NEXPOINT DIVERSIFIED REAL ESTATE TRUST The following is a discussion and analysis of our financial condition and our historical results of operations. The following should be read in conjunction with our financial statements and accompanying notes included herein and with our Annual Report, filed with theSecurities and Exchange Commission (the "SEC") onApril 4, 2022 . This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those projected, forecasted, or expected in these forward-looking statements as a result of various factors, including, but not limited to, those discussed below and elsewhere in this quarterly report. See "Cautionary Statement Regarding Forward-Looking Statements" in this report. Overview As ofSeptember 30, 2022 , our Portfolio consisted primarily of debt and equity investments in the single-family rental, self-storage, office, hospitality, life science and multifamily sectors. Substantially all of our business is conducted through the OP. The OP GP is the sole general partner of the OP and is owned 100% by the Company. As ofSeptember 30, 2022 , there were 2,000 OP Units outstanding, of which 100%, were owned by us. On the Deregistration Date, theSEC issued the Deregistration Order. The issuance of the Deregistration Order enables the Company to proceed with full implementation of the Business Change. As a result of the Business Change, we have not provided a comparison of our financial statements to prior periods in which we were operating as a registered investment company because it would not be useful to our shareholders. The discussion herein is principally limited to our financial condition and results of operations during the period from the Deregistration Date toSeptember 30, 2022 . As a diversified REIT, the Company's primary investment objective is to provide both current income and capital appreciation. The Company seeks to achieve this objective through the Business Change. Target underlying property types primarily include, but are not limited to, single-family rentals, multifamily, self-storage, life science, office, industrial, hospitality, net lease and retail. The Company may, to a limited extent, hold, acquire or transact in certain non-real estate securities. We are externally managed by the Adviser through the Advisory Agreement, by and among the Company and the Adviser. The Advisory Agreement was datedJuly 1, 2022 , and amended onOctober 25, 2022 , for an initial three-year term. The Adviser is wholly owned byNexPoint Advisors, L.P. We have elected to be taxed as a REIT under Sections 856 through 860 of the Code, and expect to continue to qualify as a REIT. To qualify as a REIT, we must meet a number of organizational and operational requirements, including a requirement that we distribute at least 90% of our REIT taxable income to our shareholders. As a REIT, we will be subject to federal income tax on our undistributed REIT taxable income and net capital gain and to a 4% nondeductible excise tax on any amount by which distributions we pay with respect to any calendar year are less than the sum of (1) 85% of our ordinary income, (2) 95% of our capital gain net income and (3) 100% of our undistributed income from prior years. We believe we qualify for taxation as a REIT under the Code, and we intend to continue to operate in such a manner, but no assurance can be given that we will operate in a manner so as to qualify as a REIT. Taxable income from certain non-REIT activities is managed through a TRS and is subject to applicable federal, state, and local income and margin taxes. OnOctober 15, 2021 , a lawsuit was filed by a trust set up in connection with theHighland Capital Management, L.P. bankruptcy in theUnited States Bankruptcy Court for the Northern District of Texas . The lawsuit makes claims against a number of entities, including our Sponsor andJames Dondero . The lawsuit does not include claims related to our business or our assets or operations. Our Sponsor andMr. Dondero have informed us they believe the lawsuit has no merit and they intend to vigorously defend against the claims. We do not expect the lawsuit will have a material effect on our business, results of operations or financial condition. Macroeconomic trends, including increases in inflation and rising interest rates, may adversely impact our business, financial condition and results of operations. Inflation inthe United States has recently accelerated and is currently expected to continue at an elevated level in the near-term. Rising inflation could have an adverse impact on our operating expenses and our floating rate mortgages and credit facilities, as these costs could increase at a rate higher than our rental and other revenue. There is no guarantee we will be able to mitigate the impact of rising inflation. TheFederal Reserve has recently started raising interest rates to combat inflation and restore price stability and it is expected that rates will continue to rise throughout the remainder of 2022. In addition, to the extent our exposure to increases in interest rates on any of our debt is not eliminated through interest rate swaps and interest rate protection agreements, such increases will result in higher debt service costs which will adversely affect our cash flows. We cannot make assurances that our access to capital and other sources of funding will not become constrained, which could adversely affect the availability and terms of future borrowings, renewals or refinancings. Such future constraints could increase our borrowing costs, which would make it more difficult or expensive to obtain additional financing or refinance existing obligations and commitments, which could slow or deter future growth
Components of Our Revenues and Expenses
Revenues Rental income. Our rental income is primarily attributable to the rental revenue from our investment inCityplace Tower , a 42-story, 1.35 million-square-foot, trophy office building acquired in 2018 as well as rental income from two retail properties (see Note 5 to our consolidated financial statements). Also included are utility reimbursements, late fees, common area maintenance reimbursements, and other rental fees charged to tenants. 35
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Interest and dividends. Interest and dividends include interest earned from our debt investments and dividends from our equity investments.
Other income. Other income includes ancillary income earned from tenants such as non-refundable fees, parking fees, and other miscellaneous fees charged to tenants and income items.
Expenses
Property operating expenses. Property operating expenses include property maintenance costs, salary and employee benefit costs, utilities, casualty-related expenses and recoveries and other property operating costs of property owned directly or indirectly by us.
Real estate taxes and insurance. Real estate taxes include the property taxes assessed by local and state authorities depending on the location of each property owned directly or indirectly by us. Insurance includes the cost of commercial, general liability, and other needed insurance for each property owned directly or indirectly by us.
Property management fees. Property management fees include fees paid to NexVest, our property manager, for managing each property directly or indirectly owned by us (see Note 13 to our consolidated financial statements). Advisory and administrative fees. Advisory and administrative fees include the fees paid to our Adviser pursuant to the Advisory Agreement (see Note 13 to our consolidated financial statements). Corporate general and administrative expenses. Corporate general and administrative expenses include, but are not limited to, audit fees, legal fees, listing fees, board of trustee fees, investor relations costs and payments of reimbursements to our Adviser for operating expenses. Corporate general and administrative expenses and the Advisory Fees and Administrative Fees paid to our Adviser will not exceed the Expense Cap for the 12 months subsequent to the Deregistration Date, calculated in accordance with the Advisory Agreement. The Expense Cap does not limit the reimbursement by us of expenses related to securities offerings paid by our Adviser. The Expense Cap also does not apply to legal, accounting, financial, due diligence, and other service fees incurred in connection with mergers and acquisitions, extraordinary litigation, or other events outside our ordinary course of business or any out-of-pocket acquisition or due diligence expenses incurred in connection with the acquisition or disposition of real estate assets. Additionally, in the sole discretion of the Adviser, the Adviser may elect to waive reimbursement for eligible out-of-pocket expenses paid on the Company's behalf. Once waived, such expenses are considered permanently waived and become non-recoupable in the future.
Property general and administrative expenses. Property general and administrative expenses include the costs of marketing, professional fees, general office supplies, and other administrative related costs of each property owned directly or indirectly by us.
Depreciation and amortization. Depreciation and amortization costs primarily include depreciation of our real properties and amortization of acquired in-place leases on property owned directly or indirectly by us.
Other Income and Expense Interest expense. Interest expense primarily includes the cost of interest expense on debt, the amortization of deferred financing costs, if any, and the related impact of interest rate derivatives, if any, used to manage our interest rate risk. Equity in earnings (losses) of unconsolidated ventures. Equity in earnings (losses) of unconsolidated ventures represents the change in our basis in equity method investments resulting from our share of the investments' income and expenses. Profit and loss from equity method investments for which we've elected the fair value option are classified in divided income, change in unrealized gains and realized gains as applicable.
Tax Expense. Tax expense is primarily derived from taxable gains from asset sales and other income earned from investments held in our TRS.
Unrealized Gain (Loss) on Investments. Unrealized gains and losses represent
changes in fair value for equity method investments, CLO equity investments,
bonds, common stock, convertible notes, LLC interests, LP interests, rights and
warrants, and senior loans for which the fair value option has been elected.
Realized Gain (Loss) on Investments. The Company recognizes the excess, or
deficiency, of net proceeds received, less the carrying value of such
investments, as realized gains or losses, respectively. The Company reverses
cumulative, unrealized gains or losses previously reported in its Consolidated
Statements of Operations on both the Successor and Predecessor basis with
respect to the investment sold at the time of the sale.
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Results of Operations for the Three Months Ended
The three months ended
As a result of the Business Change, we have not provided a comparison of our financial statements to prior periods in which we were operating as a registered investment company because it would not be useful to our shareholders. The discussion herein is principally limited to our financial condition and results of operations during the period from the Deregistration Date toSeptember 30, 2022 .
The following table sets forth a summary of our operating results for the three
months ended
For the Three Months
Ended September 30,
2022
Total revenues $ 40,763
Total expenses (12,720 )
Operating income 28,043
Interest expense (2,541 )
Equity in losses of unconsolidated ventures (1,581 )
Tax expense (7,516 )
Change in unrealized losses (78,238 )
Realized gains 2,846
Net loss (58,987 )
Net income attributable to preferred shareholders (1,155 )
Net loss attributable to common shareholders $ (60,142 )
The net loss for the three months ended September 30, 2022 primarily relates to
mark-to-market losses on our investments accounted for at fair value partially
offset by interest and dividends.
Revenues
Rental income. Rental income was
Interest and dividends. Interest and dividends totaled$36.1 million for the three months endedSeptember 30, 2022 . Interest and dividends consists primarily of dividends from CLO equity investments of$29.1 million , NREF OP distributions of$3.5 million and VB OP distributions of$1.4 million .
Other income. Other income was approximately
Expenses Property operating expenses. Property operating expenses were$1.8 million for the three months endedSeptember 30, 2022 . Property operating expenses consist primarily of expenses from our investment inCityplace Tower . Real estate taxes and insurance. Real estate taxes and insurance costs were$1.5 million for the three months endedSeptember 30, 2022 . Real estate taxes and insurance expenses consist primarily of expenses from our investment inCityplace Tower . Property management fees. Property management fees were$0.2 million for the three months endedSeptember 30, 2022 . Property management fees are primarily based on gross revenues derived primarily from our investment inCityplace Tower . Advisory and administrative fees. For the three months endedSeptember 30, 2022 , the Company incurred Administrative Fees and Advisory Fees of$2.9 million , inclusive of$0.9 million in expenses that were deferred to comply with the Expense Cap. Should the Company's Fees and expenses subject to the Expense Cap be less than the 1.5% limit for the twelve month period subsequent to the Deregistration Date, some or all of the deferred expenses could be recouped by the Adviser up to the Expense Cap. Corporate general and administrative expenses. Corporate general and administrative expenses were$1.9 million for the three months endedSeptember 30, 2022 . Corporate general and administrative expenses were primarily driven by legal fees$0.6 million and valuation fees of$0.4 million .
Property general and administrative expenses. Property general and
administrative expenses were
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Depreciation and amortization. Depreciation and amortization costs were$3.6 million for the three months endedSeptember 30, 2022 . Depreciation and amortization expenses consist primarily of expenses from our investment inCityplace Tower . Due to the Business Change, the fair value of our real properties as ofJuly 1, 2022 became the new cost basis for the Company. This change reset the depreciable basis of our properties as well as caused the recognition of new intangible lease assets. The amortization of intangible lease assets over a six-month period from the date of acquisition is expected to increase the amortization expense during the first year from the date of the Business Change. Other Income and Expense
Interest expense. Interest expense was
Equity in losses of unconsolidated ventures. Equity in losses of unconsolidated ventures was$1.6 million for the three months endedSeptember 30, 2022 and was primarily driven by amortization of the basis difference on theSAFStor Ventures of approximately$1.3 million . Tax expense. The Company has recorded a current income tax expense of$10.8 million associated with the TRS for the three months endedSeptember 30, 2022 , which is largely driven by income from the Company's legacy CLO investments. The tax expense is partially offset by removing the valuation allowance on a deferred tax asset of$3.3 million for a net expense of$7.5 million that is recorded on the Consolidated Statement of Operations. Change in unrealized losses. Unrealized losses from our investments accounted for at fair value was$78.2 million for the three months endedSeptember 30, 2022 . Losses were primarily driven by mark-to-market losses on NREF OP units of$36.9 million and losses on our CLO equity portfolio of$27.2 million . Our CLO equity portfolio consists primarily of CLOs that are in the process of winding down operations and liquidating their remaining holdings. The losses on the CLO equity portfolio are offset by dividends received of$29.1 million which are shown in interest and dividends on the consolidated statement of operations. Realized gains. Realized gains were$2.9 million for three months endedSeptember 30, 2022 , driven primarily by gains on life settlement maturities of$3.4 million partially offset by a legacy investment that was written off for a loss of$0.6 million .
Liquidity and Capital Resources
Our short-term liquidity requirements consist primarily of funds necessary to pay for debt maturities, operating expenses and other expenditures including:
? capital expenditures to continue the ongoing development of
? interest expense and scheduled principal payments on outstanding indebtedness
(see "-Obligations and Commitments" below);
? recurring maintenance necessary to maintain our properties;
? distributions necessary to qualify for taxation as a REIT;
? income taxes for taxable income generated by the TRS;
? acquisition of additional properties or investments;
? advisory and administrative fees payable to our Adviser;
? general and administrative expenses;
? reimbursements to our Adviser; and
? property management fees.
We expect to meet our short-term liquidity requirements generally through net
cash provided by operations and existing cash balances. As of September 30,
2022 , we had $29.2 million of cash available to meet our short-term liquidity
requirements. As of September 30, 2022 , we also had $34.5 million of restricted
cash held in reserve by the lender on the Cityplace debt. These reserves
include escrows for property taxes and insurance, reserves for tenant
improvements as well as required excess collateral.
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Our long-term liquidity requirements consist primarily of funds necessary to pay for the costs of acquiring additional properties, make additional accretive investments pursuant to our investment strategy, renovations and other capital expenditures to improve our properties and scheduled debt payments and distributions. We expect to meet our long-term liquidity requirements through various sources of capital, which may include a revolving credit facility and future debt or equity issuances, existing working capital, net cash provided by operations, long-term mortgage indebtedness and other secured and unsecured borrowings, and property and non-real estate asset dispositions. However, there are a number of factors that may have a material adverse effect on our ability to access these capital sources, including the state of overall equity and credit markets, our degree of leverage, our unencumbered asset base and borrowing restrictions imposed by lenders (including as a result of any failure to comply with financial covenants in our existing and future indebtedness), general market conditions for REITs, our operating performance and liquidity, market perceptions about us and restrictions on sales of properties under the Code. The success of our business strategy will depend, in part, on our ability to access these various capital sources. In addition to our ongoing renovation of Cityplace, our other properties will require periodic capital expenditures and renovation to remain competitive. We estimate an additional$120 million to$130 million of capital expenditures to complete the Cityplace renovation. Also, acquisitions, redevelopments, or expansions of our properties will require significant capital outlays. Long-term, we may not be able to fund such capital improvements solely from net cash provided by operations because we must distribute annually at least 90% of our REIT taxable income, determined without regard to the deductions for dividends paid and excluding net capital gains, to qualify and maintain our qualification as a REIT, and we are subject to tax on any retained income and gains. As a result, our ability to fund capital expenditures, acquisitions, or redevelopment through retained earnings long-term is limited. Consequently, we expect to rely heavily upon the availability of debt or equity capital for these purposes. If we are unable to obtain the necessary capital on favorable terms, or at all, our financial condition, liquidity, results of operations, and prospects could be materially and adversely affected. We believe that our available cash, expected operating cash flows, and potential debt or equity financings will provide sufficient funds for our operations, anticipated scheduled debt service payments and dividend requirements for the twelve-month period followingSeptember 30, 2022 . Cash Flows
The following table presents selected data from our consolidated statements of
cash flows for the three months ended
For the Three
Months Ended
September 30,
2022
Net cash provided by operating activities $ 27,944
Net cash used in investing activities (13,545 ) Net cash used in financing activities (1,477 ) Net increase in cash, cash equivalents and restricted cash
12,922
Cash, cash equivalents and restricted cash, beginning of period
50,776
Cash, cash equivalents and restricted cash, end of period $
63,698 Cash flows from operating activities. During the three months endedSeptember 30, 2022 , net cash provided by operating activities was$27.9 million . Operating cash flows were primarily driven by dividends received from our CLO equity portfolio. Cash flows from investing activities. During the three months endedSeptember 30, 2022 , net cash used in investing activities was$13.6 million . Cash flows from investing activities was primarily driven by acquisitions of new real estate investments of$26.5 million partially offset by proceeds from the redemption of our Caddo Sustainable Timberlands investment of$10.9 million . Cash flows from financing activities. During the three months endedSeptember 30, 2022 , net cash used in financing activities was$1.5 million . Cash flows from financing activities was primarily driven by borrowings of$13.3 million , offset by credit facility repayments of$9.5 million and dividends paid to common shareholders of$5.6 million . Debt Mortgage Debt As ofSeptember 30, 2022 , our consolidated subsidiaries had aggregate mortgage debt outstanding to third parties of approximately$145.3 million at a weighted average interest rate of 5.7%. See Note 7 to our consolidated financial statements for additional information. 39
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We intend to invest in additional real estate investments as suitable opportunities arise and adequate sources of equity and debt financing are available. We expect that future investments in properties, including any improvements or renovations of current or newly acquired properties, will depend on and will be financed by, in whole or in part, our existing cash, future borrowings and the proceeds from additional issuances of common shares or other securities or investment and property dispositions. Although we expect to be subject to restrictions on our ability to incur indebtedness, we expect that we will be able to refinance existing indebtedness or incur additional indebtedness for acquisitions or other purposes, if needed. However, there can be no assurance that we will be able to refinance our indebtedness, incur additional indebtedness or access additional sources of capital, such as by issuing common shares or other debt or equity securities, on terms that are acceptable to us or at all. Furthermore, following the completion of our renovation and development programs and depending on the interest rate environment at the applicable time, we may seek to refinance our floating rate debt into longer-term fixed rate debt at lower leverage levels. Credit Facility OnJanuary 8, 2021 , the Company entered into the$30.0 million Credit Facility withRaymond James Bank, N.A. and drew the full balance. The Credit Facility, as amended, bears interest at one-month LIBOR plus 3.5% and matures onMarch 6, 2023 . The Company paid down$10.0 million on the Credit Facility during the year endedDecember 31, 2021 . During the nine months endedSeptember 30, 2022 , the Company paid down$6.0 million on the Credit Facility. As ofSeptember 30, 2022 , the Credit Facility had an outstanding balance of$14.0 million . For additional information regarding our Credit Facility, see Note 7. Obligations and Commitments The following table summarizes our contractual obligations and commitments as ofSeptember 30, 2022 for the next four calendar years subsequent toSeptember 30, 2022 . Payments Due by Period (in thousands) Total 2022 2023 2024 2025 2026 Thereafter Property Level Debt Principal payments$ 158,510 $ 591 $ 144,669 $ -$ 13,250 $ - $ - Interest expense 5,316 2,291 1,695 830 499 - - Total$ 163,826 $ 2,882 $ 146,364 $ 830 $ 13,749 $ - $ - Prime Brokerage Borrowing Principal payments$ 10,059 $ - $ - $ - $ - $ -$ 10,059 (1) Interest expense 1,571 93 369 370 369 369 - (1) Total$ 11,630 $ 93 $ 369 $ 370 $ 369 $ 369 $ 10,059 Preferred Shares Dividend payments $ -$ 1,155 $ 4,620 $ 4,620 $ 4,620 $ 4,620 N/A (2) Credit Facility Principal payments$ 14,000 $ 3,000 $ 11,000 $ - $ - $ - $ - Interest expense 333 213 120 - - - - Total$ 14,333 $ 3,213 $ 11,120 $ - $ - $ - $ - Total contractual obligations and commitments$ 189,789 $ 7,343 $ 162,474 $ 5,821 $ 18,738 $ 4,989 $ 10,059
(1) Assumes no additional borrowings or repayments. The Prime Brokerage balance
has no stated maturity date.
(2) The Series A Preferred Shares are perpetual.
Credit Facility
The Credit Facility will mature on
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Table of Contents Cityplace Debt OnNovember 8, 2022 , we received lender consent to defer the maturity of the Cityplace debt toFebruary 7, 2023 . Management recognizes that finding an alternative source of funding is necessary to repay the debt by the maturity date. Management is evaluating multiple options to fund the repayment of the$145.3 million principal balance outstanding, including recasting the debt, securing additional equity or debt financing, selling a portion of the portfolio, or any combination thereof. Management believes that there is sufficient time before the maturity date and that the Company has sufficient access to capital to ensure the Company is able to meet its obligations as they become due. Advisory Agreement As consideration for the Adviser's services under the Advisory Agreement, we pay our Adviser the Fees The first$1 million of the monthly installment of the Advisory Fee is paid in cash and the remainder of the monthly installment, if any, is paid in our common shares, subject to certain restrictions. The Administrative Fee is paid in cash. Direct payment of operating expenses by us together with reimbursement of operating expenses to the Adviser, plus compensation expenses relating to equity awards granted under a long-term incentive plan and all other corporate general and administrative expenses of the Company, including the Fees payable under the Advisory Agreement, may not exceed the Expense Cap, for the twelve-month period following the Company's receipt of the Deregistration Order, calculated as of the end of each quarter; provided, however, that this limitation will not apply to Offering Expenses, legal, accounting, financial, due diligence and other service fees incurred in connection with extraordinary litigation and mergers and acquisitions or other events outside the ordinary course of our business or any out-of-pocket acquisition or due diligence expenses incurred in connection with the acquisition or disposition of certain real estate-related investments; provided, further, in the event the Company consolidates another entity that it does not wholly own as a result of owning a controlling interest in such entity or otherwise, expenses will be calculated without giving effect to such consolidation and instead such entity's expenses will, on a pro rata basis consistent with the Company's percentage ownership, be considered those of the Company for purposes of calculation of expenses. Income Taxes We anticipate that we will continue to qualify to be taxed as a REIT forU.S. federal income tax purposes, and we intend to continue to be organized and to operate in a manner that will permit us to qualify as a REIT. However, we can give no assurance that we will maintain REIT qualification. To qualify as a REIT, we must meet certain organizational and operational requirements, including a requirement to distribute at least 90% of our annual "REIT taxable income", as defined by the Code, to stockholders. As a REIT, we will be subject to federal income tax on our undistributed REIT taxable income and net capital gain and to a 4% nondeductible excise tax on any amount by which distributions we pay with respect to any calendar year are less than the sum of (1) 85% of our ordinary income, (2) 95% of our capital gain net income and (3) 100% of our undistributed income from prior years. Taxable income from certain non-REIT activities is managed through a TRS and is subject to applicable federal, state, and local income and margin taxes. The Company has recorded a current income tax expense of$10.8 million associated with the TRS for the three months endedSeptember 30, 2022 , which is largely driven by income from the Company's legacy CLO investments. The tax expense is partially offset by removing the valuation allowance on a deferred tax asset of$3.3 million for a net expense of$7.5 million that is recorded on the Consolidated Statement of Operations. If we fail to qualify as a REIT in any taxable year, we could be subject toU.S. federal income tax on our taxable income at regular corporate income tax rates, and dividends paid to our shareholders would not be deductible by us in computing taxable income. Any resulting corporate liability could be substantial and could materially and adversely affect our net income (loss) and net cash available for distribution to stockholders. Unless we were entitled to relief under certain Code provisions, we also would be disqualified from re-electing to be taxed as a REIT for the four taxable years following the year in which we failed to qualify to be taxed as a REIT. As ofSeptember 30, 2022 , we believe we are in compliance with all applicable REIT requirements. We evaluate the accounting and disclosure of tax positions taken or expected to be taken in the course of preparing our tax returns to determine whether the tax positions are "more-likely-than-not" (greater than 50% probability) of being sustained by the applicable tax authority. Tax positions not deemed to meet the more-likely-than-not threshold would be recorded as a tax benefit or expense in the current year. Our management is required to analyze all open tax years, as defined by the statute of limitations, for all major jurisdictions, which include federal and certain states. As ofSeptember 30, 2022 and to our knowledge, we have no examinations in progress and none are expected at this time. 41
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We recognize our tax positions and evaluate them using a two-step process. First, we determine whether a tax position is more likely than not to be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. Second, we will determine the amount of benefit to recognize and record the amount that is more likely than not to be realized upon ultimate settlement. We and our subsidiaries are subject to federal income tax as well as income tax of various state and local jurisdictions. The 2021, 2020 and 2019 tax years remain open to examination by tax jurisdictions to which our subsidiaries and we are subject. When applicable, we recognize interest and/or penalties related to uncertain tax positions on our consolidated statements of operations and comprehensive income (loss). Dividends We intend to make regular quarterly dividend payments to holders of our common shares.U.S. federal income tax law generally requires that a REIT distribute annually at least 90% of its REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains. As a REIT, we will be subject to federal income tax on our undistributed REIT taxable income and net capital gain and to a 4% nondeductible excise tax on any amount by which distributions we pay with respect to any calendar year are less than the sum of (1) 85% of our ordinary income, (2) 95% of our capital gain net income and (3) 100% of our undistributed income from prior years. We intend to make regular quarterly dividend payments of all or substantially all of our taxable income to holders of our common shares out of assets legally available for this purpose, if and to the extent authorized by our Board. Before we make any dividend payments, whether forU.S. federal income tax purposes or otherwise, we must first meet both our operating requirements and debt service on our debt payable. If our cash available for distribution is less than our taxable income, we could be required to sell assets, borrow funds or raise additional capital to make cash dividends or we may make a portion of the required dividend in the form of a taxable distribution of stock or debt securities. We will make dividend payments based on our estimate of taxable earnings per share of common stock, but not earnings calculated pursuant to GAAP. Our dividends and taxable income and GAAP earnings will typically differ due to items such as depreciation and amortization, fair value adjustments, differences in premium amortization and discount accretion, and non-deductible general and administrative expenses. Our quarterly dividends per share may be substantially different than our quarterly taxable earnings and GAAP earnings per share. Our Board declared our ninth monthly dividend of 2022 on our common shares of$0.05 per share which was paid onSeptember 30, 2022 to shareholders of record onSeptember 19, 2022 . Our Board declared our third quarterly dividend of 2022 on our Series A Preferred Shares of$0.34375 per share which was paid onSeptember 30, 2022 to shareholders of record onSeptember 23, 2022 . StartingOctober 1, 2022 , we expect that dividends on our common shares, when, if and as declared by our Board, will be declared on a quarterly basis.
Off-Balance Sheet Arrangements
As of
Critical Accounting Policies and Estimates
Management's discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires our management to make judgments, assumptions and estimates that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate these judgments, assumptions and estimates for changes that would affect the reported amounts. These estimates are based on management's historical industry experience and on various other judgments and assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these judgments, assumptions and estimates. Below is a discussion of the accounting policies that we consider critical to understanding our financial condition or results of operations where there is uncertainty or where significant judgment is required.
See Note 2, "Summary of Significant Accounting Policies", for further discussion of our accounting estimates and policies.
Fair Value Measurements Fair value measurements are determined based on the assumptions that market participants would use in pricing an asset or liability. As a basis for considering market participant assumptions in fair value measurements, ASC 820 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity's own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy):
? Level 1 inputs utilize quoted prices (unadjusted) in active markets for
identical assets or liabilities that the Company has the ability to access.
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? Level 2 inputs are inputs other than quoted prices included in Level 1 that
are observable for the asset or liability, either directly or indirectly.
Level 2 inputs may include quoted prices for similar assets and liabilities in
active markets, as well as inputs that are observable for the asset or
liability (other than quoted prices), such as interest rates and yield curves
that are observable at commonly quoted intervals.
? Level 3 inputs are the unobservable inputs for the asset or liability, which
are typically based on an entity's own assumption, as there is little, if any,
related market activity. In instances where the determination of the fair
value measurement is based on input from different levels of the fair value
hierarchy, the level in the fair value hierarchy within which the entire fair
value measurement falls is based on the lowest level input that is significant
to the fair value measurement in its entirety.
The Company's assessment of the significance of a particular input to the fair
value measurement in its entirety requires judgment and considers factors
specific to the asset or liability. The Company utilizes independent third
parties to perform the allocation of value analysis for each property
acquisition and to perform the market valuations on its derivative financial
instruments and has established policies, as described above, processes and
procedures intended to ensure that the valuation methodologies for investments
and derivative financial instruments are fair and consistent as of the
measurement date.
Valuation of Investments
As of September 30, 2022 , the Company's fair valued investments consisted of
senior loans, corporate bonds, collateralized loan obligations, convertible
notes, common stocks, rights, warrants, life settlement contracts, LP interests
and LLC interests. The fair value of the Company's senior loans, bonds, and
collateralized loan obligations are generally based on quotes received from
brokers or independent pricing services. Senior loans, bonds, and collateralized
loan obligations with quotes that are based on actual trades with a sufficient
level of activity on or near the measurement date are classified as Level 2
assets. Senior loans, bonds, and collateralized loan obligations that are priced
using quotes derived from implied values, indicative bids, or a limited number
of actual trades are classified as Level 3 assets because the inputs used by the
brokers and pricing services to derive the values are not readily observable.
The fair value of the Company's common stocks, rights, and warrants that are not
actively traded on national exchanges are generally priced using quotes derived
from implied values, indicative bids, or a limited amount of actual trades and
are classified as Level 3 assets because the inputs used by the brokers and
pricing services to derive the values are not readily observable. At the end of
each calendar quarter, the Adviser evaluates the Level 2 and 3 assets and
liabilities for changes in liquidity, including but not limited to: whether a
broker is willing to execute at the quoted price, the depth and consistency of
prices from third party services, and the existence of contemporaneous,
observable trades in the market. Additionally, the Adviser evaluates the Level 1
and 2 assets and liabilities on a quarterly basis for changes in listings or
delistings on national exchanges. Due to the inherent uncertainty of determining
the fair value of investments that do not have a readily available market value,
the fair value of the Company's investments may fluctuate from period to period.
Additionally, the fair value of investments may differ significantly from the
values that would have been used had a ready market existed for such investments
and may differ materially from the values the Company may ultimately realize.
Further, such investments may be subject to legal and other restrictions on
resale or otherwise be less liquid than publicly traded securities.
The fair value of the Company's common stocks, exchange-traded funds, other
registered investment companies and warrants that are not actively traded on
national exchanges are generally priced using quotes derived from implied
values, indicative bids, or a limited amount of actual trades and are classified
as Level 3 assets because the inputs used by the brokers and pricing services to
derive the values are not readily observable. The Company's real estate
investments include equity interests in limited liability companies and equity
issued by REITs that invest in commercial real estate. The fair value of real
estate investments that are not actively traded on national exchanges are based
on internal models developed by the Adviser. The significant inputs to the
models include cash flow projections for the underlying properties,
capitalization rates and appraisals performed by independent valuation firms.
These inputs are not readily observable, and the Company has classified the
investments as Level 3 assets. Exchange-traded options are valued based on the
last trade price on the primary exchange on which they trade. If an option does
not trade, the mid-price, which is the mean of the bid and ask price, is
utilized to value the option.
The fair value of the Company's convertible notes are categorized as Level 3
assets in the fair value hierarchy. Convertible notes are valued using a
discounted cash flow model using discount rates derived from observable market
data applied to the internal rate of return implied by the expected contractual
cash flows.
Upon initial acquisition, the Company's life settlement contracts are recognized
at the transaction price. For each subsequent reporting period, the investments
are measured at fair value by a third-party valuation specialist using a life
settlement pricing model and are categorized as Level 3 assets in the fair value
hierarchy. Key assumptions utilized in determining fair value include but are
not limited to: (i) life expectancy estimates provided by independent third
party underwriters based on actuarially developed mortality tables and industry
life expectancy reports; (ii) future premium estimates; (iii) rates of return
consistent with those sought by independent purchasers of life policies at the
time of purchase; and (iv) offers and/or commitments from purchasers. In
addition, the valuation agent will also consider recent sales as well as offers
received for the life policies deemed likely to close in the near future in
estimating fair value.
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The assumptions used to value life policies are by nature, inherently uncertain
and the effect of changes in estimates may be material. The fair value
measurement used in estimating the present value calculations are derived from
valuation techniques that include inputs that are not based on observable market
data. Changes in the fair value of the life settlement contracts are reported as
net unrealized gains or losses on the Consolidated Statement of Operations
(Successor Basis). Upon the death of an insured or the sale of a life policy,
the Company will recognize the difference between the proceeds received and the
cost of the life policy as a realized gain or loss in the Company's Consolidated
Statement of Operations (Successor basis).
Purchase Price Allocation
Upon acquisition of a property considered to be an asset acquisition, the
purchase price and related acquisition costs ("total consideration") are
allocated to land, buildings, improvements, furniture, fixtures, and equipment,
and intangible lease assets based on relative fair value in accordance with FASB
ASC 805, Business Combinations. Acquisition costs related to asset acquisitions
are capitalized in accordance with FASB ASC 805.
The allocation of total consideration, which is determined using inputs that are
classified within Level 3 of the fair value hierarchy established by FASB ASC
820, Fair Value Measurement and Disclosures (see Note 9 to our consolidated
financial statements), is based on management's estimate of the property's
"as-if" vacant fair value and is calculated by using all available information
such as the replacement cost of such asset, appraisals, property condition
reports, market data and other related information. If any debt is assumed in an
acquisition, the difference between the fair value, which is estimated using
inputs that are classified within Level 2 of the fair value hierarchy, and the
face value of debt is recorded as a premium or discount and amortized as
interest expense over the life of the debt assumed.
Impairment
Real estate assets are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. The key inputs into our impairment analysis include, but are not
limited to, the holding period, net operating income, and capitalization rates.
In such cases, we will evaluate the recoverability of such real estate assets
based on estimated future cash flows and the estimated liquidation value of such
real estate assets, and provide for impairment if such undiscounted cash flows
are insufficient to recover the carrying amount of the real estate asset. If
impaired, the real estate asset will be written down to its estimated fair
value. The Company's impairment analysis identifies and evaluates events or
changes in circumstances that indicate the carrying amount of a real estate
investment may not be recoverable, including determining the period the Company
will hold the rental property, net operating income, and the estimated
capitalization rate for each respective real estate investment.
Inflation
The real estate market has not been affected significantly by inflation in the
past several years due to increases in rents nationwide. Our lease terms are
generally for a period of one year or more and reset to market if renewed. The
majority of our leases also contain protection provisions applicable to
reimbursement billings for utilities.
Inflation may also affect the overall cost of debt, as the implied cost of
capital increases. Currently, the Federal Reserve is raising interest rates in
response to or in anticipation of continued inflation concerns. We intend to
mitigate these risks through long-term fixed interest rate loans and interest
rate hedges.
REIT Tax Election
We have elected to be taxed as a REIT under Sections 856 through 860 of the Code
and expect to continue to qualify as a REIT. To qualify as a REIT, we must meet
a number of organizational and operational requirements, including a requirement
that we distribute at least 90% of our "REIT taxable income," as defined by the
Code, to our shareholders. Taxable income from certain non-REIT activities is
managed through a TRS and is subject to applicable federal, state, and local
income and margin taxes. The Company has recorded a current income tax expense
of $10.8 million associated with the TRS for the three months ended September
30, 2022 , which is largely driven by income from the Company's legacy CLO
investments. The tax expense is partially offset by removing the valuation
allowance on a deferred tax asset of $3.3 million for a net expense of $7.5
million that is recorded on the Consolidated Statement of Operations. We believe
we qualify for taxation as a REIT under the Code, and we intend to continue to
operate in such a manner, but no assurance can be given that we will operate in
a manner so as to qualify as a REIT.
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