupported or unjustified complaints to regulatory or political authorities, make use of Residential's properties for illegal purposes, damage or make unauthorized structural changes to its properties which may not be fully covered by security deposits, refuse to leave the property when the lease is terminated, engage in domestic violence or similar disturbances, disturb nearby residents with noise, trash, odors or eyesores, fail to comply with HOA regulations, sub-let to less desirable individuals
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in violation of Residential's leases or permit unauthorized persons to live with them. The process of evicting a defaulting tenant from a family residence can be adversarial, protracted and costly. Furthermore, some tenants facing eviction may damage or destroy the property. Damage to Residential's properties may significantly delay re-leasing after eviction, necessitate expensive repairs or impair the rental revenue or value of the property. In addition, Residential will incur turnover costs associated with re-leasing the properties, such as marketing expense and brokerage commissions, and will not collect revenue while the property is vacant. Although Residential will attempt to work with tenants to prevent such damage or destruction, there can be no assurance that it will be successful in all or most cases. Such tenants will not only cause Residential not to achieve its financial objectives for the properties in which they live, but may subject Residential to liability, and may damage Residential's reputation with its other tenants and in the communities where it does business. If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
Eminent domain could lead to material losses on Residential's investments.
It is possible that governmental authorities may exercise eminent domain to acquire land on which Residential's properties are built in order to build roads or other infrastructure. Any such exercise of eminent domain would allow Residential to recover only the fair value of the affected properties, which we believe may be interpreted to be substantially less than the actual value of the property. Several cities are also exploring proposals to use eminent domain to acquire residential loans to assist borrowers to remain in their homes, potentially reducing the supply of single-family properties for sale in Residential's markets. Any of these events can cause a material loss to Residential, which could materially and adversely affect our ability to generate incentive management fees.
A significant uninsured property or liability loss could have a material adverse effect on Residential.
Residential will carry commercial general liability insurance and property insurance with respect to its single-family rental properties on terms we consider commercially reasonable. There are, however, certain types of losses (such as losses arising from acts of war or earthquake) that are not insured, in full or in part, because they are either uninsurable or the cost of insurance makes it economically impractical. If an uninsured property loss or a property loss in excess of insured limits were to occur, Residential could lose its capital invested in a single-family rental property or group of rental properties as well as the anticipated future revenues from such single-family rental property or group of properties. If an uninsured liability to a third party were to occur, Residential would incur the cost of defense and settlement with or court ordered damages to that third party. A significant uninsured property or liability loss could materially and adversely affect Residential, which could materially and adversely affect our ability to generate incentive management fees.
A significant number of Residential's single-family rental properties may be part of home owners’ associations. Residential and its renters will be subject to the rules and regulations of such home owners’ associations which may be arbitrary or restrictive and violations of such rules may subject us to additional fees and penalties and litigation which may be costly.
A significant number of Residential's single-family rental properties, when acquired, may be subject to HOAs which are private entities that regulate the activities of and levy assessments on properties in a residential subdivision. Some of the HOAs that will govern Residential's single-family rental properties may enact onerous or arbitrary rules that restrict Residential's ability to renovate, market or lease its single-family rental properties or require it to renovate or maintain such properties at standards or costs that are in excess of our planned operating budgets. Such rules may include requirements for landscaping, limitations on signage promoting a property for lease or sale or the use of specific construction materials to be used in renovations. Some HOAs also impose limits on the number of property owners who may rent their homes which, if met or exceeded, may cause Residential to incur additional costs to sell the affected single-family rental property and opportunity costs of lost rental income. Furthermore, many HOAs impose restrictions on the conduct of occupants of homes and the use of common areas, and Residential may have renters who violate these HOA rules for which Residential may be liable as the property owner. Additionally, the boards of directors of the HOAs that will govern its single-family rental properties may not make important disclosures or may block Residential's access to HOA records, initiate litigation, restrict its ability to sell, impose assessments or arbitrarily change the HOA rules. Residential may be unaware of or unable to review or comply with certain HOA rules before acquiring a single-family rental property, and any such excessively restrictive or arbitrary regulations may cause Residential to sell such property, if possible, prevent it from renting such property or otherwise reduce its cash flow from such property. Any of the above-described occurrences may materially and adversely affect Residential’s and our results of operations and financial condition.
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We rely on information supplied by prospective tenants in managing Residential's business.
We rely on information supplied to us by prospective tenants in their rental applications as part of our due diligence process to make leasing decisions, and we cannot be certain that this information is accurate. In particular, we rely on information submitted by prospective tenants regarding household income, tenure at current job, number of children and size of household. Moreover, these applications are submitted to us at the time we evaluate a prospective tenant, and we do not require tenants to provide us with updated information during the terms of their leases, notwithstanding the fact that this information can, and frequently does, change over time. Even though this information is not updated, we will use it to evaluate the overall average credit characteristics of Residential's portfolio over time. If tenant-supplied information is inaccurate or Residential's tenants’ creditworthiness declines over time, we may make poor leasing decisions and Residential's portfolio may contain more credit risk than we believe exists, which could harm Residential’s and our results of operations and financial condition.
We are subject to the risks of securities laws liability and related civil litigation.
We may be subject to risk of securities litigation and derivative actions from time to time as a result of being publicly traded. For example, in January 2015, a purported shareholder filed a derivative action against the members of Residential's Board of Directors, Residential and us in connection with Residential's asset management agreement with us. In January 2015, a putative shareholder class action complaint was filed in the U.S. district court of the Virgin Islands naming our former Chairman, certain officers and us, and alleges that the defendants violated federal securities laws by failing to disclose material information to our shareholders concerning alleged conflicts of interest AAMC’s relationship with certain other companiesfor which our former Chairman was also a director and shareholder. For more information concerning this matter, please see “Item 3. Legal Proceedings.” While we deny the allegations of wrongdoing against us in the actions initiated against us, there can be no assurance as to the ultimate outcome or timing of their resolution. The range of possible resolutions could include determinations and judgments against us or settlements that could require substantial payments by us, including the costs of defending such investigations and suits, which could have a material adverse effect on our financial condition, results of operations and cash flows. An adverse resolution of any future lawsuits or claims against us could have an adverse effect on our business, financial condition and/or operating results.
Residential likely will incur costs due to litigation, including but not limited to, class actions, tenant rights claims and consumer demands.
There are numerous tenants’ rights and consumer rights organizations throughout the country. As Residential grows in scale, it may attract attention from some of these organizations and become a target of legal demands or litigation. Many such consumer organizations have become more active and better funded in connection with mortgage foreclosure-related issues and displaced home ownership. Some of these organizations may shift their litigation, lobbying, fundraising and grass roots organizing activities to focus on landlord-tenant issues as more entities engage in the single-family rental property market. Additional actions that may be targeted at Residential include eviction proceedings and other landlord-tenant disputes, challenges to title and ownership rights (including actions brought by prior owners alleging wrongful foreclosure by their lender or servicer) and issues with local housing officials arising from the condition or maintenance of a single-family rental property. While we intend to conduct Residential's rental business lawfully and in compliance with applicable landlord-tenant and consumer laws, such organizations might work in conjunction with trial and pro bono lawyers in one state or multiple states to attempt to bring claims against Residential on a class action basis for damages or injunctive relief. We cannot anticipate what form such legal actions might take or what remedies they may seek. Any of such claims may result in a finding of liability that may materially and adversely affect Residential.
Additionally, these organizations may lobby local county and municipal attorneys or state attorneys general to pursue enforcement or litigation against Residential or may lobby state and local legislatures to pass new laws and regulations to constrain Residential's business operations. If they are successful in any such endeavors, they could directly limit and constrain Residential's business operations and impose on Residential significant litigation expenses, including settlements to avoid continued litigation or judgments for damages or injunctions. Any of the above-described occurrences may materially and adversely affect Residential, which could materially and adversely affect our ability to generate incentive management fees.
Security breaches and other disruptions could compromise Residential's and/or our information and expose us to liability, which would cause our business and reputation to suffer.
In the ordinary course of Residential's and our business, we, through Altisource or Residential's mortgage servicers, may acquire and store sensitive data on our network, such as our proprietary business information and personally identifiable information of Residential's prospective and current tenants. The secure processing and maintenance of this information is critical to our business strategy. Despite our security measures, our information technology and infrastructure may be
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vulnerable to attacks by hackers or breached due to employee error, malfeasance or other disruptions. Any such breach could compromise our networks and the information stored there could be accessed, publicly disclosed, lost or stolen. Any such access, disclosure or other loss of information could result in legal claims or proceedings, liability under laws that protect the privacy of personal information, regulatory penalties, disruption to our operations and the services we provide to customers or damage our reputation, which could materially and adversely affect Residential and/or us.
Residential may incur substantial costs due to environmental contamination or non-compliance.
Under various federal, state and local environmental and public health laws, regulations and ordinances, Residential may be required, regardless of knowledge or responsibility, to investigate and remediate the effects of hazardous or toxic substances or petroleum product releases at its single-family rental properties (including in some cases, asbestos-containing construction materials, lead-based paints, contaminants migrating from offsite sources and natural substances such as methane, mold and radon gas) and may be held liable under these laws or common law to a governmental entity or to third parties for property, personal injury or natural resources damages and for investigation and remediation costs incurred as a result of the contamination. These damages and costs may be substantial and may exceed any insurance coverage Residential may have for such events, either of which could materially and adversely affect Residential. The presence of such substances or the failure to properly remediate the contamination may adversely affect Residential's ability to borrow against, sell or rent the affected single-family rental property. In addition, some environmental laws create or allow a government agency to impose a lien on the contaminated site in favor of the government for damages and costs it incurs as a result of the contamination, which may also adversely affect Residential's ability to borrow against, sell or rent the affected single-family rental property. If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
Residential properties will be subject to property and other taxes that may increase over time.
Residential will be responsible for property taxes for its single-family rental properties, when acquired which may increase as tax rates change and properties are reassessed by taxing authorities. If Residential fails to pay any such taxes, the applicable taxing authorities may place a lien on the property and the property may be subject to a tax sale. Increases in property taxes would also adversely affect Residential's yield from rental properties. Any such occurrence may materially and adversely affect Residential which, in turn, could materially and adversely affect us.
If Residential is deemed to be an investment company under the Investment Company Act, it would have significant adverse consequences to Residential and us.
Residential does not intend or expect to be an investment company under the Investment Company Act of 1940, as amended, which we refer to as the “Investment Company Act,” since it will not engage primarily or hold itself out as being engaged primarily in the business of investing, reinvesting or trading in securities. Rather, Residential will be primarily engaged in the business of purchasing or otherwise acquiring real estate and mortgages on real estate, specifically single family rental assets and sub-performing and non-performing loans. To the extent that the SEC determines that Residential is in fact an investment company, Residential intends to rely on the exception from the Investment Company Act set forth in Section 3(c)(5)(C) of the Investment Company Act, which excludes from the definition of investment company ''any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in one or more of the following businesses: . . .(C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.'' The SEC has historically taken the position that an issuer may rely on the exception provided by Section 3(c)(5)(C) as long as at least 55% of its assets consist of ''qualifying interests,'' such as mortgage loans which are secured by real estate and other liens on and interests in real estate, and an additional 25% consists of real estate-type interests. The SEC has also historically indicated that up to 20% of an issuer's total assets may be invested in miscellaneous investments. Other than Residential's investment in NewSource, Residential believes that all of its assets will fall within the definition of ''qualifying assets.'' Additionally, Residential does not currently expect to issue redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, as those terms are defined by the Investment Company Act. Consequently, Residential believes that it will not be required to register under the Investment Company Act.
If Residential is deemed to be an investment company and its investment in NewSource accounts for more than 20% of its assets, it could be required to dispose of its NewSource investment (or a portion thereof) in order to qualify for the 3(c)(5)(C)exception. We expect that Residential's investment in NewSource will constitute less than 20% of its assets shortly after the separation date. Consequently, we do not believe that Residential's investment in NewSource will impact its ability to continue to rely on the Section 3(c)(5)(C) exemption. In August 2011, the SEC issued a concept release which indicated that the SEC is
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reviewing whether certain mortgage related pools which rely (like Residential) on the exception from registration under Section 3(c)(5)(C), should continue to be allowed to rely on such exception from registration. Since Residential's primary investment strategy is to directly invest in REO Properties and mortgages secured by real estate, Residential does not believe that the SEC's review will have a material impact on its status as a non-investment company business or its ability to continue to rely on the Section 3(c)(5)(C) exception; however, Residential cannot provide any assurance that the outcome of the SEC's review will not require Residential to register under the Investment Company Act. If Residential is determined to be an investment company or it fails to qualify for this exception from registration as an investment company, or the SEC determines that companies that engage in businesses similar to Residential's are no longer able to rely on this exception, Residential may be required to register as an investment company under the Investment Company Act.
Registration under the Investment Company Act would require Residential to comply with a variety of substantive requirements that impose, among other things:
• | limitations on capital structure; |
• | restrictions on specified investments; |
• | restrictions on retaining earnings; |
• | restrictions on leverage or senior securities; |
• | restrictions on unsecured borrowings; |
• | requirements that Residential's income be derived from certain types of assets; |
• | prohibitions on transactions with affiliates and |
• | compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly increase Residential's operating expenses. |
If Residential were required to register as an investment company but failed to do so, it would be prohibited from engaging in its business, and criminal and civil actions could be brought against it.
Registration with the SEC as an investment company would be costly, would subject Residential to a host of complex regulations and would divert attention from the conduct of Residential's business. In addition, if Residential purchases or sells any real estate assets to avoid becoming an investment company under the Investment Company Act, it could materially adversely affect its net asset value, the amount of funds available for investment and its ability to pay distributions to its shareholders. Any such occurrences would adversely impact our income from the incentive management fees paid by Residential.
Risks Related to Our Management and Our Relationships
We could have conflicts with Residential, and our former Chairman, other members of our Board of Directors or management could have conflicts of interest due to his, her or their relationship with Altisource, Ocwen or Residential, which may be resolved in a manner adverse to us.
We have engaged, and continue to engage, in a substantial amount of business with Residential. Conflicts may arise between Residential and us because of our ongoing agreement with Residential and because of the nature of our respective businesses.
Prior to his stepping down from the Board of Directors in January 2015, our former Chairman was also the Chairman of Altisource, Ocwen and Residential. As a result, he had obligations to us as well as to these other entities, which potentially could have resulted in conflicts of interest with respect to matters potentially or actually involving or affecting us and Altisource, Ocwen or Residential, as the case may be. Our former Chairman also has substantial investments in Altisource, Ocwen and Residential, and certain of our other officers own stock or options in Altisource, Ocwen and/or Residential. Such ownership interests may have created, or appeared to create, conflicts of interest with respect to matters potentially or actually involving or affecting us and Altisource, Ocwen and Residential, as the case may be.
Each of our executive officers is also an executive officer of Residential and has interests in our relationship with Residential that may be different than the interests of our stockholders. As a result, they may have obligations to us and Residential, and could have conflicts of interest with respect to matters potentially or actually involving or affecting us and Residential.
We follow policies, procedures and practices to avoid potential conflicts with respect to our dealings with Residential, including our Chairman and/or management recusing themselves from negotiations regarding, and approvals of, transactions with these entities (or where necessary, certain of our officers recusing themselves from discussions on, and approvals of transactions with Residential). We also manage potential conflicts of interest through oversight by independent members of our Board of
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Directors (independent directors constitute a majority of our Board of Directors), and we will also seek to manage these potential conflicts through dispute resolution and other provisions of our agreements with Residential. Although we are in the process of trying to lessen many of these potential conflicts of interest, there can be no assurance that such measures will be effective, that we will be able to resolve all conflicts with Residential, or that the resolution of any such conflicts will be no less favorable to us than if we were dealing with a third party that had none of the connections we have with Residential.
Our directors have the right to engage or invest in the same or similar businesses as ours.
Our directors may have other investments and business activities in addition to their interest in, and responsibilities to, us. Under the provisions of our Charter and our bylaws (the “Bylaws”), our directors have no duty to abstain from exercising the right to engage or invest in the same or similar businesses as ours or employ or otherwise engage any of the other directors. If any of our directors who are also directors, officers or employees of any company acquires knowledge of a corporate opportunity or is offered a corporate opportunity outside of his capacity as one of our directors, then our Bylaws provide that such director will be permitted to pursue that corporate opportunity independently of us, so long as the director has acted in good faith. Our Bylaws provide that, to the fullest extent permitted by law, such a director will be deemed to have satisfied his fiduciary duties to us and will not be liable to us for pursuing such a corporate opportunity independently of us. This may create conflicts of interest between us and certain of our directors and result in less than favorable treatment of us and our stockholders. As of this date, none of our Directors is directly involved as a director, officer or employee of a business that competes with us, but there can be no assurance that will remain unchanged in the future.
Risks Related to Residential's Qualification as a REIT
Residential’s failure to qualify as a REIT could materially and adversely affect Residential and us.
Residential made an election to be treated as a REIT for U.S. federal income tax purposes beginning with the year ended December 31, 2013. However, we cannot assure you that Residential will remain qualified as a REIT. Moreover, Residential's qualification and taxation as a REIT will depend upon its ability to meet on a continuing basis, through actual operating results, certain qualification tests set forth in the federal income tax laws. Accordingly, no assurance can be given that Residential's actual results of operations for any particular taxable year will satisfy such requirements. If Residential fails to qualify as a REIT in any taxable year, it will face serious tax consequences that will substantially reduce the funds available for distribution to its stockholders because:
• | Residential would not be allowed a deduction for dividends paid to stockholders in computing its taxable income; |
• | Residential could be subject to the federal alternative minimum tax to a greater extent and possibly increased state and local taxes; and |
• | unless Residential is entitled to relief under certain federal income tax laws, it could not re-elect REIT status until the fifth calendar year after the year in which it failed to qualify as a REIT. In addition, if Residential fails to qualify as a REIT, it will no longer be required to make distributions. |
As a result of all these factors, Residential's failure to qualify as a REIT could impair its ability to expand its business and raise capital, and it could materially and adversely affect Residential and the market price of its common stock. If these risks are realized by Residential, our ability to generate incentive management fees could be harmed and our results of operations and financial condition could be materially and adversely affected.
Residential's tax position with respect to the accrual of interest and market discount income with respect to distressed mortgage loans involves risk.
Residential does not accrue interest income or market discount on defaulted or delinquent loans when certain criteria are satisfied. The criteria generally relate to whether those amounts are uncollectible or of doubtful collectability. If the Internal Revenue Service were to challenge this position successfully, Residential could be subject to entity level excise tax as a result of “deficiency dividends” that it may be required to pay to its stockholders at the time of such an adjustment to its income in order to maintain its qualification as a REIT. This, in turn, could materially and adversely affect our ability to generate incentive management fees.
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Compliance with REIT requirements may cause Residential to forego otherwise attractive opportunities which may hinder or delay its ability to meet its investment objectives and reduce your overall return.
To qualify as a REIT, Residential is required at all times to satisfy certain tests relating to, among other things, the sources of our income, the nature and diversification of its assets, its financing, hedging and investment strategies, the ownership of its stock and amounts it distributes to its stockholders. Compliance with the REIT requirements may preclude Residential from certain financing or hedging strategies or cause it to forego otherwise attractive opportunities which may hinder or delay its ability to meet its investment objectives and reduce your overall return. For example, Residential may be required to pay distributions to stockholders at disadvantageous times or when it does not have funds readily available for distribution.
Compliance with REIT requirements may force Residential to liquidate otherwise attractive investments, which could materially adversely affect Residential.
To qualify as a REIT, at the end of each calendar quarter, at least 75% of Residential's assets must consist of qualified real estate assets, cash, cash items and government securities. In addition, no more than 25% of the value of Residential's assets may be represented by securities of one or more taxable REIT subsidiaries. Except for securities that qualify for purposes of the 75% asset test above and investments in Residential's qualified REIT subsidiaries and its taxable REIT subsidiaries, its investment in the value of any one issuer’s securities may not exceed 5% of the value of its total assets, and it may not own more than 10% of the total vote or value of the outstanding securities of any one issuer, except, in the case of the 10% value test, certain “straight debt” securities. In order to satisfy these requirements, Residential may be forced to liquidate otherwise attractive investments, potentially at a loss, which could materially and adversely affect Residential. This, in turn, could materially and adversely affect our ability to generate incentive management fees.
Failure to make required distributions would subject Residential to federal corporate income tax.
We intend to continue to operate Residential in a manner so as to qualify as a REIT for federal income tax purposes. In order to qualify as a REIT, Residential generally is required to distribute at least 90% of its REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gain, each year to its stockholders. To the extent that Residential satisfies this distribution requirement, but distribute less than 100% of its REIT taxable income, it will be subject to federal corporate income tax on its undistributed taxable income. In addition, Residential will be subject to a 4% nondeductible excise tax if the actual amount that it pays out to its stockholders in a calendar year is less than a minimum amount specified under the Code.
The IRS may deem the gains from sales of Residential's properties to be subject to a 100% prohibited transaction tax.
From time to time, Residential may be forced to sell properties that do not meet its investment objectives or it may need to sell properties or other assets to satisfy Residential's REIT distribution requirements, to satisfy other REIT requirements or for other purposes. The IRS may deem one or more sales of Residential's properties to be “prohibited transactions.” If the IRS takes the position that Residential has engaged in a “prohibited transaction” (i.e., if Residential sells a property held by us primarily for sale in the ordinary course of our trade or business), the gain it recognizes from such sale would be subject to a 100% tax. The Code sets forth a safe harbor for REITs that wish to sell property without risking the imposition of the 100% tax; however, there is no assurance that Residential will be able to qualify for the safe harbor. Residential do not intend to hold property for sale in the ordinary course of business; however, there is no assurance that its position will not be challenged by the IRS especially if it makes frequent sales or sales of property in which it has short holding periods. This, in turn, could materially and adversely affect our ability to generate incentive management fees.
The “taxable mortgage pool” rules may increase the taxes that Residential or Residential’s stockholders may incur, and may limit the manner in which we effect future securitizations.
Securitizations by us or our subsidiaries could result in the creation of taxable mortgage pools for U.S. federal income tax purposes, resulting in “excess inclusion income.” As a REIT, so long as we own 100% of the equity interests in a taxable mortgage pool, we generally would not be adversely affected by the characterization of the securitization as a taxable mortgage pool. Certain categories of stockholders, however, such as non-U.S. stockholders eligible for treaty or other benefits, stockholders with net operating losses, and certain tax-exempt U.S. stockholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income from us that is attributable to the excess inclusion income. In the case of a stockholder that is a REIT, a regulated investment company, or RIC, common trust fund or other pass-through entity, our allocable share of our excess inclusion income could be considered excess inclusion income of such entity. In addition, to the extent that our stock is owned by tax-exempt “disqualified organizations,” such as certain government-related
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entities and charitable remainder trusts that are not subject to tax on unrelated business income, a corporate level tax on a portion of any excess inclusion income. Because this tax generally would be imposed on us, all of our stockholders, including stockholders that are not disqualified organizations, generally would bear a portion of the tax cost associated with the classification of us or a portion of our assets as a taxable mortgage pool. A RIC, or other pass-through entity owning our stock in record name will be subject to tax at the highest U.S. federal corporate tax rate on any excess inclusion income allocated to their owners that are disqualified organizations. Moreover, we could face limitations in selling equity interests in these securitizations to outside investors, or selling any debt securities issued in connection with these securitizations that might be considered to be equity interests for tax purposes. Finally, if we were to fail to maintain our REIT qualification, any taxable mortgage pool securitizations would be treated as separate taxable corporations for U.S. federal income tax purposes that could not be included in any consolidated U.S. federal income tax return. These limitations may prevent us from using certain techniques to maximize our returns from securitization transactions.
In the future, Residential could be required to sell assets, borrow funds or raise equity capital to fund its distributions or to make a portion of its distributions in the form of a taxable stock distribution.
Residential's Board of Directors has the sole discretion to determine the timing, form and amount of any distributions to its stockholders, and the amount of such distributions may be limited. In the future, Residential could be required to sell assets, borrow funds or raise equity capital to fund its distributions or to make a portion of its distributions in the form of a taxable stock distribution. Residential's Board of Directors will make determinations regarding distributions based upon various factors, including its historical and projected financial condition, liquidity and results of operations, financing covenants, maintenance of its REIT qualification, applicable law and other factors, as its Board of Directors may deem relevant from time to time. To the extent that Residential is required to sell assets in adverse market conditions or borrow funds at unfavorable rates, it could be materially and adversely affected. To the extent Residential may have to raise equity capital, it may be unable to do so at attractive prices, on a timely basis or at all, which could adversely affect its ability to make distributions to its stockholders. This, in turn, could materially and adversely affect our ability to generate incentive management fees.
Even if Residential qualifies as a REIT, it may be subject to tax liabilities that could materially and adversely affect Residential.
Even if Residential qualifies for taxation as a REIT, it may be subject to certain federal, state and local taxes on its income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of a foreclosure, and state or local income, property and transfer taxes. In addition, Residential could, in certain circumstances, be required to pay an excise tax or penalty tax (which could be significant in amount) in order to utilize one or more of the relief provisions under the Code to maintain its qualification as a REIT. In order to meet the REIT qualification requirements or to avert the imposition of a 100% tax that applies to certain gains derived by a REIT from sales of “dealer property,” Residential may also move or hold some of its assets or conduct activities through a TRS. In addition, if Residential lends money to a TRS, the TRS may be unable to deduct all or a portion of the interest paid to Residential, which could result in an even higher corporate level tax liability. Any of these taxes would decrease cash available for distribution to Residential's stockholders.
Furthermore, the Code imposes a 100% tax on certain transactions between a TRS and its parent REIT that are not conducted on an arm’s length basis. We will structure Residential's transaction with any TRS on terms that we believe are arm’s length to avoid incurring the 100% excise tax described above. There can be no assurances, however, that Residential will be able to avoid application of the 100% tax. Any such additional tax liabilities would have an adverse effect on Residential and us.
Residential may be subject to legislative or regulatory tax changes that could materially and adversely affect Residential.
At any time, the federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be amended. We cannot predict when or if any new federal income tax law, regulation or administrative interpretation or any amendment to any existing federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation or interpretation may take effect retroactively. Residential and its stockholders could be materially and adversely affected by any such change in or any new, federal income tax law, regulation or administrative interpretation. This, in turn, could materially and adversely affect our ability to generate incentive management fees.
Our planned use of taxable REIT subsidiaries by Residential may cause it to fail to qualify to be taxed as a REIT.
The net income of Residential's TRSs is not required to be distributed to it, and income that is not distributed to Residential generally will not be subject to the REIT income distribution requirement. However, there may be limitations on Residential's
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ability to accumulate earnings in its TRSs and the accumulation or reinvestment of significant earnings in its TRSs could result in adverse tax treatment. In particular, if the accumulation of cash in Residential's TRSs causes the fair market value of its securities in our TRSs and certain other nonqualifying assets to exceed 25% of the fair market value of its assets, it would fail to qualify to be taxed as a REIT, which could materially and adversely affect us.
Risks related to our common stock
The market price and trading volume of our common stock may be volatile and may be affected by market conditions beyond our control.
The price at which our common stock trades has fluctuated, and may continue to fluctuate, significantly. The market price of our common stock may fluctuate in response to many things, including but not limited to:
• | variations in actual or anticipated results of our operations, liquidity or financial condition; |
• | changes in, or the failure to meet, our financial estimates or those of by securities analysts; |
• | actions or announcements by our competitors; |
• | potential conflicts of interest, or the discontinuance of our strategic relationships with Residential, Altisource and Ocwen; |
• | actual or anticipated accounting problem; |
• | regulatory actions; |
• | lack of liquidity; |
• | changes in the financial condition or stock price of Residential; |
• | changes in the market outlook for the real estate, mortgage or housing markets; |
• | technology changes in our business; |
• | changes in interest rates that lead purchasers of our common stock to demand a higher yield; |
• | actions by our stockholders; |
• | speculation in the press or investment community; |
• | general market, economic and political conditions, including an economic slowdown or dislocation in the global credit markets; |
• | failure to maintain the listing of our common stock on the NYSE MKT; |
• | failure of Residential to qualify or maintain qualification as a REIT; |
• | failure of Residential to maintain its exemption from registration under the Investment Company Act; |
• | changes in accounting principles; |
• | passage of legislation or other regulatory developments that adversely affect us or our industry; and |
• | departure of our key personnel. |
The market prices of securities of asset management service providers have experienced fluctuations that often have been unrelated or disproportionate to the operating results of these companies. These market fluctuations could result in extreme volatility in the market price of our common stock.
Furthermore, our small size and different investment characteristics may not continue to appeal to our current investor base that may seek to dispose of large amounts of our common stock. There is no assurance that there will be sufficient buying interest to offset those sales, and, accordingly, the market price of our common stock could be depressed and/or experience periods of high volatility.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
Our principal executive offices are located at 402 Strand Street, Frederiksted, St. Croix, United States Virgin Islands 00840-3531 where we sublease approximately 2,000 square feet from Ocwen under a sublease expiring June 30, 2017. The annual rent under the sublease was $40,000 per year until June 30, 2014 and continues at $45,000 per year until the termination date of the lease, plus one-half of the lease-related operating expenses and leasehold improvements. We do not currently own any real property that we use as office space. We are currently seeking new, larger space in St. Croix to further increase our staff to manage our business and the business of Residential.
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For information concerning Residential's current portfolio of residential mortgage loans and REO properties (including its single-family rental properties), see “Item 1. Business–Residential's Existing Portfolio.” The following table sets forth a summary of Residential's single-family properties as of December 31, 2014 ($ in thousands):
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State / District | Number of properties | Carrying value (1) | Weighted average age (2) | ||||
Alabama | 28 | $ | 4,410 | 21 | |||
Alaska | 1 | 185 | 28 | ||||
Arizona | 97 | 16,722 | 22 | ||||
Arkansas | 46 | 4,119 | 31 | ||||
California | 512 | 151,844 | 33 | ||||
Colorado | 25 | 4,871 | 28 | ||||
Connecticut | 25 | 4,639 | 45 | ||||
Delaware | 10 | 1,883 | 35 | ||||
District of Columbia | 1 | 244 | 103 | ||||
Florida | 696 | 104,922 | 23 | ||||
Georgia | 165 | 19,080 | 22 | ||||
Hawaii | 2 | 339 | 20 | ||||
Idaho | 9 | 1,095 | 32 | ||||
Illinois | 359 | 51,260 | 44 | ||||
Indiana | 155 | 16,726 | 33 | ||||
Iowa | 6 | 401 | 61 | ||||
Kansas | 27 | 2,255 | 45 | ||||
Kentucky | 54 | 6,033 | 30 | ||||
Louisiana | 22 | 2,329 | 27 | ||||
Maine | 14 | 1,669 | 116 | ||||
Maryland | 84 | 16,249 | 35 | ||||
Massachusetts | 36 | 6,977 | 81 | ||||
Michigan | 80 | 9,473 | 46 | ||||
Minnesota | 71 | 11,400 | 39 | ||||
Mississippi | 9 | 912 | 28 | ||||
Missouri | 75 | 6,859 | 44 | ||||
Montana | 3 | 295 | 39 | ||||
Nebraska | 5 | 997 | 37 | ||||
Nevada | 17 | 2,284 | 20 | ||||
New Hampshire | 13 | 2,079 | 49 | ||||
New Jersey | 47 | 7,782 | 64 | ||||
New Mexico | 30 | 3,864 | 21 | ||||
New York | 45 | 8,611 | 68 | ||||
North Carolina | 259 | 29,979 | 19 | ||||
Ohio | 124 | 13,127 | 45 | ||||
Oklahoma | 23 | 2,372 | 29 | ||||
Oregon | 8 | 1,336 | 30 | ||||
Pennsylvania | 188 | 24,361 | 54 | ||||
Rhode Island | 46 | 5,707 | 72 | ||||
South Carolina | 84 | 9,641 | 22 | ||||
South Dakota | 2 | 295 | 52 | ||||
Tennessee | 76 | 9,366 | 23 | ||||
Texas | 118 | 14,447 | 23 | ||||
Utah | 63 | 9,864 | 30 | ||||
Vermont | 3 | 561 | 140 | ||||
Virginia | 42 | 10,931 | 26 | ||||
Washington | 19 | 4,161 | 38 | ||||
West Virginia | 3 | 648 | 25 | ||||
Wisconsin | 132 | 14,728 | 49 | ||||
Wyoming | 1 | 275 | 21 | ||||
Total | 3,960 | $ | 624,607 | 34 | |||
_____________
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(1) | The carrying value of an asset is based on historical cost which generally consists of the market value at the time of foreclosure sale plus renovation costs, net of any accumulated depreciation. |
(2) | Weighted average age is based on the age weighted by carrying value for each state. |
Item 3. Legal proceedings
From time to time, we may be involved in various claims and legal actions arising in the ordinary course of business. As of December 31, 2014, we were not a party to, and our properties were not subject to, any pending or threatened legal proceedings that individually or in the aggregate, are expected to have a material impact on our financial condition, results of operations or cash flows. Subsequent to December 31, 2014, the following legal proceedings were commenced with respect to us:
On January 15, 2015, a shareholder derivative action was filed in the Circuit Court of Maryland for Baltimore City by a purported shareholder of Residential under the caption The Police Retirement System of Saint Louis v. Erbey, et al., 24-C-15-000223. The action names as defendants William C. Erbey and each of the members of Residential's Board of Directors and alleges that Mr. Erbey and Residential's directors breached fiduciary duties in connection with the asset management agreement among Residential, Altisource Residential, L.P. and us. The action also names Altisource Residential, L.P. and us as defendants and alleges that we aided and abetted the purported breaches of fiduciary duty and have been unjustly enriched by the asset management agreement. The complaint also names Residential as a nominal defendant. The plaintiff seeks, among other things, an order declaring that Mr. Erbey and the director defendants have breached their fiduciary duties, an order declaring that Mr. Erbey and we have been unjustly enriched, an order declaring that the asset management agreement is unenforceable and directing Residential's Board of Directors to terminate the asset management agreement, damages, disgorgement by Mr. Erbey and us of allegedly wrongful profits, changes to Residential's corporate governance and an award of attorney’s and other fees and expenses. We believe the complaint is without merit. At this time, we are not able to predict the ultimate outcome of this matter, nor can we estimate the range of possible loss, if any.
On January 16, 2015, a putative shareholder class action complaint was filed in the United States District Court of the Virgin Islands by a purported shareholder of AAMC under the caption City of Cambridge Retirement System v. Altisource Asset Management Corp., et al., 15-cv-00004. The action names as defendants AAMC, Mr. Erbey and certain officers of AAMC and alleges that the defendants violated federal securities laws by failing to disclose material information to AAMC shareholders concerning alleged conflicts of interest held by Mr. Erbey with respect to AAMC’s relationship and transactions with Residential, Altisource, Home Loan Servicing Solutions Ltd., Southwest Business Corporation, NewSource Reinsurance Company and Ocwen Financial Corporation, including allegations that the defendants failed to disclose (i) the nature of relationships between Mr. Erbey, AAMC and those entities; and (ii) that the transactions were the result of an allegedly unfair process from which Mr. Erbey failed to recuse himself. The action seeks, among other things, an award of monetary damages to the putative class in an unspecified amount, and an award of attorney’s and other fees and expenses. We believe the complaint is without merit. At this time, we are not able to predict the ultimate outcome of this matter, nor can we estimate the range of possible loss, if any.
On December 24, 2014, a shareholder derivative action was filed in the United States District Court for the Southern District of Florida by a purported shareholder of Ocwen under the caption Sokolowski v. Erbey, et al., 14-cv-8160-1. The action named the directors of Ocwen as defendants and alleged, among other things, various breaches of fiduciary duties by the directors of Ocwen. On February 11, 2015, plaintiff filed an amended complaint naming the directors of Ocwen as defendants and also naming Altisource, Residential, Home Loan Servicing Solutions and us as alleged aiders and abettors of the purported breaches of fiduciary duties. The amended complaint alleges that the directors of Ocwen breached their fiduciary duties by, among other things, allegedly failing to exercise oversight over Ocwen's compliance with applicable laws, rules and regulations; failing to exercise oversight responsibilities with respect to the accounting and financial reporting processes of Ocwen; failing to prevent conflicts of interest and allegedly improper related party transactions; failing to adhere to Ocwen's code of conduct and corporate governance guidelines; selling personal holdings of Ocwen stock on the basis of material adverse inside information; and disseminating allegedly false and misleading statements regarding Ocwen's compliance with regulatory obligations and allegedly self-dealing transactions with related companies. Plaintiff claims that as a result of the alleged breaches of fiduciary duties, Ocwen has suffered damages including settlements with regulatory agencies in excess of $2 billion, injury to its reputation and corporate goodwill, and exposure to governmental investigations and securities and consumer class action lawsuits. In addition to the derivative claims, the plaintiff also alleges an individual claim that Ocwen's 2014 proxy statement allegedly contained untrue statements of material fact and failed to disclose material information in violation of federal securities laws. The plaintiff seeks, among other things, an order requiring the defendants to repay to Ocwen unspecified amounts by which Ocwen has been damaged or will be damaged, an award of an unspecified amount of exemplary damages, changes to Ocwen's corporate governance, and an award of attorney's and other fees and expenses. We believe the claims
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against us in the matter are without merit. At this time, we are not able to predict the ultimate outcome of this matter, nor can we estimate the range of possible loss, if any.
Management does not believe that we have incurred an estimable, probable or material loss by reason of any of the above actions.
Item 4. Mine safety disclosures
Not applicable.
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Part II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Our common stock has been listed on the NYSE MKT under the symbol “AAMC” since September 12, 2013, and before such time, was quoted on the OTCQX under the same symbol since December 13, 2012. The following table sets forth the high and low close of day sales prices for our common stock as reported by the OTCQX through September 11, 2013 and thereafter the NYSE MKT for the periods indicated:
2014 | 2013 | ||||||||||||
Quarter ended | High | Low | High | Low | |||||||||
March 31 | $ | 1,196.36 | $ | 769.59 | $ | 148.00 | $ | 76.00 | |||||
June 30 | 1,112.37 | 723.06 | 336.00 | 128.35 | |||||||||
September 30 | 763.75 | 540.00 | 533.00 | 265.00 | |||||||||
December 31 | 699.92 | 310.12 | 1,035.00 | 515.40 | |||||||||
The number of holders of record of our common stock as of February 19, 2015 was 53. The number of beneficial stockholders is substantially greater than the number of holders as a large portion of our stock is held through brokerage firms. Information regarding securities authorized for issuance under equity compensation plans is set forth in Note 9 to the consolidated financial statements.
Dividends
We will pay dividends at the sole and absolute discretion of our Board of Directors in light of conditions then existing including our earnings, financial condition, liquidity, capital requirements, the availability of capital, general overall economic conditions and other factors. We paid no dividends from inception to December 31, 2014.
Issuer Purchases of Equity Securities
The Board of Directors has authorized total repurchases of $300.0 million of common stock. At December 31, 2014, we have remaining approximately $59.4 million authorized by our Board of Directors for share repurchases. Repurchased shares will be held as treasury stock and will be available for general corporate purposes. Below is a summary of our stock repurchases for the quarter ending December 31, 2014 (dollars in thousands).
(a) Total number of shares purchased (2) | (b) Average price paid per share (2) | (c) Total number of shares purchased as part of publicly announced plans or programs | (d) Maximum dollar value of shares that may yet be purchased under plans or programs(1) | |||||||||||
October 2014 | 10,455 | $ | 700.37 | 254,953 | $ | 60,755 | ||||||||
November 2014 | 3,000 | 464.64 | 257,953 | 59,361 | ||||||||||
December 2014 | — | — | 257,953 | 59,361 | ||||||||||
As of period ended December 31, 2014 | 13,455 | 647.81 | 257,953 | 59,361 | ||||||||||
__________
(1) Since Board approval of repurchases is based on dollar amount, we cannot estimate the number of shares yet to be purchased.
(2) The number of shares above excludes shares of common stock tendered to satisfy the tax withholding on equity awards as part of our equity incentive plan. For the year ended December 31, 2014, 6,012 shares were reacquired at a weighted average per share price of $803.04 pursuant to our equity incentive plan.
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Performance Graph
The following stock price performance graph compares the performance of our common stock to the S&P 500 and the Russell 2000. The stock price performance graph assumes an investment of $100 in our common stock and the two indices on December 13, 2012 and further assumes the reinvestment of all dividends. Stock price performance is not necessarily indicative of future results.
For the period from December 13, 2012 to December 31, | |||||||||
Index | 2012 | 2013 | 2014 | ||||||
Altisource Asset Management Corporation | $ | 546.67 | $ | 6,200.00 | $ | 2,067.47 | |||
S&P 500 | 100.47 | 130.22 | 145.05 | ||||||
Dow Jones Asset Manager Index | 99.60 | 142.17 | 154.24 | ||||||
The performance graph above is being furnished as part of this Annual Report solely in accordance with the requirement under Rule 14a-3(b)(9) to furnish the Company’s stockholders with such information and, therefore, is not deemed to be filed, or incorporated by reference in any filing, by the Company under the Securities Act of 1933 or the Securities Exchange Act of 1934.
Item 6. Selected Financial Data
The following table sets forth selected financial data which is derived from our audited consolidated financial statements ($ in thousands, except per share data). The historical results presented below may not be indicative of our future performance and do not necessarily reflect what our financial position would have been had we operated as a separate, stand-alone entity since inception. The data should be read in conjunction with our consolidated financial statements and notes thereto, included elsewhere in this report, and “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.”
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Year ended December 31, 2014 | Year ended December 31, 2013 | March 15, 2012 (inception) to December 31, 2012 | |||||||
Total revenue | $ | 423,298 | $ | 72,297 | $ | — | |||
Net income (loss) attributable to common stockholders | 59,679 | (5,293 | ) | (46 | ) | ||||
Earnings (loss) per basic share | 26.31 | (2.26 | ) | (0.02 | ) | ||||
Earnings (loss) per diluted share | 21.07 | (2.26 | ) | (0.02 | ) | ||||
December 31, 2014 | December 31, 2013 | December 31, 2012 | |||||||
Total assets | $ | 2,760,698 | $ | 1,405,104 | $ | 105,815 | |||
Repurchase agreements | 1,015,000 | 602,382 | — | ||||||
Other secured borrowings | 324,082 | — | |||||||
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Overview
Our primary business is to provide asset management and certain corporate governance services to Residential and NewSource. In October 2013, we applied for and were granted registration by the SEC as a registered investment adviser under section 203(c) of the Investment Advisers Act of 1940.
We have a capital light operating strategy. Residential is currently our primary source of revenue and will drive our results. 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 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.
On March 18, 2014, we closed a private placement for the issuance and sale of 250,000 shares of our Series A Convertible Preferred Stock, to Luxor Capital Group, LP, a New York based investment manager, and other institutional investors for proceeds of $250.0 million. We used substantially all of the proceeds from this transaction to repurchase shares of our common stock and for other corporate purposes. In the future we may use excess cash generated from operations to repurchase shares of our common stock when trading at attractive prices. Such stock repurchases may be made in the open market, block trades or privately-negotiated transactions. In connection with the foregoing, the Company's Board of Directors has approved a share repurchase program that authorizes us to repurchase up to $300.0 million in shares of our common stock.
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.
Since Residential has commenced operations, we have 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:
During the year ended December 31, 2014, Residential completed the acquisition of an aggregate of 7,326 residential mortgage loans, substantially all of which were non-performing, and 190 REO properties having an aggregate unpaid principal balance (“UPB”) of approximately $1.9 billion and an aggregate market value of underlying properties of $1.8 billion. The aggregate purchase price for these acquisitions was $1.2 billion.
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On June 27, 2014, Residential acquired 879 re-performing mortgage loans with an aggregate market value of underlying properties of $271.1 million for an aggregate purchase price of $144.6 million. During October 2014, Residential sold 770 of these re-performing mortgage loans.
In 2013, Residential acquired portfolios consisting of an aggregate of 8,491 residential mortgage loans and 40 REO properties, substantially all of which were non-performing, having an aggregate UPB of approximately $2.2 billion and an aggregate market value of underlying properties of $1.8 billion. The aggregate purchase price for these portfolios was $1.2 billion.
During 2014 and 2013, Residential modified an aggregate of 619 mortgage loans, converted an aggregate of 3,908 mortgage loans into REO properties and disposed of an aggregate of 946 mortgage loans through short sale, refinancing or other liquidation events.
Following the above-referenced transactions, as of December 31, 2014, Residential's portfolio consisted of 10,963 residential mortgage loans, substantially all of which were non-performing, having an aggregate UPB of approximately $2.9 billion and an aggregate market value of underlying properties of $2.7 billion. Residential also owned 3,960 REO properties with an aggregate carrying value of $624.6 million, of which 3,349 were held for use and 611 were held for sale. Of the 3,349 REO properties held for use, 336 REO properties had been rented and were occupied by tenants, 197 were being listed for rent and 254 were in varying stages of renovation. With respect to the remaining 2,562 REO properties held for use, Residential will make a final determination whether each property meets its rental profile after (a) applicable state redemption periods have expired, (b) the foreclosure sale has been ratified, (c) Residential has recorded the deed for the property, (d) utilities have been activated and (e) Residential has secured access for interior inspection. Residential also owned 102 re-performing mortgage loans held for sale having an aggregate UPB of approximately $18.4 million and an aggregate market value of underlying properties of approximately $22.5 million as of December 31, 2014.
To date, Residential has acquired its non-performing and re-performing mortgage loans through direct acquisitions from institutions such as banks, HUD and private equity funds.
NewSource commenced reinsurance activities during the second quarter of 2014, and generated approximately $5.0 million of title reinsurance premiums during 2014. In December 2014, NewSource sold its title reinsurance contract to an unaffiliated party. NewSource continues to maintain its reinsurance license and will continue to seek additional opportunities to provide reinsurance services to third parties.
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, properties in foreclosure and REO to remain steady over the next two years as GSEs, HUD, banks and other mortgage lenders seek to dispose of their distressed inventories. We continue to see substantial volumes of distressed residential mortgage loan portfolios offered for sale by banks, HUD, GSEs and private equity funds, among others. We believe that the distressed loan channel gives Residential a cost advantage over other acquisition channels such as foreclosure auctions and REO acquisitions, involves less competition and positions Residential to be selected as the buyer of diverse portfolios of such loans since Residential is not geographically constrained. 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.
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:
Revenues
Residential’s revenues primarily consist of the following:
i. | 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 |
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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.
ii. | 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. The difference between the carrying value of the asset at the time of conversion and the most recent market value, based on BPOs, is recorded in Residential's statement of operations as net unrealized gain on mortgage loans. 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 its 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 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. |
iii. | Net unrealized gains from the change in fair value of loans. After Residential's sub-performing and non-performing 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 our consolidated statements of operations. The exact nature of resolution will be dependent on a number of factors that are beyond our control, including borrower willingness to pay, property value, availability of refinancing, interest rates, conditions in the financial markets, the regulatory environment and other factors. |
iv. | Net realized gain on real estate. REO properties that do not meet Residential's investment criteria are sold out of its taxable REIT subsidiary. The realized gain or loss recognized in financial statements reflects the net amount of realized and unrealized gains on sold REOs from the time of acquisition to sale completion. |
As a greater number of Residential’s REO properties are renovated and deemed suitable for rental, we expect a greater portion of its revenues will be 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 leasing expenses, or reduced rental revenues.
Although Residential seeks to lease the majority of REO properties it acquires on foreclosure, it may also sell the properties that do not meet its rental 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.
Expenses
Residential's expenses primarily consist of rental property operating expenses, depreciation and amortization, real estate selling cost and impairment, mortgage loan servicing, interest expense, general and administrative expenses, expense reimbursement, incentive management fees. Rental property operating expenses are expenses associated with Residential's ownership and operation of rental properties including expenses such as Altisource's property management fees, expenses towards repairs, utility expenses on vacant properties, 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 these properties are depreciated on a straight-line basis over a fixed life. Real estate selling cost and impairment represents Residential's estimate for the costs to be incurred to sell a property and an amount that represents the carrying amount over the estimated fair value less costs to sell. Mortgage loan servicing costs are primarily for servicing fees, foreclosure fees and advances of residential property insurance. Interest expense consists of the costs to borrow money in connection with Residential's debt financing of its portfolios. General and administrative expenses consist of the costs related to the general operation and overall administration of Residential's and our business. Expense reimbursement consists
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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:
Acquisitions
Residential’s operating results will depend on our ability to source sub-performing and non-performing loans, as well as other residential mortgage loans and REO property assets. We believe that there is currently a large supply of sub-performing and non-performing mortgage 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 at times involve large portfolios of loans, and the timing and extent of Residential's success in acquiring such loans cannot be predicted. In addition, for any given portfolio of loans that we agree to acquire, we typically acquire fewer loans than originally expected, as certain loans may be resolved prior to the closing date or may fail to meet our diligence standards. Although the number of unacquired loans typically constitutes a relatively small portion of a particular portfolio, in certain cases, the number of loans we do not acquire could be a significant portion of a particular portfolio. In any case where we do not acquire the full portfolio, appropriate adjustments are made to the applicable purchase price.
Financing
Our ability to grow Residential’s business 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 will need to distribute at least 90% of its taxable income each year 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 changes 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 to cash gains, which can be used to fund the distribution requirements from the corresponding taxable gains. Distribution requirements from 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.
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Resolution Activities
First quarter 2013 | Second quarter 2013 | Third quarter 2013 | Fourth quarter 2013 | Year ended December 31, 2013 | First quarter 2014 | Second quarter 2014 | Third quarter 2014 | Fourth quarter 2014 | Year ended December 31, 2014 | ||||||||||||
Mortgage Loans (1) | |||||||||||||||||||||
Beginning balance | — | 673 | 1,332 | 5,020 | — | 8,054 | 11,509 | 12,070 | 12,090 | 8,054 | |||||||||||
Acquisitions | 684 | 720 | 3,783 | 3,304 | 8,491 | 4,207 | 1,590 | 1,289 | 240 | 7,326 | |||||||||||
Dispositions | (10 | ) | (28 | ) | (54 | ) | (119 | ) | (211 | ) | (116 | ) | (135 | ) | (165 | ) | (319 | ) | (735 | ) | |
Mortgage loan conversions to REO | (1 | ) | (33 | ) | (43 | ) | (151 | ) | (228 | ) | (637 | ) | (907 | ) | (1,113 | ) | (1,061 | ) | (3,718 | ) | |
Reversions to mortgage loans (2) | — | — | 2 | — | 2 | 1 | 13 | 9 | 13 | 36 | |||||||||||
Ending balance | 673 | 1,332 | 5,020 | 8,054 | 8,054 | 11,509 | 12,070 | 12,090 | 10,963 | 10,963 | |||||||||||
Modifications | — | 18 | 29 | 54 | 101 | 81 | 90 | 179 | 168 | 518 | |||||||||||
Loan reinstatements | 4 | 10 | 6 | 8 | 28 | 19 | 30 | 64 | 55 | 168 | |||||||||||
Real Estate Owned | |||||||||||||||||||||
Beginning balance | — | 7 | 40 | 114 | — | 262 | 896 | 1,958 | 2,984 | 262 | |||||||||||
Acquisitions | 6 | — | 34 | — | 40 | — | 190 | — | 47 | 237 | |||||||||||
Dispositions | — | — | (1 | ) | (3 | ) | (4 | ) | (2 | ) | (22 | ) | (78 | ) | (119 | ) | (221 | ) | |||
Mortgage loan conversions to REO | 1 | 33 | 43 | 151 | 228 | 637 | 907 | 1,113 | 1,061 | 3,718 | |||||||||||
Reversions to mortgage loans | — | — | (2 | ) | — | (2 | ) | (1 | ) | (13 | ) | (9 | ) | (13 | ) | (36 | ) | ||||
Ending balance | 7 | 40 | 114 | 262 | 262 | 896 | 1,958 | 2,984 | 3,960 | 3,960 | |||||||||||
Leased | — | 1 | 5 | 14 | 14 | 35 | 102 | 216 | 336 | 336 | |||||||||||
Renovations complete | — | — | 6 | 11 | 11 | 17 | 40 | 90 | 197 | 197 | |||||||||||
Renovations in process | — | 5 | 3 | 18 | 18 | 48 | 140 | 270 | 254 | 254 | |||||||||||
Evaluating strategy/held for sale | 7 | 34 | 100 | 219 | 219 | 796 | 1,676 | 2,408 | 3,173 | 3,173 | |||||||||||
7 | 40 | 114 | 262 | 262 | 896 | 1,958 | 2,984 | 3,960 | 3,960 | ||||||||||||
_____________
(1) | Excludes mortgage loans held for sale. |
(2) | Subsequent to the foreclosure sale, we may be notified that the foreclosure sale was invalidated for certain reasons. |
In addition, as of December 31, 2014, 207 of Residential's mortgage loans were on trial modification plans, compared to 197 mortgage loans on trial modification plans as of September 30, 2014.
Portfolio size
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, property management fees to Altisource and fees payable to AAMC. Residential may also incur additional interest expense if it incurs additional 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 and NewSource under U.S. GAAP. We also look at our stand-alone results because the effect of amounts received from Residential and NewSource are still recognized in net income attributable to our stockholders through the adjustment for earnings attributable to our noncontrolling interest in Residential.
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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.
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.
Altisource Asset Management Corporation
Consolidating Statement of Operations
Year ended December 31, 2014
(In thousands)
Residential (GAAP) | NewSource Stand-alone (Non-GAAP) | AAMC Stand-alone (Non-GAAP) | Consolidating Entries | AAMC Consolidated (GAAP) | |||||||||||
Revenues: | |||||||||||||||
Rental revenues | $ | 1,564 | $ | — | $ | — | $ | — | $ | 1,564 | |||||
Net unrealized gain on mortgage loans | 350,822 | — | — | — | 350,822 | ||||||||||
Net realized gain on mortgage loans | 55,766 | — | — | — | 55,766 | ||||||||||
Net realized gain on re-performing mortgage loans | 2,771 | — | — | — | 2,771 | ||||||||||
Net realized gain on real estate | 9,482 | — | — | — | 9,482 | ||||||||||
Interest income | 2,893 | 156 | — | (156 | ) | 2,893 | |||||||||
Incentive management fee | — | — | 67,949 | (67,949 | ) | — | |||||||||
Expense reimbursements | — | — | 7,011 | (7,011 | ) | — | |||||||||
Total revenues | 423,298 | 156 | 74,960 | (75,116 | ) | 423,298 | |||||||||
Expenses: | |||||||||||||||
Residential property operating expenses | 26,018 | — | — | — | 26,018 | ||||||||||
Real estate depreciation and amortization | 1,067 | — | — | — | 1,067 | ||||||||||
Real estate selling costs and impairment | 21,788 | — | — | — | 21,788 | ||||||||||
Mortgage loan servicing costs | 68,181 | — | — | — | 68,181 | ||||||||||
Interest expense | 35,812 | — | — | (165 | ) | 35,647 | |||||||||
General and administrative | 7,047 | 4,168 | 8,676 | — | 19,891 | ||||||||||
Related party general and administrative | 77,030 | 941 | 2,474 | (74,960 | ) | 5,485 | |||||||||
Total expenses | 236,943 | 5,109 | 11,150 | (75,125 | ) | 178,077 | |||||||||
Other income | 2,543 | 5,015 | 9 | (2,160 | ) | 5,407 | |||||||||
Income before income taxes | 188,898 | 62 | 63,819 | (2,151 | ) | 250,628 | |||||||||
Income tax expense | 45 | — | 2,051 | — | 2,096 | ||||||||||
Net income | 188,853 | 62 | 61,768 | (2,151 | ) | 248,532 | |||||||||
Net income attributable to noncontrolling interest in consolidated affiliate | — | — | — | (188,853 | ) | (188,853 | ) | ||||||||
Net income attributable to common stockholders | $ | 188,853 | $ | 62 | $ | 61,768 | $ | (191,004 | ) | $ | 59,679 | ||||
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Altisource Asset Management Corporation
Consolidating Statement of Operations
Year ended December 31, 2013
(In thousands)
Residential (GAAP) | NewSource Stand-alone (Non-GAAP) | AAMC Stand-alone (Non-GAAP) | Consolidating Entries | AAMC Consolidated (GAAP) | |||||||||||
Revenues: | |||||||||||||||
Rental revenues | $ | 36 | $ | — | $ | — | $ | — | $ | 36 | |||||
Net unrealized gain on mortgage loans | 61,092 | — | — | — | 61,092 | ||||||||||
Net realized gain on mortgage loans | 10,482 | — | — | — | 10,482 | ||||||||||
Interest income | 687 | — | — | — | 687 | ||||||||||
Incentive management fee | — | — | 4,880 | (4,880 | ) | — | |||||||||
Expense reimbursements | — | — | 5,411 | (5,411 | ) | — | |||||||||
Total revenues | 72,297 | — | 10,291 | (10,291 | ) | 72,297 | |||||||||
Expenses: | |||||||||||||||
Residential property operating expenses | 767 | — | — | — | 767 | ||||||||||
Real estate depreciation and amortization | 25 | — | — | — | 25 | ||||||||||
Real estate selling costs and impairment | 184 | — | — | — | 184 | ||||||||||
Mortgage loan servicing costs | 10,418 | — | — | — | 10,418 | ||||||||||
Interest expense | 4,568 | — | — | — | 4,568 | ||||||||||
General and administrative | 4,208 | 77 | 13,980 | — | 18,265 | ||||||||||
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 | — | — | — | — | — | ||||||||||
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 | ) | |
Altisource Asset Management Corporation
Consolidating Statement of Operations
March 15, 2012 (inception) to December 31, 2012
(In thousands)
Residential (GAAP) | AAMC Stand-alone (Non-GAAP) | Consolidating Entries | AAMC Consolidated (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 | ) | |
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Altisource Asset Management Corporation
Consolidating Balance Sheet
December 31, 2014
(In thousands)
Residential (GAAP) | NewSource stand-alone (non-GAAP) | AAMC Stand-alone (Non-GAAP) | Consolidating Entries | AAMC Consolidated (GAAP) | |||||||||||
Assets: | |||||||||||||||
Real estate held for use: | |||||||||||||||
Land | $ | 14,424 | $ | — | $ | — | $ | — | $ | 14,424 | |||||
Rental residential properties, net | 60,908 | — | — | — | 60,908 | ||||||||||
Real estate owned | 457,045 | — | — | — | 457,045 | ||||||||||
Total real estate held for use, net | 532,377 | — | — | — | 532,377 | ||||||||||
Real estate assets held for sale | 92,230 | — | — | — | 92,230 | ||||||||||
Mortgage loans | 1,959,044 | — | — | — | 1,959,044 | ||||||||||
Mortgage loans held for sale | 12,535 | — | — | — | 12,535 | ||||||||||
Cash and cash equivalents | 66,166 | 6,026 | 44,590 | — | 116,782 | ||||||||||
Restricted cash | 13,282 | — | — | — | 13,282 | ||||||||||
Accounts receivable | 10,313 | 919 | 1 | (165 | ) | 11,068 | |||||||||
Related party receivables | 17,491 | 14,991 | 28,512 | (43,503 | ) | 17,491 | |||||||||
Investment in affiliate | 18,000 | — | 2,000 | (20,000 | ) | — | |||||||||
Deferred leasing and financing costs, net | 4,251 | — | — | — | 4,251 | ||||||||||
Prepaid expenses and other assets | 373 | 3 | 1,262 | — | 1,638 | ||||||||||
Total assets | $ | 2,726,062 | $ | 21,939 | $ | 76,365 | $ | (63,668 | ) | $ | 2,760,698 | ||||
Liabilities: | |||||||||||||||
Repurchase agreements | $ | 1,015,000 | $ | — | $ | — | $ | — | $ | 1,015,000 | |||||
Other secured borrowings | 339,082 | — | — | (15,000 | ) | 324,082 | |||||||||
Accounts payable and accrued liabilities | 11,678 | 3,173 | 2,040 | (165 | ) | 16,726 | |||||||||
Related party payables | 33,391 | 941 | 349 | (28,512 | ) | 6,169 | |||||||||
Total liabilities | 1,399,151 | 4,114 | 2,389 | (43,677 | ) | 1,361,977 | |||||||||
Commitments and contingencies | — | — | — | — | — | ||||||||||
Preferred stock | — | — | 248,927 | — | 248,927 | ||||||||||
Equity: | |||||||||||||||
Common stock | 572 | — | 25 | (572 | ) | 25 | |||||||||
Additional paid-in capital | 1,227,091 | 20,000 | 14,152 | (1,247,091 | ) | 14,152 | |||||||||
Retained earnings/(accumulated deficit) | 99,248 | (2,175 | ) | 56,340 | (99,239 | ) | 54,174 | ||||||||
Treasury stock | — | — | (245,468 | ) | — | (245,468 | ) | ||||||||
Total stockholders' equity | 1,326,911 | 17,825 | (174,951 | ) | (1,346,902 | ) | (177,117 | ) | |||||||
Noncontrolling interest in consolidated affiliate | — | — | — | 1,326,911 | 1,326,911 | ||||||||||
Total equity | 1,326,911 | 17,825 | (174,951 | ) | (19,991 | ) | 1,149,794 | ||||||||
Total liabilities and equity | $ | 2,726,062 | $ | 21,939 | $ | 76,365 | $ | (63,668 | ) | $ | 2,760,698 | ||||
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Altisource Asset Management Corporation
Consolidating Balance Sheet
December 31, 2013
(In thousands)
Residential (GAAP) | NewSource stand-alone (non-GAAP) | AAMC Stand-alone (Non-GAAP) | Consolidating Entries | AAMC Consolidated (GAAP) | |||||||||||
Assets: | |||||||||||||||
Real estate held for use: | |||||||||||||||
Land | $ | 478 | $ | — | $ | — | $ | — | $ | 478 | |||||
Rental residential properties, net | 3,092 | — | — | — | 3,092 | ||||||||||
Real estate owned | 32,332 | — | — | — | 32,332 | ||||||||||
Total real estate held for use, net | 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 | — | — | — | 5,87 | ||||||||||