| ARBOR REALTY TRUST INC ITEM 1A RISK FACTORS Our business is subject to various risks, including the risks listed below |
| If any of these risks actually occur, our business, financial condition and results of operations could be materially adversely affected and the value of our common stock could decline |
| Risks Related to Our Business We may be unable to invest excess equity capital on acceptable terms or at all, which would adversely affect our operating results |
| We may not be able to identify investments that meet our investment criteria and we may not be successful in closing the investments that we identify |
| Unless and until we identify structured finance and mortgage-related security investments consistent with our investment criteria, any excess equity capital may be used to repay borrowings under our warehouse credit facility, bridge loan warehouse facility and repurchase agreements, which would not produce a return on capital |
| In addition, the investments that we acquire with our equity capital may not produce a return on capital |
| There can be no assurance that we will be able to identify attractive opportunities to invest our equity capital which would adversely affect our results of operations |
| 13 _________________________________________________________________ [68]Table of Contents We depend on key personnel with long standing business relationships, the loss of whom could threaten our ability to operate our business successfully |
| Our future success depends, to a significant extent, upon the continued services of our manager and our employees |
| In particular, the mortgage lending experience of Mr |
| Ivan Kaufman and Mr |
| Fred Weber and the extent and nature of the relationships they have developed with developers of multi-family and commercial properties and other financial institutions are critical to the success of our business |
| We cannot assure you of their continued employment with Arbor Commercial Mortgage or us |
| The loss of services of one or more members of our manager’s officers or our officers could harm our business and our prospects |
| The majority of our investments as of December 31, 2005 are mezzanine loans which are subject to a greater risk of loss than loans with a first priority lien on the underlying real estate |
| We invest in mezzanine loans that take the form of subordinated loans secured by second mortgages on the underlying property or loans secured by a pledge of the ownership interests of either the entity owning the property or a pledge of the ownership interests of the entity that owns the interest in the entity owning the property |
| These types of investments involve a higher degree of risk than long term senior mortgage lending secured by income producing real property because the investment may become unsecured as a result of foreclosure by the senior lender |
| In the event of a bankruptcy of the entity providing the pledge of its ownership interests as security, we may not have full recourse to the assets of such entity, or the assets of the entity may not be sufficient to satisfy our mezzanine loan |
| If a borrower defaults on our mezzanine loan or debt senior to our loan, or in the event of a borrower bankruptcy, our mezzanine loan will be satisfied only after the senior debt |
| As a result, we may not recover some or all of our investment |
| In addition, mezzanine loans may have higher loan to value ratios than conventional mortgage loans, resulting in less equity in the property and increasing the risk of loss of principal |
| We invest in multi-family and commercial real estate loans, which may involve a greater risk of loss than single family real estate loans |
| Our investments include multi-family and commercial real estate loans that are considered to involve a higher degree of risk than single family residential lending because of a variety of factors, including generally larger loan balances, dependency for repayment on successful operation of the mortgaged property and tenant businesses operating therein, and loan terms that include amortization schedules longer than the stated maturity and provide for balloon payments at stated maturity rather than periodic principal payments |
| In addition, the value of commercial real estate can be affected significantly by the supply and demand in the market for that type of property |
| Volatility of values of multi-family and commercial properties may adversely affect our loans and investments |
| Multi-family and commercial property values and net operating income derived from such properties are subject to volatility and may be affected adversely by a number of factors, including, but not limited to, national, regional and local economic conditions (which may be adversely affected by industry slowdowns and other factors); local real estate conditions (such as an oversupply of housing, retail, industrial, office or other commercial space); changes or continued weakness in specific industry segments; construction quality, age and design; demographic factors; retroactive changes to building or similar codes; and increases in operating expenses (such as energy costs) |
| In the event a property’s net operating income decreases, a borrower may have difficulty paying our loan, which could result in losses to us |
| In addition, decreases in property values reduce the value of the collateral and the potential proceeds available to a borrower to repay our loans, which could also cause us to suffer losses |
| 14 _________________________________________________________________ [69]Table of Contents We may be unable to generate sufficient revenue from operations to pay our operating expenses and to pay dividends to our stockholders |
| As a REIT, we are generally required to distribute at least 90prca of our taxable income each year to our stockholders |
| In order to qualify for the tax benefits accorded to REITs, we intend to pay quarterly dividends and to make distributions to our stockholders in amounts such that we distribute all or substantially all of our taxable income each year, subject to certain adjustments |
| However, our ability to make distributions may be adversely affected by the risk factors described in this form 10-K In the event of a downturn in our operating results and financial performance or unanticipated declines in the value of our asset portfolio, we may be unable to declare or pay quarterly dividends or make distributions to our stockholders |
| The timing and amount of dividends are in the sole discretion of our board of directors, which considers, among other factors, our earnings, financial condition, debt service obligations and applicable debt covenants, REIT qualification requirements and other tax considerations and capital expenditure requirements as our board may deem relevant from time to time |
| Among the factors that could adversely affect our results of operations and impair our ability to make distributions to our stockholders are: • our ability to make profitable structured finance investments; • defaults in our asset portfolio or decreases in the value of our portfolio; • the fact that anticipated operating expense levels may not prove accurate, as actual results may vary from estimates; and • increased debt service requirements, including those resulting from higher interest rates on variable rate indebtedness |
| A change in any one of these factors could affect our ability to make distributions |
| If we are not able to comply with the restrictive covenants and financial ratios contained in our credit facilities, our ability to make distributions to our stockholders may also be impaired |
| We cannot assure you that we will be able to make distributions to our stockholders in the future or that the level of any distributions we make will increase over time |
| In addition, distributions to stockholders are generally taxable to our stockholders as ordinary income, but a portion of these distributions may be designated by us as long-term capital gains to the extent they are attributable to capital gain income recognized by us, or may constitute a return of capital to the extent they exceed our earnings and profits as determined for tax purposes |
| We may need to borrow funds under our credit facilities in order to satisfy our REIT distribution requirements, and a portion of our distributions may constitute a return of capital |
| Debt service on any borrowings for this purpose will reduce our cash available for distribution |
| We may need to borrow funds to meet the REIT requirement that we distribute at least 90prca of our taxable income each year to our stockholders if our cash flows from operations are not sufficient to cover the distribution requirements or because there are differences in timing between the recognition of taxable income and the actual receipt of income in cash |
| Our warehouse credit facility, bridge loan warehouse facility and master repurchase agreements allow us to borrow up to a maximum amount against each of our investments financed under these credit facilities |
| If we have not borrowed the maximum allowable amount against any of these investments, we may borrow funds under our credit facilities up to these maximum amounts in order to satisfy REIT distribution requirements |
| Any required debt service will reduce cash and net income available for operations or distribution to our stockholders |
| In order to maximize the return on our funds, cash generated from operations is generally used to temporarily pay down borrowings under credit facilities whose primary purpose is to fund our new loans and investments |
| When making distributions, we borrow the required funds by drawing on credit capacity available under our credit facilities |
| To date, all distributions have been funded in this manner |
| If distributions exceed 15 _________________________________________________________________ [70]Table of Contents cash available in the future, we may be required to borrow additional funds, which would reduce the amount of cash available for other purposes, or sell assets in order to meet our REIT distribution requirements |
| Failure to maintain an exemption from the Investment Company Act would adversely affect our results of operations |
| We believe that we conduct and we intend to conduct our business in a manner that allows us to avoid being regulated as an investment company under the Investment Company Act of 1940, as amended, or the Investment Company Act |
| Under Section 3(c) (5) (C), the Investment Company Act exempts entities that are primarily engaged in the business of purchasing or otherwise acquiring “mortgages and other liens on and interests in real estate |
| ” The staff of the SEC has provided guidance on the availability of this exemption |
| Specifically, the staff’s position generally requires us to maintain at least 55prca of our assets directly in qualifying real estate interests |
| To constitute a qualifying real estate interest under this 55prca requirement, a real estate interest must meet various criteria |
| Loans that are secured by equity interests in entities that directly or indirectly own the underlying real property, rather than a mortgage on the underlying property itself, and ownership of equity interests in owners of real property may not qualify for purposes of the 55prca test depending on the type of entity |
| Mortgage-related securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may also not qualify for purposes of the 55prca test |
| Therefore, our ownership of these types of debt instruments and equity interests may be limited by the provisions of the Investment Company Act |
| To the extent that we do not comply with the SEC staff’s 55prca test or another exemption or exclusion from registration under the Investment Company Act or other interpretations under the Investment Company Act, we may be deemed to be an investment company |
| If we fail to maintain an exemption or other exclusion from registration as an investment company we could, among other things, be required either (a) to substantially change the manner in which we conduct our operations to avoid being required to register as an investment company or (b) to register as an investment company, either of which could have an adverse effect on us and the market price of our common stock |
| If we were required to register as an investment company under the Investment Company Act, we would become subject to substantial regulation with respect to our capital structure (including our ability to use leverage), management, operations, transactions with affiliated persons (as defined in the Investment Company Act), portfolio composition, including restrictions with respect to diversification and industry concentration and other matters |
| We are substantially controlled by Arbor Commercial Mortgage and its controlling equity owner, Mr |
| Ivan Kaufman is our chairman and chief executive officer and the president and chief executive officer of our manager |
| Further, Mr |
| Kaufman and the Kaufman entities together beneficially own approximately 90prca of the outstanding membership interests of Arbor Commercial Mortgage |
| Arbor Commercial Mortgage owns approximately 3dtta8 million operating partnership units, representing a 18prca limited partnership interest in our operating partnership and we own the remaining 82prca |
| The operating partnership units are redeemable for cash or, at our election, for shares of our common stock generally on a one-for-one basis |
| Each of the operating partnership units Arbor Commercial Mortgage owns is paired with one share of our special voting preferred stock, each of which entitle Arbor Commercial Mortgage to one vote on all matters submitted to a vote of our stockholders |
| Arbor Commercial Mortgage is currently entitled to approximately 3dtta8 million votes, or 18prca of the voting power of our outstanding stock |
| Kaufman, as its controlling equity owner, an exemption from the ownership limitation contained in our charter, in connection with Arbor Commercial Mortgage’s acquisition of approximately 3dtta1 million shares of our special voting preferred stock on July 1, 2003 |
| Because of his position with us and our manager and his ability to effectively vote a substantial minority of our outstanding voting stock, Mr |
| Kaufman has significant influence over our policies and strategy |
| 16 _________________________________________________________________ [71]Table of Contents Our charter as amended generally does not permit ownership in excess of 8dtta3prca of our capital stock, and attempts to acquire our capital stock in excess of this limit are ineffective without prior approval from our board of directors |
| For the purpose of preserving our REIT qualification, our charter generally prohibits direct or constructive ownership by any person of more than 8dtta3prca (by value or by number of shares, whichever is more restrictive) of the outstanding shares of our common stock or 8dtta3prca (by value) of our outstanding shares of capital stock |
| For purposes of this calculation, warrants held by such person will be deemed to have been exercised if such exercise would result in a violation |
| Our charter’s constructive ownership rules are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity |
| As a result, the acquisition of less than these percentages of the outstanding stock by an individual or entity could cause that individual or entity to own constructively in excess of these percentages of the outstanding stock and thus be subject to our charter’s ownership limit |
| Any attempt to own or transfer shares of our common or preferred stock in excess of the ownership limit without the consent of the board of directors will result in the shares being automatically transferred to a charitable trust or otherwise be void |
| Risks Related to Conflicts of Interest We are dependent on our manager with whom we have conflicts of interest |
| Fred Weber, Mr |
| Walter Horn, Mr |
| Gene Kilgore, a two-person securitization group and a 16-person asset management group, and are dependent upon our manager, Arbor Commercial Mortgage, to provide services to us that are vital to our operations |
| Our chairman, chief executive officer and president, Mr |
| Ivan Kaufman, is also the chief executive officer and president of our manager |
| Our chief financial officer, Mr |
| Paul Elenio, is the chief financial officer of our manager, and our secretary, general counsel, and director of compliance, Mr |
| Walter Horn, is the general counsel of our manager |
| Kaufman and the Kaufman entities together beneficially own approximately 90prca of the outstanding membership interests of Arbor Commercial Mortgage and Messrs |
| Elenio, Weber, Fogel, Martello and Horn, also hold an ownership interest in Arbor Commercial Mortgage |
| Martello also serves as the trustee of one of the Kaufman entities that holds a majority of the outstanding membership interests in Arbor Commercial Mortgage and co-trustee of another Kaufman entity that owns an equity interest in our manager |
| Arbor Commercial Mortgage holds an 18prca limited partnership interest in our operating partnership which as a result has 18prca of the voting power of our outstanding stock |
| We may enter into transactions with Arbor Commercial Mortgage outside the terms of the management agreement with the approval of majority vote of the independent members of our board of directors |
| Transactions required to be approved by a majority of our independent directors include, but are not limited to, our ability to purchase securities and mortgage and other assets from Arbor Commercial Mortgage or to sell securities and assets to Arbor Commercial Mortgage |
| Arbor Commercial Mortgage may from time to time provide permanent mortgage loan financing to clients of ours, which will be used to refinance bridge financing provided by us |
| We and Arbor Commercial Mortgage may also make loans to the same borrower or to borrowers that are under common control |
| Additionally, our policies and those of Arbor Commercial Mortgage may require us to enter into intercreditor agreements in situations where loans are made by us and Arbor Commercial Mortgage to the same borrower |
| We have entered into a management agreement with our manager under which our manager provides us with all of the services vital to our operations other than asset management services |
| However, the management agreement was not negotiated at arm’s length and its terms, including fees payable, may not be as favorable to us as if it had been negotiated with an unaffiliated third party |
| Certain matters relating to our organization also were not approved at arm’s length and the terms of the contribution of assets to us may not be as favorable to us as if the contribution was with an unaffiliated third party |
| The results of our operations is dependent upon the availability of, and our manager’s ability to identify and capitalize on, investment opportunities |
| Our manager’s officers and employees are also responsible for 17 _________________________________________________________________ [72]Table of Contents providing the same services for Arbor Commercial Mortgage’s portfolio of investments |
| As a result, they may not be able to devote sufficient time to the management of our business operations |
| Our directors have approved very broad investment guidelines for our manager and do not approve each investment decision made by our manager |
| Our manager is authorized to follow very broad investment guidelines |
| Our directors will periodically review our investment guidelines and our investment portfolio |
| However, our board does not review each proposed investment |
| In addition, in conducting periodic reviews, the directors rely primarily on information provided to them by our manager |
| Furthermore, transactions entered into by our manager may be difficult or impossible to unwind by the time they are reviewed by the directors |
| Our manager has great latitude within the broad investment guidelines in determining the types of assets it may decide are proper investments for us |
| Our manager has broad discretion to invest funds and may acquire structured finance assets where the investment returns are substantially below expectations or that result in net operating losses |
| Our manager has broad discretion, within the general investment criteria established by our board of directors, to allocate the proceeds of the concurrent offerings and to determine the timing of investment of such proceeds |
| Such discretion could result in allocation of proceeds to assets where the investment returns are substantially below expectations or that result in net operating losses, which would materially and adversely affect our business, operations and results |
| The management compensation structure that we have agreed to with our manager may cause our manager to invest in high risk investments |
| Our manager is entitled to a base management fee, which is based on the equity of our operating partnership |
| The amount of the base management fee does not depend on the performance of the services provided by our manager or the types of assets it selects for our investment, but the value of our operating partnership’s equity will be affected by the performance of these assets |
| Our manager is also entitled to receive incentive compensation based in part upon our achievement of targeted levels of funds from operations |
| In evaluating investments and other management strategies, the opportunity to earn incentive compensation based on funds from operations may lead our manager to place undue emphasis on the maximization of funds from operations at the expense of other criteria, such as preservation of capital, in order to achieve higher incentive compensation |
| Investments with higher yield potential are generally riskier or more speculative |
| This could result in increased risk to the value of our invested portfolio |
| Risk Related to Our Status as a REIT If we fail to remain qualified as a REIT, we will be subject to tax as a regular corporation and could face substantial tax liability |
| We conduct our operations to qualify as a REIT under the Internal Revenue Code |
| However, qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only limited judicial and administrative authorities exist |
| Even a technical or inadvertent mistake could jeopardize our REIT status |
| Our continued qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis |
| In particular, our ability to qualify as a REIT depends in part on the relative values of our common and special voting preferred stock, which have not been determined by independent appraisal, are susceptible to fluctuation, and could, if successfully challenged by the IRS, cause us to fail to meet the ownership requirements |
| In addition, our ability to satisfy the requirements to qualify as a REIT depends in part on the actions of third parties over which we have no control or only limited influence, including in cases where we own an equity interest in an entity that is classified as a partnership for US federal income tax purposes |
| 18 _________________________________________________________________ [73]Table of Contents Furthermore, new tax legislation, administrative guidance or court decisions, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to qualify as a REIT If we fail to qualify as a REIT in any tax year, then: • we would be taxed as a regular domestic corporation, which, among other things, means we would be unable to deduct distributions to stockholders in computing taxable income and would be subject to federal income tax on our taxable income at regular corporate rates; • any resulting tax liability could be substantial and would reduce the amount of cash available for distribution to stockholders; and • unless we were entitled to relief under applicable statutory provisions, we would be disqualified from treatment as a REIT for the subsequent four taxable years following the year during which we lost our qualification, and thus, our cash available for distribution to stockholders would be reduced for each of the years during which we did not qualify as a REIT |