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. 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 ofDecember 31, 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 ofDecember 31, 2022 , there were 2,000 OP Units outstanding, of which 100%, were owned by us. OnJuly 1, 2022 , or the Deregistration Date, theSEC issued the Deregistration Order pursuant to Section 8(f) of the Investment Company Act declaring that the Company has ceased to be an investment company under the Investment Company Act. The issuance of the Deregistration Order enables the Company to proceed with full implementation of its new business mandate to operate as a diversified REIT that focuses primarily on investing in various commercial real estate property types and across the capital structure, including but not limited to equity, mortgage debt, mezzanine debt and preferred equity (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 toDecember 31, 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 58
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term that will expire on
We have elected to be taxed as a REIT under Sections 856 through 860 of the Code. 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 one or more TRS entities and are subject to applicable federal, state, and local income and margin taxes. OnOctober 15, 2021 , the Bankruptcy Trust Lawsuit was filed by a litigation subtrust formed in connection with the Highland Bankruptcy against various persons and entities, including our Sponsor andJames Dondero . In addition, onFebruary 8, 2023 , the UBS Lawsuit was filed againstMr. Dondero and a number of other persons and entities. Neither the Bankruptcy Trust Lawsuit nor theUBS Lawsuit include claims related to our business or our assets. Our Sponsor andMr. Dondero have informed us they believe the Bankruptcy Trust Lawsuit has no merit, andMr. Dondero has informed us he believes the UBS Lawsuit has no merit; we have been advised that the defendants named in each of the lawsuits intend to vigorously defend against the claims. We do not expect theBankruptcy Trust Lawsuit or the UBS 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. 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). Our rental income also includes utility reimbursements, late fees, common area maintenance reimbursements, and other rental fees charged to tenants.
Interest income. Interest income includes interest earned from our debt investments.
Dividend income. Dividend income includes 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.
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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 14 to our consolidated financial statements).
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.
Advisory and administrative fees. Advisory and administrative fees include the fees paid to our Adviser pursuant to the Advisory Agreement (see Note 14 to our consolidated financial statements).
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.
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. Conversion expense. In connection with the Deregistration Order, the Company has incurred legal fees and other fees in preparation for the Business Change. These conversion expenses are included in the consolidated statement of operations and comprehensive income (loss) as conversion expenses.
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) ofUnconsolidated 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.
Income Tax Expense. Income tax expense is primarily derived from taxable gains from asset sales and other income earned from investments held in our TRSs.
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 Six Months Ended
The six 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 toDecember 31, 2022 .
The following table sets forth a summary of our operating results for the six
months ended
For the Six Months
Ended December 31,
2022
Total revenues $55,130
Total expenses (24,358)
Operating income 30,772
Interest expense (5,759)
Equity in losses of unconsolidated ventures (2,257)
Income tax expense (9,975)
Change in unrealized losses (92,031)
Realized loss (2,323)
Net loss (81,573)
Net income attributable to preferred shareholders (2,310)
Net loss attributable to common shareholders $ (83,883)
The net loss for the six months ended December 31, 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$10.1 million for the six months endedDecember 31, 2022 . Rental income primarily consists of lease revenue from our investment inCityplace Tower . Interest and dividends. Interest and dividends totaled$45.0 million for the six months endedDecember 31, 2022 . Interest and dividends consists primarily of dividends from CLO equity investments of$29.1 million , NREF OP distributions of$7.0 million andVineBrook Homes Operating Partnership, L.P. ("VB OP") distributions of$2.8 million .
Other income. Other income was approximately
Expenses
Property operating expenses. Property operating expenses were
Property management fees. Property management fees were$0.3 million for the six months endedDecember 31, 2022 . Property management fees are primarily based on gross revenues derived primarily from our investment inCityplace Tower .
Real estate taxes and insurance. Real estate taxes and insurance costs were
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Advisory and administrative fees. For the six months endedDecember 31, 2022 , the Company incurred Administrative Fees and Advisory Fees of$5.5 million , inclusive of$1.8 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. Property general and administrative expenses. Property general and administrative expenses were$0.3 million for the six months endedDecember 31, 2022 . Property general and administrative expenses consist primarily of expenses from our investment inCityplace Tower . Corporate general and administrative expenses. Corporate general and administrative expenses were$3.1 million for the six months endedDecember 31, 2022 . Corporate general and administrative expenses were primarily driven by legal fees$0.8 million . Conversion expenses. Conversion expenses were$1.6 million for the six months endedDecember 31, 2022 . Conversion fees were primarily driven by legal fees related to the Deregistration Order of$0.9 million . Depreciation and amortization. Depreciation and amortization costs were$7.2 million for the six months endedDecember 31, 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 estate 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.
Other Income and Expense
Interest expense. Interest expense was
Equity in losses of unconsolidated ventures. Equity in losses of unconsolidated ventures was$2.3 million for the six months endedDecember 31, 2022 and was primarily driven by amortization of the basis difference on theSAFStor Ventures of approximately$2.2 million . Income tax expense. The Company has recorded a current income tax expense of$10.7 million associated with the TRSs for the six months endedDecember 31, 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$2.2 million and increased by a 2021 return-to-provision adjustment of$1.5 million for a net expense of$10.0 million for the six months endedDecember 31, 2022 , that is recorded on the Consolidated Statement of Operations. Change in unrealized losses. Unrealized losses from our investments accounted for at fair value was$92.0 million for the six months endedDecember 31, 2022 . Losses were primarily driven by mark-to-market losses on NREF OP Units of$21.3 million , mark-to-market losses on NSP OC Common Units and equity of$23.6 million and losses on our CLO equity portfolio of$27.9 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 (losses). Realized losses were$2.3 million for the six months endedDecember 31, 2022 , driven primarily by a realized loss of$6.9 million on the contribution of theSAFStor Ventures to the NSP OC as discussed in Note 14 of the Company's consolidated financial statements. This was partially offset by gains on maturities in our life settlement portfolio of$3.5 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);
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•recurring maintenance necessary to maintain our properties;
•distributions necessary to qualify for taxation as a REIT;
•income taxes for taxable income generated by TRS entities;
•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 ofDecember 31, 2022 , we had$13.4 million of cash available to meet our short-term liquidity requirements. As ofDecember 31, 2022 , we also had$35.3 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. 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$190 million to$210 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 followingDecember 31, 2022 . 63
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Cash Flows
The following table presents selected data from our consolidated statements of
cash flows for the six months ended
For the Six Months
Ended December 31
2022
Net cash provided by operating activities $31,431
Net cash used in investing activities (14,418)
Net cash used in financing activities (19,140)
Net decrease in cash, cash equivalents and restricted cash (2,127)
Cash, cash equivalents and restricted cash, beginning of period 50,776
Cash, cash equivalents and restricted cash, end of period $48,649
Cash flows from operating activities. During the six months ended December 31,
2022 , net cash provided by operating activities was $31.4 million . Operating
cash flows were primarily driven by dividends received from our CLO equity
portfolio.
Cash flows from investing activities. During the six months ended December 31,
2022 , net cash used in investing activities was $14.4 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 in cash.
Cash flows from financing activities. During the six months ended December 31,
2022 , net cash used in financing activities was $19.1 million . Cash flows from
financing activities was primarily driven by borrowings of $9.5 million , offset
by credit facility repayments of $12.5 million , prime brokerage repayments of
$14.4 million and dividends paid to common shareholders of $11.2 million .
Debt
Mortgage Debt
As ofDecember 31, 2022 , our consolidated subsidiaries had aggregate mortgage debt outstanding to third parties of approximately$144.7 million at a weighted average interest rate of 7.3%. See Note 7 to our consolidated financial statements for additional information. 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. 64
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Credit Facility
OnJanuary 8, 2021 , the Company entered into a$30.0 million credit facility (the "Credit Facility") withRaymond James Bank, N.A. and drew the full balance. As ofDecember 31, 2022 , the Credit Facility, as amended, bore interest at one-month LIBOR plus 3.5% and matures onNovember 6, 2023 . OnMarch 6, 2023 , the interest rate on the Credit Facility increased to one-month LIBOR plus 4.25%. The Company paid down$9.0 million on the Credit Facility during the year endedDecember 31, 2022 . During the six months endedDecember 31, 2022 , the Company paid down$5.0 million on the Credit Facility. As ofDecember 31, 2022 , the Credit Facility had an outstanding balance of$11.0 million . For additional information regarding our Credit Facility, see Note 7.
Obligations and Commitments
The following table summarizes our contractual obligations and commitments as ofDecember 31, 2022 for the next five calendar years subsequent toDecember 31, 2022 .
Payments Due by Period (in thousands)
Total 2023 2024 2025 2026 2027 Thereafter
Property Level Debt
Principal payments $ 157,918 $ 144,668 $ - $ 13,250 $ - $ - $ -
Interest expense 5,846 4,517 830 499 - - -
Total $ 163,764 $ 149,185 $ 830 $ 13,749 $ - $ - $ -
Prime Brokerage Borrowing
Principal payments $ 2,624 $ - $ - $ - $ - $ - $ 2,624 (1)
Interest expense 481 96 97 96 96 96 - (1)
Total $ 3,105 $ 96 $ 97 $ 96 $ 96 $ 96 $ 2,624
Preferred Shares
Dividend payments $ - $ 9,240 $ 9,240 $ 9,240 $ 9,240 $ 9,240 N/A (2)
Credit Facility
Principal payments $ 11,000 $ 11,000 $ - $ - $ - $ - $ -
Interest expense 120 120 - - - - -
Total $ 11,120 $ 11,120 $ - $ - $ - $ - $ -
Total contractual
obligations and
commitments $ 177,989 $ 169,641 $ 10,167 $ 23,085 $ 9,336 $ 9,336 $ 2,624
(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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Cityplace Debt
OnNovember 8, 2022 , we received lender consent to defer the maturity of the Cityplace debt toFebruary 8, 2023 . OnFebruary 8, 2023 , the lenders agreed to defer the maturity of the debt by three months toMay 8, 2023 with the possibility to extend for an additional four months toSeptember 8, 2023 provided certain metrics are met. The purpose of the deferral was to allow for continued discussions around refinancing the debt. Management recognizes that finding an alternative source of funding is necessary to repay the debt by the maturity date. 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, which includes the Advisory Fee equal to 1.00% of Managed Assets and the Administrative Fee equal to 0.20% of the Company's Managed Assets. The Advisory Agreement provides that the first portion of the monthly installment of the Advisory Fee shall be paid in cash up to$1.0 million and the remainder of the monthly installment of the Advisory Fee, if any, shall be paid in common shares of the Company, subject to certain restrictions. For additional information, see Note 14 to our consolidated financial statements. The Advisory Agreement also provides that the Administrative Fee shall be paid in cash. We also generally reimburse our Adviser for operating or offering expenses it incurs on our behalf or in connection with the services it performs for us. 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 of 1.5% of Managed Assets, calculated as of the end of each quarter, for the twelve-month period following the Company's receipt of the Deregistration Order; 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. The Adviser may, at its discretion and at any time, waive its right to reimbursement for eligible out-of-pocket expenses paid on the Company's behalf. Once waived, these expenses are considered permanently waived and become non-recoupable in the future. 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 an income tax expense of$2.0 million for the six months endedJune 30, 2022 , which is largely driven by income from the Company's legacy CLO investments. The Company has recorded a current income tax expense of$10.7 million associated with the TRSs for the six months endedDecember 31, 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$2.2 million and increased by a 2021 return-to-provision adjustment of$1.5 million , for a net expense of$10.0 million for the six months endedDecember 31, 2022 , 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 66
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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 ofDecember 31, 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 ofDecember 31, 2022 and to our knowledge, we have no examinations in progress and none are expected at this time. 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 had no material unrecognized tax benefit or expense, accrued interest or penalties as ofDecember 13, 2022 . 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, investments held through our TRSs, book/tax differences on income derived from partnerships, 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 tenth dividend of 2022 on our common shares of$0.15 per share which was paid onDecember 30, 2022 to shareholders of record onDecember 15, 2022 . Our Board declared our fourth quarterly dividend of 2022 on our Series A Preferred Shares of$0.34375 per share which was sent to the transfer agent prior toDecember 31, 2022 and paid onJanuary 3, 2023 to shareholders of record onDecember 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 ofDecember 31, 2022 , we had the following off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. 67
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Commitments
The Company is the guarantor on three secured loans to, and dividend payments with respect to Series D Preferred Stock of NSP, an affiliate of the Adviser, with the secured loans having an aggregate principal amount of approximately$662.1 million outstanding as ofDecember 31, 2022 . NSP is current on all debt and dividend payments and in compliance with all debt compliance provisions. See Note 14 for additional information. The Company is a limited guarantor and an indemnitor on one of NHT's loans with an aggregate principal amount of$77.4 million as ofDecember 31, 2022 . The obligations include a customary environmental indemnity and a so-called "bad boy" guarantee, which is generally only applicable if and when the borrower directly, or indirectly through an agreement with an affiliate, joint venture partner or other third party, voluntarily files a bankruptcy or similar liquidation or reorganization action or takes other actions that are fraudulent or improper. NHT is current on all debt payments and in compliance with all debt compliance provisions.
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.
Valuation of Level 3 Fair Valued Investments
As ofDecember 31, 2022 , approximately 56.3% of the total assets owned by the Company are comprised of fair valued level 3 investments. The Company elected the fair-value option in accordance withFinancial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 825-10-10. On an annual basis, the Company hires independent third-party valuation firms to provide updated fair values for subsequent measurement absent a readily available market price. The valuation is determined using widely accepted valuation techniques. See Note 10, "Fair Value of Derivatives and Financial Instruments", for further discussion of our valuation techniques of level 3 investments. The necessary inputs for these valuations includes a variety of valuation techniques and unobservable inputs. These inputs are subject to assumptions and estimates. As a result, the determination of fair value is uncertain because it involves subjective judgments and estimates that are unobservable. For the year endedDecember 31, 2022 , the unrealized loss related to the change in fair value of level 3 investments is$58.8 million . See Notes 10 for additional disclosures regarding the valuation of level 3 fair valued investments.
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 (see Note 10 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.
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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 directly affected 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 rental rates 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. The
REIT Tax Election
We have elected to be taxed as a REIT under Sections 856 through 860 of the Code. 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 are managed through one or more TRS entities and is subject to applicable federal, state, and local income and margin taxes. The Company has recorded a current income tax expense of$2.0 million for the six months endedJune 30, 2022 and$10.7 million associated with the TRSs for the six months endedDecember 31, 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$2.2 million and increased by a 2021 return-to-provision adjustment of$1.5 million for a net expense of$12.0 million for the twelve months endedDecember 31, 2022 , 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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