****


**UNITED
STATES**


**SECURITIES
AND EXCHANGE COMMISSION**


**Washington,
D.C. 20549**


**_______________**


**FORM
10-K**


**FOR
ANNUAL AND TRANSITION REPORTS PURSUANT TO**


**SECTION
13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**


**(Mark
One)**





x
    ANNUAL REPORT
      PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
      For
      the fiscal year ended December 31,
2004





OR


o
    TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
      For
      the transition period from ____________to
      _____________


Commission
file number 001-32039










**CAPITAL
LEASE FUNDING, INC.**


(EXACT
NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)







**Maryland**
      (State
      or Other Jurisdiction of
      Incorporation
      or Organization)
    **52-2414533**
      (I.R.S.
      Employer Identification No.)**110
      Maiden Lane, New York, NY**
      (Address
      of Principal Executive Offices)
    **10005**
      (Zip
      code)





**(212)**  **217-6300**


**(Registrant’s
Telephone Number, Including Area Code)**


**Securities
registered pursuant to Section 12(b) of the Act:**




**Title
      of each Class**
      Common
      stock, $0.01 par value
    **Name
      of each exchange on which registered**
      New
      York Stock Exchange





**Securities
registered pursuant to Section 12(g) of the Act: None**




Indicate
by check mark whether the Registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes x No o




Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. x




Indicate
by check mark whether the Registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes oNo x





As of
June 30, 2004, the aggregate market value of the common stock, $0.01 par value
per share, of Capital Lease Funding, Inc. (“Common Stock”), held by
non-affiliates (outstanding shares, excluding shares held by executive officers
and directors) of the registrant was approximately $251.0 million, based upon
the closing price of $10.40 on the New York Stock Exchange on such
date.




As of
March 15, 2005, there were 27,501,700 shares of Common Stock
outstanding.




**DOCUMENTS
INCORPORATED BY REFERENCE**




1.
    
    Portions
      of the registrant's definitive proxy statement for the registrant's 2005
      Annual Meeting, to be filed within 120 days after the close of the
      registrant's fiscal year, are incorporated by reference into Part III
      of this Annual Report on Form 10-K.










**TABLE
OF CONTENTS**




PART
      I.
    1Item
      1.
    Business.
    1Item
      2.
    Properties.
    22Item
      3.
    Legal
      Proceedings.
    22Item
      4.
    Submission
      of Matters to a Vote of Security Holders.
    22PART
      II.
    23Item
      5.
    Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities.
    23Item
      6.
    Selected
      Financial Data.
    25Item
      7.
    Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.
    27Item
      7A.
    Quantitative
      and Qualitative Disclosures About Market Risk.
    38Item
      8.
    Financial
      Statements and Supplementary Data.
    57Item
      9.
    Changes
      in and Disagreements With Accountants on Accounting and Financial
      Disclosure.
    89Item
      9A.
    Controls
      and Procedures.
    89Item
      9B.
    Other
      Information.
    89PART
      III.
    90Item
      10.
    Directors
      and Executive Officers of the Registrant.*
    90Item
      11.
    Executive
      Compensation.*
    90Item
      12.
    Security
      Ownership of Certain Beneficial Owners and Management.*
    90Item
      13.
    Certain
      Relationships and Related Transactions.*
    90Item
      14.
    Principal
      Accounting Fees and Services.*
    90PART
      IV.
    91Item
      15.
    Exhibits
      and Financial Statement Schedules.
    91PART
      V.
    95





* Items
10, 11, 12, 13 and 14 are incorporated by reference herein from the Proxy
Statement.















**PART
I.**




**Item** **1.** **Business** **.**




**Overview**




We are an
internally-managed specialty finance company that focuses on investing in
commercial real estate properties that are leased typically on a long-term basis
to primarily single tenants. We concentrate on properties that are leased to
high credit quality tenants pursuant to what we call a net lease, where the
tenant (rather than the landlord) has the obligation to pay for, or pay for and
perform, all or substantially all aspects of the property and its operations
during the lease term.




We invest
at all levels of the capital structure of net lease properties, including direct
investments in real estate (equity) and debt investments (mortgage loans and net
lease mortgage-backed securities) and mezzanine investments secured by mortgages
or other collateral on net lease properties. Tenants underlying our property
investments generally are: (i) large public companies with investment grade or
near investment grade ratings from either or both of Moody’s Investors Service
(“Moody’s”) and Standard & Poor’s Corporation (“Standard & Poor’s” or
“S&P”), (ii) governmental and quasi-governmental entities and (iii)
not-for-profit entities. The following tenants are representative of those
underlying our current and expected future investments: Aon Corporation, Kohl’s
Corporation, Choice Hotels International, CVS Corporation, University of
Connecticut Health Center, Koninklijke Ahold N.V., Best Buy Co., Inc., Home
Depot USA, Inc., Yahoo, Inc. and General Services Administration. A significant
majority of our investments have been and we expect will continue to be in
properties net leased to investment grade tenants, although at any particular
time our portfolio may not reflect this. As of December 31, 2004, approximately
73.2% of our assets in portfolio involved properties leased to, or leases
guaranteed by, companies with an investment grade credit rating. Please see
“Portfolio” below for how we define our assets in portfolio.




We were
incorporated during October 2003 for the purpose of continuing the existing
business operations and acquiring the assets and liabilities of Caplease, LP,
the successor-in-interest to Capital Lease Funding, LLC, which has been in the
net lease business since 1994. We completed this acquisition in connection with
our initial public offering during March 2004. As discussed in more detail
below, on March 24, 2004, we completed an initial public offering of 23.0
million shares of our common stock priced to the public at $10.50 per share. As
of December 31, 2004, we have fully utilized all of the net proceeds and we are
now using leverage.




We are
organized and we conduct our operations to qualify as a real estate investment
trust, or REIT, for federal income tax purposes. As such, we are generally not
subject to federal income tax on that portion of our income that is distributed
to stockholders if we distribute at least 90% of our REIT taxable income to our
stockholders by prescribed dates and comply with various other
requirements.




**History**




We were
formed in October 2003 to continue the business of our predecessor, Caplease,
LP, the successor-in-interest to Capital Lease Funding, LLC. Prior to our
initial public offering, we were focused on originating net lease loan
transactions and selling substantially all of the loans we originated, either
through whole-loan or small pool sales or through gain-on-sale securitizations.




Our
senior management team has worked together for over 10 years and has been an
innovator in the net lease marketplace. Since 1996, we have originated,
structured and closed approximately $3.0 billion in net lease transactions
(primarily debt), involving more than 500 properties with more than 75 credit
tenants. We believe we were the first lender to originate and securitize a rated
transaction of commercial mortgage loans on properties with long-term,
single-tenant net leases to a diverse group of high credit-quality tenants. This
first securitization was completed in 1997. We also have played a lead role in
working with the rating agencies to develop and implement lease enhancement
mechanisms that have improved the ability to finance net lease properties based
on the tenant’s credit. Many of these mechanisms are now market standard. Prior
to our initial public offering, we participated in four securitizations
aggregating approximately $1.5 billion. In addition, we structured or sold in
excess of $1.0 billion of loans on a whole-loan basis or in small structured
loan pools.




In late
2000, we developed a 10-year credit tenant loan product designed to take
advantage of the liquidity and pricing certainty provided by the commercial
mortgage-backed securities, or CMBS, and collateralized debt obligation, or CDO
markets. We were issued a United States patent for this product in January 2005.
Our 10-year credit tenant loan product offers borrowers who own properties
subject to shorter-term leases or leases to lower investment grade or near
investment grade tenants the maximum leverage and low debt service coverage
ratios typically only offered by long-term credit tenant loans.




1


****


**Change
In Strategy**




Upon
completion of our initial public offering, we made two important changes to our
business strategy:




·
    expanding
      our investments beyond just mortgage financing to all levels of the
      capital structure of net lease properties, including direct acquisitions
      of net lease real estate properties; and




·
    holding
      our net lease investments in our portfolio generally for the medium to
      long-term.




Due to
our shift in strategy, our net income or loss now depends on the spread between
the yields on our assets and our cost to finance those assets, rather than our
ability to generate gains from the sale of assets. We receive interest income
from property loans that we finance and from the debt securities that we hold,
and rental revenue on the properties that we own. Our other income consists of
occasional gain-on-sale income, and fees charged to third parties, including our
borrowers.




We incur
some property level expenses on properties that we own that are not subject to
what we call triple-net or bondable net leases. These expenses may include
parking lot improvements or repair, roof replacement or repair or other such
capital expenses. We also may incur additional property related expenses, such
as real estate taxes, insurance and routine maintenance and operating expenses,
on properties we own, although we typically pass these expenses through to the
underlying tenant pursuant to the net lease. For property acquisitions where we
have obligations to maintain and operate the property, we typically retain
experienced third-party property managers.




**Our
Initial Public Offering**




Pursuant
to a registration statement declared effective by the Securities and Exchange
Commission (the “SEC”) on March 18, 2004 (File No. 333-110644), we issued and
sold 20.0 million shares of our common stock, par value $0.01 per share, in an
initial public offering. The managing underwriters were Friedman, Billings
Ramsey & Co., Inc., Wachovia Capital Markets, LLC and RBC Capital Markets
Corporation. As part of the initial public offering, the underwriters were
granted an over-allotment option to purchase up to an additional 3.0 million
shares of common stock. The underwriters exercised this option in full. In
connection with that exercise, we filed a post-effective amendment to the
registration statement (File No. 333-113817) which became effective upon filing
on March 22, 2004. The aggregate offering price for the 23.0 million shares was
$241.5 million. On March 24, 2004, the initial public offering closed and we
received net proceeds of approximately $224.0 million from the sale, reflecting
the aggregate offering price of $241.5 million less an underwriting discount of
approximately $16.9 million and expenses paid to the underwriters of
approximately $0.6 million, but before other expenses of the offering of
approximately $2.2 million, primarily made up of legal and accounting
fees.




We have
fully utilized the net proceeds of our initial public offering as
follows:




·
    $79.5
      million to repay indebtedness under our short-term warehouse credit
      facilities;




·
    $143.2
      million to fund investments in net lease
assets;




·
    $0.8
      million to pay other expenses of the offering;
and




·
    $0.5
      million for working capital purposes.




2





**Net
Leases and Net Lease Real Estate Properties**




We
generally classify net leases into the following four categories:




**Bondable
      Net Lease**
    
    **Triple
      Net Lease**
    
    **Double
      Net Lease**
    
    **Modified
      Gross Lease****Tenant
      Responsibility**
    
    
    ·Tenant is responsible for all
      aspects of the property and its operation during the lease
      term.
    
    
    ·Tenant is responsible
      for all aspects of the property and its operation during the lease
      term.
    
    
    ·Tenant is responsible
      for all aspects of the property and its operation during the lease term,
      except that the landlord has the obligation with respect to certain
      capital expenditures on the property, such as replacement obligations for
      roof, structure and parking.
    
    
    ·Landlord is responsible
      for most property related expenses during the lease term, but cost of most
      of those expenses is passed through to the tenant pursuant to the
      lease.**Termination
      Right**
    
    
    ·Tenant can only
      terminate the lease upon a condemnation, in which case the tenant must
      offer to purchase the property for at least the then outstanding unpaid
      principal balance of the loan, plus accrued interest
    
    
    ·Tenant may have a right
      to terminate the lease or abate rent due to a casualty (usually in the
      last few years) or to condemnation of a portion or all of the
      property.
    
    
    ·      Tenant may have a right
      to terminate the lease or abate rent due to a casualty or condemnation or
      due to the landlord’s failure to perform its obligations under the
      lease.
    
    
    ·Tenant may have a right
      to terminate the lease or abate rent due to a casualty or condemnation or
      due to the landlord’s failure to perform its obligations under the
      lease.


When we
refer to a net lease property, we mean a real estate property that is leased to
a commercial tenant under a net lease.




As of
December 31, 2004, we had the following number of asset investments in each net
lease category:




**By
      Segment****Total**
    
    **Lending
      Investments**
    
    **Operating
      Net Lease Real Estate**Bondable
      net leases
    
    
    13
    
    
    13
    
    
    —Triple
      net leases
    
    
    16
    
    
    13
    
    
    3Double
      net leases
    
    
    26
    
    
    23
    
    
    3Modified
      gross leases
    
    
    2
    
    
    —
    
    
    257
    
    
    49
    
    
    8





**Our
Property Acquisition Activity**




Our real
property acquisitions, all of which have been made since the closing of our
initial public offering, have been primarily in properties subject to net leases
that fall into one of the above four categories, but also include investments in
a limited number of leased properties (one as of December 31, 2004) where we
bear the financial risk of operating the property. While our focus continues to
be on net lease properties, we expect to make select additional investments in
properties where we bear such financial risk in the future. Our investment
underwriting on property acquisitions is based on the credit of the underlying
tenant and the related lease term and other lease provisions, as well
as:




·
    the
      location and type of property (e.g., office or
retail);




·
    vacancy
      rates and trends in vacancy rates and demand in the property’s
      market;




3




·
    an
      analysis of the rental rates within the
market;




·
    an
      analysis of sales prices in the market; and




·
    demographics
      in the property’s market.




**Our
Loan Origination Activity**




Our loan
origination activity has historically and we expect will continue to be
primarily focused on properties subject to bondable net leases, triple net
leases and double net leases. When we refer to a net lease loan, we mean a
mortgage loan made to an owner of a commercial property leased to a tenant under
a net lease described in the prior sentence. A net lease loan is secured by a
first mortgage on a commercial real property subject to a long-term net lease to
a tenant, and by a collateral assignment of the lease and all rents due under
the lease. Under a net lease loan, the principal credit underlying the loan is
the credit of the tenant rather than the credit of the borrower or the
liquidation value of the applicable real estate.




Our net
lease loan products generally offer commercial real property owners greater loan
proceeds than a traditional commercial real estate lender because our
underwriting and due diligence process focuses on the value of the cash flow
stream generated by the underlying net lease rather than the value of the real
property. We may use the specialized lease enhancement mechanisms that we helped
to develop to substantially mitigate the risk of a potential interruption in the
rental stream due to real estate related events so that triple-net and
double-net leases can be evaluated as if they were bondable net leases. Our
lease enhancement mechanisms consist primarily of an integrated set of
specialized insurance policies, loan documents and various borrower and expense
reserve accounts. The specialized insurance policies are generally
non-cancelable for the term of the lease, are written for the benefit of the
holder of the mortgage and have been designed to protect against risks such as
rent abatement or lease termination as a result of a casualty or condemnation
event under the underlying net lease.




A
properly structured net lease investment and net lease with appropriate lease
enhancements can be expected to receive a rating from one or more of the rating
agencies equivalent to the unsecured debt rating of the underlying tenant. The
expected receipt of that rating improves our ability to finance the loan on a
long-term basis through a CDO.




**Market
Opportunity**




We
believe that there is a significant market opportunity to earn attractive
risk-adjusted returns in the net lease market. We estimate that the total amount
of net lease transactions in the United States that would meet our general
criteria is approximately $15 billion to $25 billion per year. Corporations and
many other users of real estate utilize single tenant properties for a variety
of purposes, including office buildings for corporate headquarters and regional
operations, industrial facilities for the storage and distribution of goods, and
freestanding retail stores such as major discount stores, drug stores and home
improvement stores.




Investment
yields on high credit quality net lease assets have traditionally exceeded those
on comparably rated unsecured bonds (based on our experience in financing these
assets since 1996). We believe that these two investments are comparable as they
are each subject to the same credit risk (the failure of the underlying tenant
or bond issuer). In addition, we believe high credit quality net lease
investments present a lower overall risk than unsecured bonds. Our loan
investments generally require three distinct triggering events before our cash
flows from the investment are interrupted.




Trigger
Number 1:  Bankruptcy
or default of the underlying tenant.




Trigger
Number 2:  Tenant
rejects the underlying lease.




·
    Provisions
      of the U.S. Bankruptcy Code permit the tenant in a Chapter 11 bankruptcy
      reorganization to assume or reject the
lease.




Trigger
Number 3:  Borrower/owner
of the property does not meet its obligations to pay the loan.




·
    The
      borrower/owner may desire to protect its interest in the property (e.g.,
      if the property value exceeds the loan amount or for other strategic
      reasons).




In
addition, if these three triggers occur, we have a mortgage on the property
which permits us to foreclose and sell or re-lease the property.




4





Our real
property purchases generally require the first two triggers (but not the third),
and if both occur, we, as owner of the property, can sell or re-lease the
property.




**Corporate
Structure**




We
conduct substantially all of our business operations through our operating
partnership, Caplease, LP (the successor-in-interest to Capital Lease Funding,
LLC). We own the sole limited partnership interest of Caplease, LP and our
wholly-owned subsidiary, CLF OP General Partner LLC, is the sole general
partner. We conduct activities that we believe could jeopardize our REIT status,
such as our gain-on-sale business, through our taxable REIT subsidiary, Caplease
Services Corp. As of December 31, 2004, our company was organized as
follows:












**Business
Segments**




Beginning
with this annual report on Form 10-K, we have begun reporting our results
through two operating segments:




·
    lending
      investments; and




·
    operating
      net lease real estate.




5





Our 2004
revenues attributable to each segment and segment profit, along with a
reconciliation of these amounts to our total revenue and net income, are as
follows:




**Lending
      Investments**
    
    **Operating
      Net Lease Real Estate**
    
    **Corporate/
      Unallocated**
    
    **Total**(*in
      thousands*)Total
      revenue
    
    $
    14,045
    
    $
    6,356
    
    $
    603
    
    $
    21,004Net
      income (loss)
    
    
    10,476
    
    
    2,150
    
    
    (11,266
    )
    
    1,360





Our
lending investments business includes our loan business as well as our
investments in structured interests and structuring fees
receivable.




For
fiscal years 2002 and 2003, we were only in the net lease lending business, and
all of our revenues and net income were allocated to that segment. See note 18
to our consolidated financial statements.




During
2004, Aon Corporation accounted for approximately $4.2 million, or 20.0%, of our
total revenues. As we continue to add assets to our balance sheet and as those
assets and existing assets begin to generate income, we expect revenues from our
lease with Aon to generate a smaller percentage of our total revenues. Any
financial difficulty or bankruptcy resulting in nonpayment or delay of rental
payments and other amounts due under our lease with Aon Corporation could have a
material adverse effect on our cash flows and operating results.




**Our
Competitive Strengths**




*Experienced
management team.* Our
chief executive officer, Paul H. McDowell, our president, William R. Pollert,
and our senior vice president, chief financial officer and treasurer, Shawn P.
Seale, founded the predecessor to our company in 1994 and have since managed our
business. Our chairman, Lewis S. Ranieri, joined us in 1995 in connection with
an investment in our company by Hyperion Partners II L.P. Over the years, we
have added key senior management personnel, including our senior vice president
and chief investment officer, Robert C. Blanz, in 1999, who has significant
rating agency experience as a former executive with Standard & Poor’s.




*Market
expertise* . We have
recognized expertise in the net lease marketplace and the specialized lease
enhancement mechanisms that we helped to develop are now market standard. These
lease enhancement mechanisms are discussed in detail above and are designed to
mitigate or eliminate the risks associated with the termination or abatement of
rent under a net lease for reasons other than the bankruptcy of the underlying
tenant. We have worked extensively with Moody’s and Standard & Poor’s to
develop rating criteria for net lease financing, and we continue to provide
ongoing advice and assistance to these rating agencies on net lease financing
issues.




*Origination
and underwriting capabilities* . We have
an experienced in-house team of originators and underwriters that originate,
structure, underwrite and close our transactions. In addition, we have developed
an extensive national network of borrowers, tenants, mortgage brokers,
investment sale brokers, lenders, institutional investors and other market
participants that helps us to identify and originate a variety of net lease
financing and investment opportunities. We also have an in-depth understanding
of the real estate and credit risks unique to net lease financing and
investment. Prior to funding, we subject each investment we make to a
comprehensive due diligence review and the approval of our investment committee.
Our investment committee consists of six of our key employees. We also have an
investment oversight committee of our board of directors that approves our
investments in excess of $50.0 million.




*Securitization
expertise* . We have
substantial experience in securitizing net lease assets. Prior to our initial
public offering, we generally structured outright sales of pools of our loans to
securitization vehicles, commonly referred to as “gain-on-sale” securitizations.
In addition to traditional mortgage debt, we now intend to finance our assets
over the long-term through CDOs. We completed our first CDO financing in March
2005. A CDO is a form of securitization that is treated as a “financing” for tax
and accounting purposes. In a CDO, we retain ownership of the securitized assets
through a trust or other bankruptcy remote subsidiary and finance those assets
with long-term fixed-rate debt. We seek to match the generally fixed payments on
our long-term assets with long-term fixed rate debt, such that changes in
prevailing interest rates, credit spreads and the credit quality of the tenant
during the term of the debt obligation will not increase our financing costs for
those assets. We expect this match-funded strategy to reduce our refinancing
risk and to allow us to earn consistent returns on our investments.




*Financing
relationships* . We
benefit from our relationships with major financial institutions, including
Wachovia Bank, N.A., a significant investor in, and secured warehouse lender to,
our company. We currently may borrow up to $250.0 million under our repurchase
agreement with Wachovia, provided certain conditions are met. Our relationship
with Wachovia has also allowed us to obtain competitive pricing on our long-term
traditional mortgage debt financings of property acquisitions.




6


**Our
Strategy**




Our
principal business objective is to generate attractive risk-adjusted investment
returns by investing in a broad range of assets. We plan to achieve our
objective by focusing on the following core business strategies:




*Expanding
Net Lease Lending Business* . We
intend to continue to build on our strong market presence and expanding borrower
base to grow origination volume of our existing net lease loan products. Our
existing loan products include:




*Long-Term
Credit Tenant Loans* . We
offer traditional long-dated fully amortizing (or nearly fully amortizing) or
insured balloon loans secured by first mortgages on properties subject to
long-term net leases, primarily to investment grade tenants. This product
enables a borrower to receive the highest proceeds that a property’s rent
payments will support. We expect this type of loan to continue to be our primary
loan product. As of December 31, 2004, our portfolio contained $167.8 million of
long-term credit tenant loans.




*10-Year
Credit Tenant Loans* . For
loans secured by net leases to lower investment grade tenants or near investment
grade tenants, or shorter-term leases, we have developed a 10-year credit tenant
loan product, for which we have received a United States patent. These loans are
bifurcated into two notes, a real estate and a corporate credit note. Both notes
are secured by a first mortgage on the underlying real property and an
assignment of the lease and payments under the lease. The following summarizes
the characteristics of the two notes:


**Real
      Estate Note**
    
    **Corporate
      Credit Note**·70
      to 75% of loan amount
      
      ·Senior
      claim on real estate
      
      ·Junior
      claim on rents in bankruptcy
      
      ·10-year
      term, balloon at maturity
      
      ·Significant debt
      service coverage and loan-to-value ratio
    
    ·15
      to 20% of loan amount
      
      ·Junior
      claim on real estate
      
      ·Senior
      claim on rents in bankruptcy
      
      ·10-year
      term, fully amortizing
      
      ·Provides diversity
      and favorable yield when placed in a
CDO
  
 We
typically sell the real estate note to a CMBS conduit promptly following
origination, and retain the corporate credit note in our portfolio. As of
December 31, 2004, our portfolio contained $13.8 million of corporate credit
notes.




*Recapitalized
Loans* . From
time to time, as part of our long-term credit tenant loan program, we identify
existing loans where we can offer the borrower improved terms, typically by
amending the underlying lease to a long-term lease and refinancing or replacing
the existing loan. We expect to continue to identify these opportunities in the
future. As of December 31, 2004, our portfolio contained $24.9 million of
recapitalized loans.




*Acquiring
Real Properties Net Leased to Credit Tenants* . Since
our initial public offering, we have purchased net leased properties outright
and have made this one of the core components of our business. In doing so, we
have drawn on our extensive experience in the net lease business to evaluate
tenant credit quality, lease structures and the commercial properties subject to
net leases. When we reach our target borrowing level, we anticipate that net
lease real estate will constitute approximately 40% to 60% of our assets in
portfolio. Management has broad authority to modify this range without
stockholder approval. As of December 31, 2004, our portfolio contained $194.5
million of purchased net leased real properties.




*Acquiring
Structured Interests in Net Lease Assets* . We
intend to continue to acquire structured interests in net lease assets from time
to time. These investments may include CMBS or CDOs issued by our company or
others, interest-only classes of CMBS and subordinate, mezzanine and equity
interests in encumbered net lease assets. We do not have a policy that limits
the amount or percentage we may invest in any asset or any type of asset. When
we reach our target borrowing level, we anticipate that these types of real
estate securities will constitute approximately 5% to 20% of our assets in
portfolio. Management has broad authority to modify this range without
stockholder approval. We believe we are well positioned to evaluate these
investments due to our expertise with net lease assets. As of December 31, 2004,
our portfolio contained $87.8 million of structured interest in net lease
assets.




7


*Selectively
Developing Net Lease Properties* . We have
entered into arrangements with experienced real estate developers where we have
the right to provide financing of construction and pre-construction costs for up
to 20 Walgreen stores to be developed. We believe these investments will offer
us the ability to capture above average returns with minimal capital invested
and give us an advantage in making the permanent loan on the property, or
purchasing our joint venture partner’s interest at completion. Our investments
have been and we expect will continue to be in the form of a subordinate loan
and an equity interest in the owner and developer of the underlying project. As
of December 31, 2004, we have funded loans on five properties for approximately
$0.8 million.




*Selectively
Continuing Gain-on-Sale Transactions* . On a
limited and opportunistic basis, we intend to continue acquiring and promptly
reselling net lease assets for an immediate gain. We will conduct this
gain-on-sale business through a taxable REIT subsidiary. Since our initial
public offering and through December 31, 2004, we have sold $25.4 million of
assets for net gains of approximately $794,000 as part of our 10-year credit
tenant loan program.




*Leveraging* . Our
financing goal is to generate interest income from the loans we originate and
rental income on the properties we own in excess of the interest costs on our
financings. We intend to finance our assets on a long-term basis primarily
through fixed-rate financings. We believe that the use of CDO structures and
other term securitization structures, as well as traditional mortgage debt, will
allow us to enhance returns on our assets, while reducing our exposure to
interest rate fluctuations and refinancing risk, and allowing us to earn
consistent returns on our investments. Overall, we expect our leverage to
average 70% to 85% of our assets in portfolio.




*Introducing
Value-Added, Innovative Products* . As we
have done in the past with our 10-year credit tenant loan product, we intend to
develop new financing products and identify investment opportunities. As part of
our product development strategy, we seek to design products and financing
structures to assist us in meeting the specific requirements of our borrowers
and tenants earlier in the construction, acquisition and borrowing cycle as a
means of expanding and better controlling our asset originations. We also look
for ways to expand our existing products. For example, during 2004, we began
offering floating rate bridge loans to our borrowers.




*Maintaining
Flexibility Through Portfolio Model* . Since
our initial public offering, we have pursued an on-balance sheet portfolio
investment strategy, rather than an originate-and-sell strategy to provide us
with greater flexibility in all areas of our business to finance and acquire net
lease assets that meet our risk-adjusted return criteria.




In
addition to the core strategies we have outlined above, over time we intend to
grow our fee-based net lease financial advisory services whereby we advise
participants in the net lease market, including developers, owners and tenants
of, and institutional investors in, net lease assets. We intend to conduct our
financial advisory business through a taxable REIT subsidiary. In the future, we
intend to explore acting, either directly or through a taxable REIT subsidiary,
as a primary servicer, subservicer or special servicer of our asset portfolio.
By doing so, we believe we would be afforded greater control over the
performance of our portfolio. We presently outsource the servicing of our net
lease assets.




**Portfolio**




Our shift
in strategy subsequent to our initial public offering allowed us to invest in
net lease assets (including real properties) for the medium to long-term and we
plan to continue to invest in these types of assets for investment by leveraging
our existing portfolio and with additional funds from future capital raising
activity and our operations.




When we
discuss our assets in portfolio, we mean the following categories of assets
which are included on our balance sheet:




**Balance
      as of 12/31/04***(in
      thousands)*Owned
      Properties
    
    $
    194,541Mortgage
      Loans
    
    
    206,510
    (1)Development
      Loans
    
    
    837Structured
      Interests
    
    
    87,756Structuring
      Fees
    
    
    4,426Total
    
    $
    494,070
  (1) Reflects
our carry value less deferred origination costs of
$546.








8




*Owned
Properties.*




The
following is a tabular presentation of the properties that we own and related
data as of December 31, 2004.




**(in
      thousands)****(2)****Tenant
      or Guarantor**
    
    **Location**
    
    **Ratings(S&P/Moody’s)****(1)**
    
    **Business**
      **Category**
    
    **SquareFeet**
    
    **Property
      Type**
    
    **Purchase
      Date**
    
    **Lease
      Maturity**
    
    **2005
      EstimatedAnnual Rent****(3)**
    
    **Purchase
      Price**
    
    **Book
      Value asof 12/31/04**Abbott
      Laboratories
    
    Columbus,
      OH
    
    
    AA/A1
    
    Office
    
    
    111,776
    
    
    Office
    
    
    11/2004
    
    
    10/2016
    
    $
    893
    
    $
    12,025
    
    $
    12,013Aon
      Corporation(4)
    
    Glenview,
      IL
    
    
    BBB+/Baa2
    
    Office
    
    
    416,209
    
    
    Office
    
    
    8/2004
    
    
    4/2017
    
    
    6,151
    
    
    85,750
    
    
    85,934Baxter
      International, Inc.
    
    Bloomington,
      IN
    
    
    A-/Baa1
    
    Office/Whse
    
    
    125,500
    
    
    Office/Whse
    
    
    10/2004
    
    
    9/2016
    
    
    790
    
    
    10,500
    
    
    10,722Bob’s
      Stores, Corp.
    
    Randolph,
      MA
    
    
    A-/A3(5)
    
    Retail
    
    
    88,420
    
    
    Retail
      Store
    
    
    9/2004
    
    
    1/2014
    
    
    744
    
    
    10,450
    
    
    14,051Choice
      Hotels International, Inc.(6)
    
    Silver
      Spring, MD
    
    
    BBB-/Baa3
    
    Office
    
    
    223,912
    
    
    Office
    
    
    11/2004
    
    
    5/2013
    
    
    4,587
    
    
    43,500
    
    
    45,475Crozer-Keystone
      Health System
    
    Ridley
      Park, PA
    
    
    Private(7)
    
    Medical Office
    
    
    22,708
    
    
    Office
    
    
    8/2004
    
    
    4/2019
    
    
    397
    
    
    4,477
    
    
    5,139Department
      of Veterans Affairs
    
    Ponce,
      PR
    
    
    Private(8)
    
    Office
    
    
    56,500
    
    
    Office
    
    
    11/2004
    
    
    2/2015
    
    
    1,300
    
    
    13,600
    
    
    13,620Walgreen
      Co.
    
    Pennsauken,
      NJ
    
    
    A+/Aa3
    
    Retail
      Drug
    
    
    18,500
    
    
    Retail
      Store
    
    
    11/2004
    
    
    10/2016
    
    
    297
    
    
    3,089
    
    
    3,239Walgreen
      Co.
    
    Portsmouth,
      VA
    
    
    A+/Aa3
    
    Retail
      Drug
    
    
    13,905
    
    
    Retail
      Store
    
    
    11/2004
    
    
    7/2018
    
    
    356
    
    
    4,165
    
    
    4,350**Totals**
    **$**
    **15,515**
    
    **$**
    **187,556**
    
    **$**
    **194,541**
____________
(1)
    Ratings
      represent publicly available long-term corporate credit rating or
      long-term senior unsecured debt ratings as of December 31,
  2004.

(2)
    All
      amounts are rounded to the nearest thousand. Sums may not equal totals due
      to rounding.

(3)
    Reflects
      annual rent due for 2005 under our lease with the tenant. Does not include
      expense recoveries or above or below market rent amortization adjustments
      required by Statement of Financial Accounting Standards
      No. 141.

(4)
    As
      of December 31, 2004, approximately 2% of the property was leased to one
      other tenant.

(5)
    Represents
      the credit rating of CVS Corporation, the guarantor of the lease. Bob’s
      Stores, Corp. is a wholly-owned subsidiary of The TJX Companies,
      Inc.

(6)
    As
      of December 31, 2004, approximately 29% of the property was leased to six
      other tenants.

(7)
    The
      credit does not carry public ratings from S&P or Moody’s. The credit’s
      subsidiary had a Baa2 rating from Moody’s as of December 31,
    2004.

(8)
    The
      Department of Veterans Affairs has no public rating from S&P or
      Moody’s. The Department of Veterans Affairs is an independent
      establishment of the executive branch of the United States
      government.





*Mortgage
Loans.*




Our
outstanding mortgage loans as of December 31, 2004 are summarized in the
following table.




**(in
      thousands)****(2)****As
      of 12/31/04****Tenant
      or Guarantor**
    
    **Location**
    
    
    **Ratings
      (S&P/****Moody’s)****(1)**
    
    **Business
      Category**
    
    **Square
      Feet**
    
    **PropertyType**
    
    **Coupon**
    
    **LeaseExpiration**
    
    **Loan
      Maturity**
    
    **Original
      Principal Balance**
    
    **PrincipalBalance**
    
    **BookValue**
    
    **Loan toRealtyValue**(3)**Long-Term
      Credit Tenant Loans**Autozone,
      Inc.
    
    Douglas,
      GA / Valdosta, GA(4
    )
    
    BBB+/Baa2
    
    Auto
      Parts Store
    
    13,383
    
    Retail
      Store
    
    6.50
    %
    
    6/2023
      / 4/2024
    
    11/2022
    
    $
    2,108
    
    $
    2,103
    
    $
    2,103
    
    78
    %Best
      Buy Co., Inc..
    
    Chicago,
      IL
    
    
    BBB-/Baa3
    
    Retail
    
    45,720
    
    Retail
      Store
    
    6.43
    %
    
    3/2025
    
    3/2025
    
    
    17,609
    
    
    17,609
    
    
    17,609
    
    91
    %City
      of Jasper, TX
    
    Jasper,
      TX
    
    
    NR/Baa3
    
    Office
    
    12,750
    
    Office
    
    7.00
    %
    
    12/2024
    
    11/2024
    
    
    1,736
    
    
    1,736
    
    
    1,681
    
    87
    %CVS
      Corporation
    
    Asheville,
      NC
    
    
    A-/A3
    
    Retail
      Drug
    
    10,880
    
    Retail
      Store
    
    6.53
    %
    
    1/2026
    
    1/2026
    
    
    2,360
    
    
    2,336
    
    
    2,405
    
    91
    %CVS
      Corporation
    
    Athol,
      MA
    
    
    A-/A3
    
    Retail
      Drug
    
    13,013
    
    Retail
      Store
    
    6.46
    %
    
    1/2025
    
    1/2025
    
    
    1,502
    
    
    1,501
    
    
    1,501
    
    79
    %CVS
      Corporation
    
    Bangor,
      PA
    
    
    A-/A3
    
    Retail
      Drug
    
    13,013
    
    Retail
      Store
    
    6.28
    %
    
    1/2026
    
    1/2026
    
    
    2,521
    
    
    2,472
    
    
    2,426
    
    88
    %CVS
      Corporation
    
    Bluefield,
      WV
    
    
    A-/A3
    
    Retail
      Drug
    
    10,125
    
    Retail
      Store
    
    8.00
    %
    
    1/2021
    
    1/2021
    
    
    1,439
    
    
    1,354
    
    
    1,493
    
    80
    %CVS
      Corporation
    
    Oak
      Ridge, NC
    
    
    A-/A3
    
    Retail
      Drug
    
    10,880
    
    Retail
      Store
    
    6.99
    %
    
    1/2025
    
    8/2024
    
    
    3,243
    
    
    3,224
    
    
    3,224
    
    83
    %CVS
      Corporation
    
    Sunbury,
      PA
    
    
    A-/A3
    
    Retail
      Drug
    
    10,125
    
    Retail
      Store
    
    7.50
    %
    
    1/2021
    
    1/2021
    
    
    1,829
    
    
    1,699
    
    
    1,654
    
    81
    %CVS
      Corporation
    
    Washington,
      DC
    
    
    A-/A3
    
    Retail
      Drug
    
    7,920
    
    Retail
      Store
    
    8.10
    %
    
    1/2023
    
    1/2023
    
    
    2,781
    
    
    2,569
    
    
    2,760
    
    78
    %Home
      Depot U.S.A., Inc.
    
    Tullytown,
      PA
    
    
    Private(5
    )
    Retail
    
    116,016
    
    Retail
      Store
    
    6.62
    %
    
    1/2033
    
    1/2033
    
    
    8,447
    
    
    8,444
    
    
    8,444
    
    98
    %Home
      Depot U.S.A., Inc.
    
    Westminster,
      CO
    
    
    Private(5
    )
    Retail
    
    107,400
    
    Retail
      Store
    
    7.50
    %
    
    7/2018
    
    5/2009
    
    
    8,500
    
    
    8,581
    
    
    8,581
    
    97
    %Kohl’s
      Corporation
    
    Chicago,
      IL
    
    
    A-/A3
    
    Retail
    
    133,000
    
    Retail
      Store
    
    6.69
    %
    
    9/2030
    
    9/2030
    
    
    48,270
    
    
    48,270
    
    
    48,270
    
    94
    %Koninklijke
      Ahold n.v.
    
    North
      Kingstown, RI
    
    
    BB/Ba3
    
    Retail
      Grocer
    
    125,772
    
    Retail
      Store
    
    7.50
    %
    
    11/2025
    
    11/2025
    
    
    6,794
    
    
    6,693
    
    
    6,671
    
    74
    %Koninklijke
      Ahold n.v.
    
    Tewksbury,
      MA
    
    
    BB/Ba3
    
    Retail
      Grocer
    
    58,450
    
    Retail
      Store
    
    7.50
    %
    
    1/2027
    
    1/2027
    
    
    6,625
    
    
    6,572
    
    
    6,567
    
    74
    %Koninklijke
      Ahold n.v.
    
    Upper
      Darby, PA
    
    
    BB/Ba3
    
    Retail
      Grocer
    
    54,800
    
    Retail
      Store
    
    7.29
    %
    
    4/2024
    
    4/2024
    
    
    6,889
    
    
    6,799
    
    
    6,475
    
    93
    %Lowe’s
      Companies, Inc
    
    Matamoras,
      PA
    
    
    A+/A2
    
    Retail
    
    162,070
    
    Retail
      Store
    
    6.61
    %
    
    5/2030
    
    5/2030
    
    
    7,208
    
    
    7,196
    
    
    7,196
    
    96
    %National
      City Bank of the Midwest (f/k/a National City Bank of
      Michigan/Illinois)
    
    Chicago,
      IL
    
    
    A+/Aa3
    
    Bank
      Branch
    
    5,274
    
    Bank
      Branch
    
    5.89
    %
    
    12/2024
    
    12/2024
    
    
    3,114
    
    
    3,114
    
    
    3,202
    
    78
    %Neiman
      Marcus Group, Inc
    
    Las
      Vegas, NV
    
    
    BBB/Baa2
    
    Retail
    
    167,000
    
    Retail
      Store
    
    6.06
    %
    
    11/2022
    
    11/2021
    
    
    8,267
    
    
    7,900
    
    
    8,602
    
    83
    %United
      States Postal Service
    
    Sammon
      Bay, AK
    
    
    Private(6
    )
    Post
      Office
    
    2,080
    
    Post
      Office
    
    7.05
    %
    
    10/2021
    
    10/2021
    
    
    1,015
    
    
    986
    
    
    1,008
    
    76
    %University
      of Connecticut Health Center
    
    Farmington,
      CT
    
    
    AA/Aa3(7
    )
    Medical
    
    100,000
    
    Medical
      Office
    
    6.34
    %
    
    11/2029
    
    11/2024
    
    
    22,800
    
    
    22,752
    
    
    23,667
    
    91
    %Walgreen
      Co.
    
    Dallas,
      TX(8
    )
    
    A+/Aa3
    
    Retail
      Drug
    
    14,550
    
    Retail
      Store
    
    6.46
    %
    
    12/2029
    
    12/2029
    
    
    2,718
    
    
    2,718
    
    
    2,718
    
    63
    %167,775
    
    
    166,628
    
    
    168,258
  9
  **(in
      thousands)****(2)****As
      of 12/31/04****Tenant
      or Guarantor**
    
    **Location**
    
    
    **Ratings
      (S&P/****Moody’s)****(1)**
    
    **Business
      Category**
    
    **Square
      Feet**
    
    **PropertyType**
    
    **Coupon**
    
    **LeaseExpiration**
    
    **Loan
      Maturity**
    
    **Original
      Principal Balance**
    
    **PrincipalBalance**
    
    **BookValue**
    
    **Loan toRealtyValue**(3)
 **Corporate
      Credit Notes**Albertson’s,
      Inc.
    
    Los
      Angeles, CA
    
    
    BBB/Baa2
    
    Retail
      Drug
    
    16,475
    
    Retail
      Store
    
    6.50
    %
    
    7/2028
    
    9/2013
    
    
    437
    
    
    398
    
    
    354
    
    85
    %Albertson’s,
      Inc.
    
    Norwalk,
      CA
    
    BBB/Baa2
    
    Retail
      Drug
    
    14,696
    
    Retail
      Store
    
    6.33
    %
    
    12/2028
    
    12/2013
    
    
    470
    
    
    436
    
    
    430
    
    76
    %Best
      Buy Co., Inc
    
    Olathe,
      KS
    
    
    BBB-/Baa3
    
    Retail
      - Elect.
    
    48,744
    
    Retail
      Store
    
    5.40
    %
    
    1/2018
    
    6/2013
    
    
    1,779
    
    
    1,595
    
    
    1,512
    
    86
    %Best
      Buy Co., Inc
    
    Wichita
      Falls, TX
    
    
    BBB-/Baa3
    
    Retail
      - Elect.
    
    30,038
    
    Retail
      Store
    
    6.15
    %
    
    1/2017
    
    11/2012
    
    
    743
    
    
    631
    
    
    593
    
    81
    %CVS
      Corporation
    
    Clemmons,
      NC
    
    
    A-/A3
    
    Retail
      Drug
    
    10,880
    
    Retail
      Store
    
    5.54
    %
    
    1/2022
    
    1/2015
    
    
    285
    
    
    285
    
    
    271
    
    66
    %CVS
      Corporation
    
    Commerce,
      MI
    
    
    A-/A3
    
    Retail
      Drug
    
    10,880
    
    Retail
      Store
    
    5.85
    %
    
    4/2025
    
    5/2013
    
    
    501
    
    
    448
    
    
    429
    
    89
    %CVS
      Corporation
    
    Garwood,
      NJ
    
    
    A-/A3
    
    Retail
      Drug
    
    11,970
    
    Retail
      Store
    
    6.12
    %
    
    6/2025
    
    8/2013
    
    
    879
    
    
    791
    
    
    764
    
    87
    %CVS
      Corporation
    
    Kennett
      Square, PA
    
    
    A-/A3
    
    Retail
      Drug
    
    12,150
    
    Retail
      Store
    
    6.40
    %
    
    1/2025
    
    10/2012
    
    
    857
    
    
    716
    
    
    685
    
    90
    %CVS
      Corporation
    
    Knox,
      IN
    
    
    A-/A3
    
    Retail
      Drug
    
    10,125
    
    Retail
      Store
    
    7.60
    %
    
    1/2024
    
    12/2011
    
    
    322
    
    
    250
    
    
    249
    
    75
    %CVS
      Corporation
    
    Rockingham,
      NC
    
    
    A-/A3
    
    Retail
      Drug
    
    10,125
    
    Retail
      Store
    
    6.12
    %
    
    1/2025
    
    10/2013
    
    
    435
    
    
    397
    
    
    386
    
    82
    %CVS
      Corporation
    
    Rutherford
      College, NC
    
    A-/A3
    
    Retail
      Drug
    
    10,125
    
    Retail
      Store
    
    6.12
    %
    
    1/2025
    
    10/2013
    
    
    346
    
    
    321
    
    
    312
    
    83
    %FedEx
      Ground Package System, Inc.
    
    McCook,
      IL
    
    
    Private(9
    )
    Distribution/Whse/Office
    
    159,699
    
    Distribution/Whse/Office
    
    5.89
    %
    
    1/2019
    
    2/2015
    
    
    2,737
    
    
    2,737
    
    
    2,699
    
    86
    %FedEx
      Ground Package System, Inc.
    
    Reno,
      NV
    
    
    Private(9
    )
    Distribution/Whse/Office
    
    106,396
    
    Distribution/Whse/Office
    
    5.90
    %
    
    9/2018
    
    10/2014
    
    
    1,374
    
    
    1,357
    
    
    1,341
    
    81
    %PerkinElmer,
      Inc.
    
    Beltsville,
      MD
    
    
    BB+/Ba2
    
    Global
      Tech.
    
    65,862
    
    LightIndustrial
    
    7.35
    %
    
    11/2021
    
    12/2011
    
    
    707
    
    
    547
    
    
    542
    
    86
    %PerkinElmer,
      Inc.
    
    Daytona,
      FL
    
    
    BB+/Ba2
    
    Global
      Tech.
    
    34,196
    
    Light
      Industrial
    
    7.35
    %
    
    11/2021
    
    12/2011
    
    
    321
    
    
    248
    
    
    246
    
    82
    %PerkinElmer,
      Inc.
    
    Phelps,
      NY
    
    
    BB+/Ba2
    
    Global
      Tech.
    
    32,700
    
    Light
      Industrial
    
    7.35
    %
    
    11/2021
    
    12/2011
    
    
    299
    
    
    231
    
    
    225
    
    90
    %PerkinElmer,
      Inc.
    
    Warwick,
      RI
    
    
    BB+/Ba2
    
    Global
      Tech.
    
    95,720
    
    Light
      Industrial
    
    7.68
    %
    
    12/2021
    
    1/2012
    
    
    939
    
    
    735
    
    
    716
    
    87
    %Staples,
      Inc.
    
    Odessa,
      TX
    
    
    BBB-/Baa2
    
    Office
      Supp.
    
    23,942
    
    Retail
      Store
    
    6.41
    %
    
    6/2015
    
    9/2012
    
    
    408
    
    
    342
    
    
    321
    
    84
    %Walgreen
      Co.
    
    Delray
      Beach, FL
    
    
    A+/Aa3
    
    Retail
      Drug
    
    15,120
    
    Retail
      Store
    
    6.20
    %
    
    1/2021
    
    1/2013
    
    
    595
    
    
    508
    
    
    505
    
    79
    %Walgreen
      Co.
    
    Riverside,
      CA
    
    
    A+/Aa3
    
    Retail
      Drug
    
    12,804
    
    Retail
      Store
    
    6.10
    %
    
    10/2028
    
    12/2013
    
    
    571
    
    
    529
    
    
    515
    
    77
    %Walgreen
      Co.
    
    Waterford,
      MI
    
    
    A+/Aa3
    
    Retail
      Drug
    
    14,490
    
    Retail
      Store
    
    5.50
    %
    
    1/2023
    
    6/2013
    
    
    953
    
    
    842
    
    
    780
    
    87
    %15,958
    
    
    14,342
    
    
    13,872**Recapitalized
      Loans**Natural
      Gas Pipeline Company of America
    
    Oak
      Brook, IL
    
    
    Private(9)
    
    Natural
      Gas Transport. & Storage
    
    201,189
    
    Office
    
    5.97
    %
    
    5/2008
    
    6/2007
    
    
    15,244
    
    
    11,724
    
    
    11,724
    
    47
    %Xerox
      Corporation
    
    El
      Segundo, CA
    
    
    BB-/B1
    
    Office
    
    330,266
    
    Office
    
    4.71
    %
    (10)
    11/2007
    
    11/2007
    
    
    16,483
    
    
    13,202
    
    
    13,202
    
    27
    %31,727
    
    
    24,926
    
    
    24,926**Totals**
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    **$**
    **215,460**
    
    **$**
    **205,896**
    
    **$**
    **207,056**
  (1)
    Ratings
      represent publicly available long-term corporate credit rating or
      long-term senior unsecured debt ratings as of December 31,
  2004.
 (2)
    All
      amounts are rounded to the nearest thousand. Sums may not equal totals due
      to rounding.
  (3)
    All
      percentages have been rounded to the nearest whole percentage. Loan to
      Realty Value is the ratio of the principal balance of the loan as of
      December 31, 2004 to the appraised value of the real estate that secures
      the loan at the time of the loan. The Loan to Realty Value for each
      corporate credit note includes the principal balance of the portion of the
      loan we have sold.
  (4)
    Represents
      two loans to the same borrower with the same underlying tenant that are
      cross-collateralized.
  (5)
    The
      credit does not carry public ratings from S&P or Moody’s, but the loan
      received a private rating in connection with our initial CDO transaction
      completed in March 2005. The credit’s parent had an AA/Aaa3 rating from
      S&P and Moody’s as of December 31, 2004.
  (6)
    The
      United States Postal Service (“USPS”) has no public rating from either
      S&P or Moody’s. The USPS is an independent establishment of the
      executive branch of the United States government. The loan received a
      private rating from S&P and Moody’s in connection with our initial CDO
      transaction in March 2005.
  (7)
    The
      University of Connecticut Health Center (“UCHC”) is a constituent unit of
      the University of Connecticut. The financial obligations of the UCHC are
      binding on the State of Connecticut. The State of Connecticut had a AA and
      Aa3 rating from S&P and Moody’s, respectively, as of December 31,
      2004.
  (8)
    Represents
      the first of two fundings on the same loan. The second funding will occur
      in January 2005.
  (9)
    This
      credit does not carry public ratings from S&P or Moody’s, but the loan
      received a private rating from S&P and Moody’s in connection with our
      initial CDO transaction completed in March 2005. The credit’s parent had a
      BBB/Baa2 rating from S&P and Moody’s as of December 31,
  2004.
  (10)
    
    The
      coupon is 4.71% through and including December 31, 2004 after which the
      coupon will be reset monthly at LIBOR plus
3.25%.





10




*Development
Loans.*




As part
of our developer loan program, we have funded loans on five properties as of
December 31, 2004. We have agreed to fund up to an aggregate of $2.0 million on
these properties, and have funded $0.8 million as of December 31, 2004. These
loans are generally mezzanine type loans, meaning our security interest in the
owner of the property is junior to another lender’s mortgage on the
property.




*Structured
Interests.*




Our
structured interests in net lease assets as of December 31, 2004 are summarized
in the following table.




**(in
      thousands)****(1)****Security
      Description**
    
    
    **CUSIP
      No.**
    
    **Ratings(S&P
      or Fitch)**
    
    
    **FaceAmount**
    
    
    **Cost**
    
    
    **CarryValue**
    
    
    **Coupon**
    
    
    **Yield**(2)**Investments
      in Commercial Mortgage Loan Securitizations****(3)**BSCMS
      1999-CLF1, Class E
    
    
    07383FCC0
    
    BB
    
    $
    3,326
    
    $
    2,034
    
    $
    2,512
    
    
    7.11
    %
    
    10.31
    %BSCMS
      1999-CLF1, Class F
    
    
    07383FCD8
    
    B-
    
    
    2,494
    
    
    1,019
    
    
    1,019
    
    
    7.11
    %
    
    19.00
    %CALFS
      1997-CTL1, Class D
    
    
    140281AF3
    
    BBB-
    
    
    3,000
    
    
    2,903
    
    
    2,951
    
    
    6.16
    %
    
    6.42
    %CMLBC
      2001-CMLB-1, Class E
    
    
    201736AJ4
    
    BBB+
    
    
    9,526
    
    
    10,108
    
    
    11,375
    
    
    7.88
    %
    
    6.14
    %CMLBC
      2001-CMLB-1, Class G
    
    
    201736AL9
    
    BBB-
    
    
    9,526
    
    
    8,760
    
    
    10,825
    
    
    7.88
    %
    
    6.66
    %CMLBC
      2001-CMLB-1, Class H
    
    
    201736AM7
    
    BB-
    
    
    11,907
    
    
    6,343
    
    
    8,000
    
    
    6.25
    %
    
    10.32
    %CMLBC
      2001-CMLB-1, Class J
    
    
    201736AN5
    
    B-
    
    
    7,144
    
    
    3,024
    
    
    3,388
    
    
    6.25
    %
    
    14.58
    %CMLBC
      2001-CMLB-1, Class K
    
    
    201736AP0
    
    NR
    
    
    4,766
    
    
    1,089
    
    
    1,089
    
    
    6.25
    %
    
    29.00
    %NLFC
      1999-LTL-1, Class D
    
    
    63859CCK7
    
    BBB
    
    
    5,000
    
    
    3,251
    
    
    5,117
    
    
    6.45
    %
    
    6.27
    %NLFC
      1999-LTL-1, Class E
    
    
    63859CCL5
    
    BB-
    
    
    11,081
    
    
    4,964
    
    
    6,555
    
    
    5.00
    %
    
    10.25
    %NLFC
      1999-LTL-1, Class IO
    
    
    63859CCG6
    
    AAA
    
    
    9,908
    
    
    9,908
    
    
    10,164
    
    
    0.50
    %
    
    8.51
    %Other
    
    
    Various
    
    BBB
    
    
    914
    
    
    682
    
    
    626
    
    
    None
    
    
    11.64
    %(4)**Investments
      in Certificated Loan Transactions****(5)**Yahoo,
      Inc.
    
    
    984332AC0
    
    BB+
    
    
    16,999
    
    
    16,495
    
    
    17,169
    
    
    6.65
    %
    
    6.34
    %CVS
      Corporation.
    
    
    94999ABV4
    
    A-
    
    
    6,180
    
    
    6,966
    
    
    6,966
    
    
    8.26
    %
    
    6.68
    %**Totals**
    
    
    
    
    
    
    **$**
    **101,771**
    
    **$**
    **77,547**
    
    **$**
    **87,756**
  (1)
    All
      amounts are rounded to the nearest thousand. Sums may not equal totals due
      to rounding.
  (2)
    Represents
      the yield to maturity, computed using the effective interest method, based
      on our carry value.
  (3)
    The
      interests represent investments in a class of a prior commercial mortgage
      loan securitization. Class designations are generally descriptive of the
      security and its relative priority within the securitization (with letters
      generally reflecting descending priority).
  (4)
    Represents
      our average yield to maturity on all included
securities.
  (5)
    Represents
      loan transactions where our investment is evidenced by a trust
      certificate.


**


*Structuring
Fees Receivable.*




As of
December 31, 2004, our assets also included approximately $4.4 million of
structuring fees receivable from various borrowers on net lease loans we
previously originated and then sold. These structuring fees represent cash flows
we have the right to receive subsequent to the sale of the loans. We are
entitled to receive a monthly income stream out of lease payments on the
properties. As of December 31, 2004, all structuring fee payments were
current.




**Credit
Facilities**




We
utilize secured warehouse credit facilities, also commonly referred to as
repurchase agreements, to finance our net lease asset investments on a
short-term basis. We currently have a secured warehouse facility with Wachovia
Bank, N.A. We have maintained a facility with Wachovia Bank since 2001. Our
current aggregate borrowing limit under this agreement is $250.0 million,
provided certain conditions described below are met.




As of
December 31, 2004, we also had a warehouse facility with Bank of America, N.A.,
but we chose not to renew it and it expired pursuant to its terms on March 1,
2005.




*Wachovia
Bank* *F* *acility.*




During
September 2004, we entered into a new master repurchase agreement with Wachovia
Bank, N.A. to finance our asset investments on a short-term basis prior to
obtaining long-term financing. The master repurchase agreement replaced our
existing credit facilities with Wachovia Bank.




11


Under the
new agreement, Caplease, LP and certain of our other subsidiaries sell assets to
Wachovia Bank and agree to repurchase those assets on a date certain at a
repurchase price generally equal to the original purchase price plus accrued but
unpaid interest. Each asset financed under the facility is purchased by Wachovia
Bank at a percentage of the asset’s value on the date of origination (the
purchase rate) and we pay interest to Wachovia Bank at prevailing short-term
interest rates (one-month LIBOR) plus a pricing spread. We have agreed to a
schedule of purchase rates and pricing spreads with Wachovia Bank generally
based upon the class and credit rating of the asset financed. The facility is
recourse to us and we have agreed to guarantee all obligations of our
subsidiaries under the agreement. For financial reporting purposes we
characterize all of the borrowings under the facility as on balance sheet
financing transactions, meaning the assets financed and liabilities we incur
will be reported on our balance sheet.




The
repurchase agreement is a $250.0 million uncommitted facility, meaning Wachovia
Bank must agree to each asset financed under the agreement. The facility may be
increased to $450.0 million if requested by us and Wachovia Bank agrees. The
agreement expires on September 21, 2005, but may be extended for not more than
two successive 364-day periods if requested by us and Wachovia Bank
agrees.




We can
finance each of our existing primary products under the agreement, including
commercial real estate whole loans, CMBS and acquisitions of commercial real
estate. Commercial real estate acquisitions will be financed through mortgage
loans made by Caplease, LP to a subsidiary of Caplease, LP formed for the
purpose of owning the real property acquired followed by the sale of such
mortgage loans to Wachovia Bank under the terms of the facility. Unless
otherwise agreed to by Wachovia Bank, for any asset financed under the facility
for more than 240 days, Wachovia Bank may (a) require that the asset be removed
from the facility or (b) require all income generated by the asset be applied to
reducing the outstanding balance under the facility.




The
agreement includes sublimits on certain asset classes and credit or tenant
concentrations. If at any time (i) the repurchase price of any financed asset
exceeds its asset value (as defined in the agreement), (ii) either Standard
& Poor’s or Moody’s downgrades any asset financed under the facility or
(iii) the aggregate repurchase price of all financed assets exceeds the maximum
facility size, Wachovia Bank may require a repurchase of the assets or a
contribution of additional cash or other eligible assets to satisfy the
difference. If required, these payments could be material and could have a
material adverse effect on our operations or on our ability to make further net
lease investments.




We are
required to maintain the following financial covenants during the term of the
agreement:




·
    liquidity
      (as defined in the agreement) of at least $8.0 million; and




·
    consolidated
      tangible net worth (as defined in the agreement) of at least $100.0
      million (plus 75% of the aggregate net proceeds from future equity
      offerings or capital contributions).




In
addition to being an uncommitted facility, if an event of default (as defined in
the agreement) occurs, we will be unable to finance assets under the facility
and our obligations to repurchase assets financed under the facility may, at the
option of Wachovia Bank, be accelerated. The definition of event of default
under the agreement includes the following events:




·
    we
      fail to maintain the above financial
covenants;




·
    a
      judgment in excess of $5.0 million in the aggregate is rendered against us
      and is not satisfied or otherwise stayed within 90
days;




·
    we
      default in the payment of a matured obligation of at least $5.0 million
      under any indebtedness or material contract; and




·
    we
      default under any indebtedness or material contract in an amount of at
      least $5.0 million and an acceleration of the maturity under such
      indebtedness or material contract occurs.







12





The
following summarizes certain information regarding this facility as of December
31, 2004:




**Mortgage
      Loans**
    
    **Structured
      Interests**(*in
      thousands, except interest rate data*)Unpaid
      Borrowings
    $102,288
    
    $31,543Face
      Amount of Collateral
    $136,477
    
    $41,130Scheduled
      Interest Rate on Assets Financed
    One-month
      LIBOR plus .95%
    
    One-month
      LIBOR plus .40%-.95%Weighted
      Average Interest Rate on Assets Financed
    3.34%
    
    3.02%





As of
December 31, 2004, we were in compliance with the terms of the agreements with
our secured lenders. We believe that we have an excellent relationship with
Wachovia Bank. If we are unable to finance assets under our Wachovia Bank
facility, our ability to continue to execute our business plan could be
materially adversely affected.




**Long-Term
Financings**




We
finance our investments through short-term financing arrangements and, as soon
as practicable thereafter, we obtain long-term financing for these investments,
generally on a secured basis. Long-term financing can be in the form of
traditional mortgage debt, CDOs or other debt mechanisms. As of December 31,
2004, we have financed an aggregate of $153.7 million of assets in portfolio on
a long-term basis through the issuance or assumption of long-term debt of $110.7
million. All of our long-term debt obligations as of that date represent
traditional mortgage debt. We completed our first CDO financing in March 2005.
See “Recent Developments—Long-Term Financings.” We expect our leverage to
average 70% to 85% of our assets in portfolio.




In a
traditional mortgage debt financing, we enter into one or more promissory notes
at a fixed rate of interest. The notes typically mature over a long-term period
of approximately ten years and debt service is payable monthly. If the financed
asset generates a sufficient level of free cash flow after paying our long-term
financing cost, we may further finance the asset through issuance of a corporate
credit note by our wholly-owned subsidiary that acquired the property to us or
one of our other subsidiaries. We expect to separately finance the corporate
credit note on a long-term basis, typically along with other assets financed
through a CDO. The notes are generally non-recourse to us but are secured by a
mortgage on the property and an assignment of the underlying lease and rents on
the property. The notes generally include non-recourse exceptions for certain
losses, damages or expenses to the lender, including those incurred as a result
of the following:




·
    waste
      to the mortgaged property or damage to the mortgaged property as a result
      of our intentional misconduct or gross
negligence;




·
    the
      existence of hazardous substances or radon on the mortgaged property or
      the failure to comply with environmental laws or regulations with respect
      to the mortgaged property; and




·
    a
      fraud or material misrepresentation committed by us or any person
      authorized to act on our behalf or the failure of us or anyone authorized
      to make statements on our behalf to disclose a material
    fact.




The notes
may become fully recourse if we fail to comply with certain covenants
prohibiting us from transferring or further encumbering the mortgaged property
or requiring us to take (or refrain from taking) various actions in order to
preserve the status of our borrower as a single-purpose entity, or the mortgaged
property becomes an asset in a bankruptcy proceeding of the
borrower.




The notes
may be fully amortizing or require a balloon payment at maturity. To the extent
the loan requires a balloon payment at maturity, we would expect to refinance
that payment at maturity. The notes are typically subject to customary events of
default, including the failure to pay principal and/or interest or the
determination that any representation or warranty made in the loan documents is
false or misleading in any material respect. Upon an event of default, the notes
will generally become immediately due and payable, at the option of the
payee.




In a
typical CDO financing, we will borrow money through a trust or other entity (the
CDO) and post or sell assets as collateral, giving the CDO investors a first
priority claim on the collateral posted and the right to foreclose on the
collateral upon an event of default. In turn, the CDO will issue securities to
investors to fund our borrowing. Our borrowing will bear a fixed rate of
interest. We will continue to own the assets financed through a CDO and will be
entitled to receive cash flows from the assets to the extent they exceed debt
service on the CDO. Once the CDO has been established, changes in interest
rates, credit spreads or the credit quality of collateral will generally have no
impact on cash flows on the CDO collateral or our financing cost under the CDO.
We expect that the term of the CDOs we will use will be approximately 10
years.




13


**Asset
Pipeline**




*Loan
Pipeline.*




Our loan
pipeline includes potential loans in various stages of review. We receive
requests for net lease financing on a daily basis and generally have from 50 to
100 potential transactions in different stages in our loan origination
qualification, pricing and due diligence process at any given time. Once we have
reviewed and determined that a lease is financeable under our program, we will,
at the borrower’s request, issue a term sheet which briefly outlines the pricing
and terms under which we propose to finance the property. Upon acceptance of the
term sheet by the borrower, we issue a form of application which sets forth the
detailed terms of the transaction. Once the borrower signs an application and
delivers it to us with a deposit and the application is accepted, we consider
such loans to be loans under commitment or committed loans, subject to our due
diligence process and final approval by our investment committee. We generally
close a committed loan four to eight weeks after the application is signed. At
any time from the date of acceptance of the application until closing, the
borrower may lock in the interest rate on the loan by payment of an additional
fee.




While we
may decline a loan application upon completion of our underwriting process, or
the prospective borrower may forfeit its deposit and withdraw the application
prior to closing, we believe, based on our experience, that the substantial
majority of these committed loans result in closed loans. Furthermore, it has
been our experience that once we commit to make a net lease loan and lock in an
interest rate (receiving a rate-lock fee), closing of that loan is relatively
assured. We believe, also based on our experience, that a significant portion of
loans in the application stage and a lesser percentage of loans in the term
sheet stage will move into the category of committed loans. Since we receive
requests for loan financing daily, our loan pipeline frequently changes as new
potential transactions are added and others are removed.




*Real
Property Pipeline.*




Our real
property pipeline includes potential acquisitions in various stages of review.
We generally have from 5 to 10 potential transactions in different stages in our
property acquisition qualification, pricing and due diligence process at any
given time. Once we determine a lease to meet our criteria for purchase of the
related property, we negotiate an expression of interest or proceed directly to
a purchase and sale agreement with the owner for the purchase of the property.
The expression of interest does not bind us to purchase, but binds the seller
not to accept another offer to purchase the property during our diligence
period. We generally seek to negotiate a 30-day due diligence period during
which we can terminate our obligations for any reason and receive back any
deposit we pay the seller. After that 30-day due diligence period, any deposit
we pay the seller typically becomes non-refundable. We seek to close our real
property acquisitions four to eight weeks after the expression of interest or
purchase and sale agreement is signed.




**Origination
Network**




*Loan
Origination.*




Our
principal source of loan origination is our national network of independent
mortgage brokers. We have established and maintain relationships with over 2,000
individual mortgage brokers at over 200 mortgage brokerage companies and
commercial banks, through which we primarily originate loans. We also originate
loans directly to developers and owners or investors in net leased properties. A
significant portion of our business is with repeat customers.




Our
mortgage brokers operate offices throughout the United States and maintain close
working relationships with the property owners they represent and are generally
compensated by the property owner. We provide these brokers with ongoing
training and information regarding our products. Although these brokers are not
required to work exclusively with us, we closely track the volume of assets
generated by each.




Mortgage
brokers working with net lease products need specialized knowledge and skills
not generally required for traditional real estate debt and equity activities.
In addition to ongoing training, we routinely meet with mortgage brokers to
discuss the latest developments in net lease financing. As part of our efforts
to educate our mortgage broker network about net lease financing, we provide
bimonthly newsletters, brochures and other written material intended to keep
mortgage brokers up to date on the latest underwriting requirements for net
lease financings and net leases, lease enhancements, and changes in tenant
credit ratings, as well as to provide information on our latest
programs.




We
maintain a comprehensive marketing, advertising and public relations program
that supports our loan origination efforts. The objective of the program is to
establish and build our name recognition and credibility as a specialty finance
company and to promote our net lease financing programs. We believe, based upon
our experience and responses from customers, that we have been successful in
achieving our objectives of market awareness and prominence in the net lease
market.




14


In
addition to our training and marketing support of mortgage brokers, our
executives and staff periodically assist brokers by meeting with owners to
explain various aspects of our net lease financing programs, and by assisting in
structuring transactions to meet the owner’s requirements. Based upon responses
from these brokers as well as our experience, we believe that our ongoing
marketing efforts, combined with comprehensive training programs, are key
factors not only in creating and maintaining relationships with productive
mortgage brokers but also in improving their productivity. Furthermore, we
believe that we have streamlined our loan approval process and centralized asset
underwriting as well as many transactional and structuring matters to make the
origination of our net lease loan assets efficient for brokers. As a result, we
believe these mortgage brokers can focus on identifying possible additional
owners of net lease assets and facilitating the loan closing process, rather
than focusing solely on underwriting each loan.




*Property
Acquisitions.*




Since our
initial public offering, we have leveraged our relationships within our loan
origination business to develop relationships with approximately 300 investment
sale brokers, through which we primarily identify real property for purchase. We
also source property acquisition opportunities directly from developers and
owners or investors in real estate assets. Because of the inherent synergies
among our products, from time to time we identify property acquisition
opportunities through our loan origination network and vice versa.




Our
property acquisition network is smaller and less specialized than our loan
origination network. As a result, we have found that our sources for property
acquisition opportunities require less marketing and training efforts than that
required in our loan origination business. From time to time, we meet with
investment sale brokers to discuss our investment criteria. We also include
members of our property acquisition network on distributions of our bimonthly
newsletters, brochures and other written materials.




**Underwriting
Process**




Once a
prospective net lease financing opportunity or investment is identified, the
potential transaction undergoes a comprehensive underwriting and due diligence
process that is overseen by our investment committee, which consists of six of
our key employees. The focus of our asset underwriting falls into three primary
areas:




·
    credit
      and financial reviews of the tenant as well as an assessment of the
      tenant’s business, the overall industry segment and the tenant’s market
      position in the industry;




·
    lease
      quality, including an analysis of the term, tenant termination and
      abatement rights, landlord obligations and other lease provisions; and




·
    a
      real estate review and analysis.




The
credit quality of the tenant under the net lease is at the core of the
underwriting of a net lease transaction. Prior to entering into any net lease
transaction, our underwriter, assisted by our chief investment officer and chief
financial officer as necessary, conducts a review of the tenant’s credit
quality. This review may include reviews of publicly available information,
including any public credit ratings, audited financial statements, debt and
equity analyst reports, and reviews of corporate credit spreads and stock
prices.




While we
have no defined minimum credit rating or balance sheet size for tenants, we
anticipate that a significant majority of the tenants underlying our net lease
investments will be public corporations with credit ratings provided by the
national statistical rating organizations such as Standard & Poor’s and
Moody’s and will be investment grade in credit quality. For those tenants that
either carry no rating or carry ratings that are below investment grade, we may
conduct additional due diligence, including additional financial reviews of the
tenant by us or a third-party provider, if practicable, and a more comprehensive
review of the business segment and industry in which the tenant operates.




In
addition, with respect to the underlying collateral, we may conduct, or engage a
third-party provider to conduct, a more comprehensive review of the real estate,
including evaluating alterative uses for the real estate and the costs
associated with converting to such alternative uses as well as examining the
surrounding real estate market in greater detail.




15


Assuming
that the credit of the tenant under the net lease is satisfactory, a thorough
review is then conducted into the quality of the lease, focusing primarily on
those provisions of the lease that would permit the tenant to terminate or abate
rent prior to the conclusion of the initial lease term. If the lease provides
for any tenant abatement or termination rights or landlord’s obligations, those
provisions are isolated and appropriate forms of lease enhancements may be
applied, including as necessary, specialized insurance, reserves or debt service
coverage covenants. In addition, each lease is reviewed by outside counsel and a
lease summary is provided to our underwriter for use in underwriting the
transaction.




Finally,
we conduct a thorough review with respect to the quality of the real estate
subject to the net lease. In the case of a loan to a property owner, this due
diligence includes a review of the background and financial capabilities of the
owner. In all cases, the property is also reviewed from a traditional real
estate perspective, including quality of construction and maintenance, location
and value of the real estate and technical issues such as title, survey and
environmental. As necessary, appraisals and environmental and engineering
reports are obtained from third-parties and reviewed by our underwriter and
legal counsel.




In the
case of structured transactions, our underwriter, assisted by our chief
investment officer, chief financial officer, general counsel and other internal
and outside advisors, as necessary, thoroughly evaluate the credit, the legal
and financial structures and the collateral quality underlying the transaction.




In
addition to our review of the quality of any individual transaction, our
investment committee also:




·
    evaluates
      our current portfolio, including consideration of how the subject
      transaction affects asset diversity and credit concentrations in the
      tenant, industry or credit level;




·
    determines
      whether we can implement appropriate legal and financial structures,
      including our ability to control the asset in a variety of circumstances,
      including in the event of a default by the tenant or the borrower, as
      applicable;




·
    evaluates
      the leveraged and unleveraged yield on the asset and how that yield
      compares to our target yields for that asset class and our analysis of the
      risk profile of the investment; and




·
    considers
      our ability to finance the asset under our existing credit structures and
      whether we can match-fund the asset.




We use
integrated systems such as customized software and models to support our
decisions on pricing and structuring investments. Before issuing any form of
commitment and again before the closing of any transaction, each transaction
must be approved by our investment committee. Our investment committee consists
of our chief executive officer, president, chief financial officer, chief
investment officer, senior vice president, investments and senior vice
president, origination. The committee meets frequently and on an as-needed basis
to evaluate potential net lease investments.




In
addition, we have formed a four-member investment oversight committee of our
board of directors which approves all transactions in excess of $50.0 million.
All but one member of this committee are not employees of our company. Our
underwriting standards are specifically tailored to our investments. As we
develop new products, we may emphasize different criteria than we currently
emphasize. We also may modify our underwriting standards.




We
believe that our standardized underwriting and origination procedures and
integrated systems will enable us to manage a large and increasing volume of
transactions while maintaining underwriting quality and high levels of service
to customers. Our investments require little ongoing management except lease
administration, and we believe that we can grow our business without significant
expansion of our cost base. As our origination and acquisition volume grows, we
expect to continue to improve cost efficiency by modestly expanding our internal
loan and asset acquisition closing support staff and relying less on outside
service providers.




**Underwriting
and Surveillance System**




We also
have created a sophisticated underwriting and on-going asset surveillance system
that allows us to:




·
    track
      the status of our assets and asset
opportunities;




·
    link
      into a management program that includes the underlying asset origination
      or acquisition documents;




16




·
    load
      asset financials from our underwriting files into the
    system;




·
    monitor
      cash flows on each asset through servicer
reports;




·
    immediately
      identify issues such as non-payment of rent and servicer advances of rent
      or debt service through servicer exception
reports;




·
    track
      credit ratings of underlying tenants; and




·
    compute
      CDO coverage and compliance tests.




Through
this single system we are able to track and document the entire life-cycle of
our assets.




**Closing
Process**




From the
time we begin to consider a net lease investment until the investment is closed,
the prospective transaction undergoes a variety of defined steps and procedures.
In connection with the closing process, we will typically need to rely on
certain third parties not under our control, including tenants, borrowers,
sellers, warehouse lenders, brokers, outside counsel, insurance companies, title
companies, environmental consultants, appraisers, engineering consultants and
other product or service providers. Our personnel carefully manage the closing
process and have developed a streamlined set of procedures, checklists and
relationships with many of the third-party providers with whom we do business on
an on-going basis.




As set
forth above under “Underwriting Process” above, each transaction goes through a
multi-stage underwriting process with reviews by our investment committee both
at commitment and immediately prior to closing. Transaction underwriting and the
documentary process surrounding it is supported by the use of standardized
transaction documents, including closing checklists and loan documents, and is
further supported by proprietary underwriting and pricing software. All of our
transactions are closed by our in-house closing and underwriting staff, many of
whom have more than five years of experience with us. That staff seeks to close
our loan transactions four to eight weeks after the application is signed and
close property acquisitions four to eight weeks after an expression of interest
or purchase and sale agreement is signed, while at the same time maintaining our
underwriting standards.




**Risk
Management Strategy**




We
believe that exposure to changes in underlying interest rates can have a
profound effect on the value (and hence profitability) of our net lease assets
while they are held in our portfolio prior to long-term financing. Accordingly,
we have employed a risk management strategy to mitigate the effects of movements
in underlying interest rates on the value of our net lease assets. We have done
so by having derivative and other risk management positions that react in a
corresponding but opposite manner to offset changes in the value of our
fixed-rate assets due to changes in underlying U.S. Treasury interest rates and,
to a lesser degree, swap spreads. For example, as underlying interest rates
fall, the value of our fixed-rate asset increases while the value of our
derivative and other risk management position declines. Conversely, as
underlying interest rates rise, the value of our fixed-rate asset falls while
the value of our derivative and other risk management position increases.




Prior to
our initial public offering (and REIT qualification), we used risk management
transactions consisting of U.S. Treasury and Agency lock transactions to hedge
the interest rate risk associated with owning fixed rate mortgage loan assets
financed by floating rate debt. Subsequent to our initial public offering (and
REIT qualification), we began using forward starting interest rate swaps to
hedge the variability of changes in the interest-related cash outflows on
forecasted future borrowings. Interest rate swaps are agreements between two
parties to exchange, at particular intervals, payment streams calculated on a
specified notional amount. The interest rate swaps that we have entered into are
single currency interest rate swaps and, as such, do not require the exchange of
a notional amount. As of December 31, 2004, we were hedging our exposure to such
variability through February 2015.




We intend
generally to continue to seek to manage our interest rate exposure taking into
account the cost of such hedging and other risk management transactions and the
limitations on hedging and other risk management transactions imposed by the
REIT tax rules.




There can
be no assurance that our hedging activities will have the desired beneficial
impact on our results of operations, or financial condition. See “Risk
Factors—Risks Related to Borrowings” below.




17


**Recent
Developments**




*Asset
Investments.*




On
January 6, 2005, we completed an acquisition of an office and technology center
in Hanover Township, Morris County, New Jersey from WXV/Whippany, LLC, an
unaffiliated third party, for cash of $48.0 million. The purchase price was
determined through arms-length negotiations. The two-story building contains
149,475 square feet of space on 15 acres of land. We financed this acquisition
with proceeds from our warehouse facility with Wachovia Bank, N.A. The property
is net leased to Cadbury Schweppes Holdings (U.S.), a wholly-owned subsidiary of
Cadbury Schweppes PLC, which was, as of December 31, 2004, rated BBB and Baa2 by
Standard & Poor’s and Moody’s, respectively. The lease expires in March
2021.




*Long-Term
Financings.*




On
February 25, 2005, we obtained long-term financing for the Cadbury Schweppes
real property we acquired on January 6, 2005. This financing was obtained
through issuance of the following separate promissory notes made by one of our
wholly-owned subsidiaries:




**Note**
    
    **Payee**
    
    **Original
      Principal Amount**
    
    **Interest
      Rate**
    
    **Maturity
      Date**Real
      estate note
    
    
    Wachovia
      Bank, N.A.
    
    $
    36,000,000
    
    
    5.26%
    
    
    March
      11, 2015Corporate
      credit note
    
    
    Caplease,
      LP
    
    $
    4,047,559
    
    
    5.26%
    
    
    March
      11, 2015





Because
the corporate credit note we issued is intercompany debt, it is eliminated from
our consolidated financial statements.




On March
10, 2005, we completed a long-term financing through an on-balance sheet
collateralized debt obligation, or CDO. Our first CDO financing was effected
through the issuance of multi-class notes and preferred shares by our newly
formed wholly-owned subsidiary Caplease CDO 2005-1, Ltd. The multi-class notes
were co-issued by another newly formed wholly-owned subsidiary, Caplease CDO
2005-1 Corp. The subsidiaries issued 5 classes of investment-grade notes with an
aggregate principal amount of $285.0 million and preferred shares with a
principal amount of $15.0 million. We retained $31.5 million in principal amount
of the securities offered, comprised of the entire principal amount of the three
most junior note classes and the preferred shares.




The
issuer used the proceeds of the note offering, after payment of fees and
expenses and amounts owing in respect of pre-closing financing and hedging
arrangements, to acquire a portfolio of assets from our wholly-owned subsidiary,
Caplease, LP. We received net proceeds in the transaction of approximately
$263.1 million, approximately $206.0 million of which was used to repay our
borrowings under our short-term credit facility with Wachovia Bank, N.A.
Wachovia Bank is an affiliate of Wachovia Capital Markets, LLC, the initial
purchaser of the Class A and Class B notes in the CDO transaction.




The
classes of the notes are summarized in the following table:




**Class
      of Notes**
    
    **PrincipalAmount/FaceAmount
      as ofClosing Date**
    
    **Percentage
      ofall Securities**
    
    **RatingsMoody’s/S&P**
    
    **Stated
      Maturity**
    
    **S****tated**
      **Coupon
      Rate**A
    
    $
    252,000,000
    
    
    84.0
    %
    
    
    Aaa/AAA
    
    
    January
      2040
    
    
    4.926
    %B
    
    
    16,500,000
    
    
    5.5
    %
    
    
    Aa2/AA
    
    
    January
      2040
    
    
    5.036
    %C
    
    
    9,000,000
    
    
    3.0
    %
    
    
    A2/A-
    
    
    January
      2040
    
    
    5.406
    %D
    
    
    4,500,000
    
    
    1.5
    %
    
    
    Baa2/BBB
    
    
    January
      2040
    
    
    6.206
    %E
    
    
    3,000,000
    
    
    1.0
    %
    
    
    Baa3/
      BBB-
    
    
    January
      2040
    
    
    6.606
    %$
    285,000,000





Our
effective blended financing rate (inclusive of debt issuance and hedge costs) on
the Class A and Class B notes (the classes we did not retain) is approximately
5.63%.




Class
designations are descriptive of the security’s relative priority among the notes
(with letters reflecting descending priority). It is anticipated that the notes
will be paid well in advance of the stated maturity date in accordance with the
priority of payments in the note indenture. The expected maturity date of the
notes is in January 2015, when the notes become subject to the auction call
procedure described below.




18


The notes
are non-recourse debt obligations of the issuer and co-issuer. The issuer has
pledged its rights under the assets acquired from us and certain other assets as
security for payment of principal and interest on the notes.




Payments
of principal and interest on the notes will be made quarterly. The aggregate
amount available for these payments and for certain expenses of the issuer and
co-issuer on any payment date will be the sum of interest proceeds and principal
proceeds received on the pledged assets during the relevant collection
period.




The
initial portfolio of pledged assets are summarized below:




**Asset
      Type**
    
    **Face
      Value**
    
    **Percentage**Long-term
      credit tenant loans
    
    $
    199,148,746
    
    
    66.53
    %Corporate
      credit notes
    
    
    23,893,987
    
    
    7.98
    %Structured
      interests in net lease assets
    
    
    61,285,399
    
    
    20.48
    %Mezzanine
      loan
    
    
    15,000,000
    
    
    5.01
    %$
    299,328,132
    
    
    100.00
    %


The
transaction includes a five-year reinvestment period that allows the principal
proceeds and sale proceeds of the pledged assets to be reinvested in qualifying
replacement assets, subject to the satisfaction of certain conditions set forth
in the indenture.




When we
sold the pledged assets to the issuer, we made representations and warranties
regarding the assets sold. If any of these representations and warranties are
inaccurate, we may be compelled to repurchase the subject assets for the sale
price plus accrued interest and certain additional charges, if any.




We or one
of our wholly-owned subsidiaries will act as collateral manager of the issuer’s
assets and will be entitled to a management fee of .20% per annum of the
issuer’s outstanding portfolio balance. The payment of 50% of the management fee
is senior to payments on the notes and the remaining payment of 50% is junior to
payments on the notes.




Subject
to certain conditions described in the indenture, in January 2008, and on any
interest payment date thereafter, the issuer has the option to redeem the notes
and the preferred shares, in whole but not in part, at the direction of holders
of at least a majority of the aggregate outstanding notional amount of the
preferred shares.




The notes
are also subject to a mandatory redemption on any interest payment date on which
certain coverage tests set forth in the note indenture are not satisfied. Any
mandatory redemption of the notes is to be paid from interest and principal
proceeds of the pledged assets in accordance with the priority or payments set
forth in the indenture, until the applicable coverage tests are
satisfied.




As a
result of the above mandatory redemption provisions, we are subject to the risk,
as owner of the Class C notes, Class D notes and Class E notes, that interest
and principal that would otherwise be payable on these subordinate classes may
be redirected to pay principal and interest on the senior note
classes.




Beginning
in January 2015, the notes and the preferred shares may be redeemed (in whole
but not in part) if a successful auction of the underlying collateral is
completed in accordance with the terms of the indenture (which requires, among
other things, that the cash purchase price for such collateral, together with
the balance of eligible investments and cash in certain accounts pledged to
secure payment of the notes, is at least equal to the amount necessary to redeem
the notes and pay certain other required amounts under the priority of payments
set forth in the indenture).




If the
notes are not redeemed prior to January 2018, interest that would otherwise
become payable on the preferred shares will be redirected to the notes in
accordance with the priority or payments set forth in the indenture until the
notes are paid in full.




The note
indenture includes customary events of default, including upon failure to pay
principal or interest when due on the notes and a default in the performance of
any covenant or other agreement of the issuer or co-issuer (subject to notice
and a cure period). If an event of default occurs and is continuing, the trustee
may (and will be required to if directed by a majority in outstanding principal
amount of each class of notes, voting as separate classes), declare the
principal of, and accrued and unpaid interest on, the notes immediately due and
payable.




19


If an
event of default and an acceleration of the notes occur and is continuing, the
trustee will:




·
    retain
      the assets and collect all payments on the assets and continue making
      payments in accordance with the priority among the notes described in the
      indenture; or




·
    if
      directed to do so by two-thirds of each class of notes (other than notes
      owned by us), liquidate the assets and make payments on the notes in
      accordance with the priority among the notes described in the
      indenture.




To the
extent the assets are insufficient to meet payments due on the notes, the
obligations of the issuer and the co-issuer will be extinguished.




**Competition**




We are
subject to significant competition in seeking asset investments. We compete with
other specialty finance companies, insurance companies, commercial banks,
investment banks, savings and loan associations, mortgage bankers, mutual funds,
institutional investors, pension funds, other lenders, governmental bodies and
individuals and other entities, including REITs. We may face new competitors
and, due to our focus on net lease properties located throughout the United
States, and because many of our competitors are locally and/or regionally
focused, we will not encounter the same competitors in each region of the United
States.




Many of
our competitors will have greater financial and other resources and may have
other advantages over our company. Our competitors may be willing to accept
lower returns on their investments and may succeed in buying the assets that we
have targeted for acquisition. We may also incur costs on unsuccessful
acquisitions that we will not be able to recover.




**Environmental
Matters**




Under
various federal, state and local environmental laws, a current owner of real
estate may be required to investigate and clean up contaminated property. Under
these laws, courts and government agencies have the authority to impose cleanup
responsibility and liability even if the owner did not know of and was not
responsible for the contamination. For example, liability can be imposed upon a
property owner based on the activities of a tenant.




In
addition to the cost of the cleanup, environmental contamination on a property
may adversely affect the value of the property and the ability of the owner to
sell, rent or borrow using such property as collateral, and may adversely impact
our investment in that property.




Under the
environmental laws, courts and government agencies also have the authority to
require that a person who sent waste to a waste disposal facility to pay for the
clean-up of that facility if it becomes contaminated and threatens human health
or the environment. A person that arranges for the disposal of, or transports
for disposal or treatment of, a hazardous substance to a property owned by
another may be liable for the costs of removal or remediation of the hazardous
substances released into the environment at that property.




Furthermore,
various court decisions have established that third parties may recover damages
for injury caused by property contamination. Also, some of these environmental
laws restrict the use of a property or place conditions on various activities.




Prior to
acquisition of or foreclosure on a property, we obtain Phase I environmental
reports. These reports are prepared in accordance with an appropriate level of
due diligence based on our underwriting standards and generally include a
physical site inspection, a review of relevant federal, state and local
environmental and health agency database records, one or more interviews with
appropriate site-related personnel, review of the property’s chain of title and
review of historic aerial photographs and other information on past uses of the
property and nearby or adjoining properties. We may also require a Phase II
investigation which may require limited subsurface investigations and tests for
substances of concern where the results of the Phase I environmental reports or
other information indicates possible contamination or where our consultants
recommend such procedures.




We
believe that our portfolio is in compliance in all material respects with all
federal, state and local laws and regulations regarding hazardous or toxic
substances and other environmental matters.




20


**Employees**




As of
December 31, 2004, we had 23 employees. We have an experienced staff, many of
the members of which have been previously employed by the real estate
departments from major financial institutions, law firms and Standard &
Poor’s. We believe that our relations with our employees are good. None of our
employees are unionized.




**Available
Information**




We are
required to file annual, quarterly and special reports, proxy statements and
other information with the SEC. Investors may read and copy any document that we
file, including this Annual Report on Form 10-K, at the SEC’s Public Reference
Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Investors may obtain
information on the operation of the Public Reference Room by calling the SEC at
1-800-SEC-0330. In addition, the SEC maintains an Internet site at
http://www.sec.gov that contains reports, proxy and information statements, and
other information regarding issuers that file electronically with the SEC, from
which investors can electronically access our SEC filings.




We also
make available free of charge on or through our Web site (www.caplease.com), our
Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on
Form 8-K and amendments to those reports filed or furnished pursuant to Section
13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as
reasonably practicable after we electronically file such material with, or
furnish it to, the SEC. Investors can access our filings with the SEC by
visiting www.caplease.com /investor/sec.html.




The
information on our web site is not, and shall not be deemed to be, a part of
this report or incorporated into any other filings we make with the SEC.




**Cautionary
Statement Regarding Forward-Looking Statements**




We may
from time to time make written or oral forward-looking statements within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended,
including statements contained in our filings with the Securities and Exchange
Commission and in our press releases and webcasts. Forward-looking statements
relate to expectations, beliefs, projections, future plans and strategies,
anticipated events or trends and similar expressions concerning matters that are
not historical facts. In some cases, you can identify forward-looking statements
by terms such as “anticipate,” “believe,” “could,” “estimate,” “expect,”
“intend,” “may,” “plan,” “potential,” “should,” “strategy,” “will” and other
words of similar meaning. The forward-looking statements are based on our
beliefs, assumptions and expectations of future performance, taking into account
all information currently available to us. These beliefs, assumptions and
expectations can change as a result of many possible events or factors, not all
of which are known to us or are within our control. If a change occurs, our
business, financial condition, liquidity and results of operations may vary
materially from those expressed in our forward-looking statements. In connection
with the “safe harbor” provisions of the Private Securities Litigation Reform
Act of 1995, we are hereby identifying important factors that could cause actual
results and outcomes to differ materially from those contained in any
forward-looking statement made by or on our behalf. Such factors include, but
are not limited to:




·
    our
      ability to invest in additional net lease assets in a timely manner or on
      acceptable terms;




·
    adverse
      changes in the financial condition of the tenants underlying our net lease
      investments;




·
    changes
      in our industry, the industries of our tenants, interest rates or the
      general economy;




·
    the
      success of our hedging strategy;




·
    the
      availability, terms and deployment of capital, including our ability to
      raise additional capital to invest in net lease assets and to obtain
      long-term financing for our assets;




·
    the
      completion of pending net lease loans and/or other net lease
      investments;




·
    demand
      for our products;




·
    impairments
      in the value of the collateral underlying our
  investments;




·
    the
      degree and nature of our competition; and




21




·
    legislative
      or regulatory changes, including changes to laws governing the taxation of
      REITs.




These
risks and uncertainties should be considered in evaluating any forward-looking
statement we may make from time to time. Any forward-looking statement speaks
only as of its date. All subsequent written and oral forward-looking statements
attributable to us or any person acting on our behalf are qualified by the
cautionary statements in this section. We undertake no obligation to update or
publicly release any revisions to forward-looking statements to reflect events,
circumstances or changes in expectations after the date made.




**Item
2.** **Properties** **.**


We
presently lease office space at 110 Maiden Lane, New York, New York 10005. This
lease expires on May 31, 2006. We also lease a sales office in Laguna Hills,
California.




**Item
3.** **Legal
Proceedings** **.**


From time
to time, we are involved in legal proceedings in the ordinary course of
business. We do not believe any matter we are currently involved in will have a
material adverse effect on our business, results of operations or financial
condition.




**Item
4.** **Submission
of Matters to a Vote of Security Holders** **.**


No
matters were submitted to a vote of our stockholders during the fourth quarter
ended December 31, 2004.




22


**PART
II.**




**Item
5.** **Market
for Registrant’s Common Equity, Related Stockholder Matters** **and Issuer Purchases of Equity Securities.**




**Market
Information and Holders of Record**




Our
common stock began trading on the New York Stock Exchange (“NYSE”) on March 19,
2004 under the symbol “LSE.” On February 15, 2005, the reported closing sale
price per share of common stock on the NYSE was $12.25 and there were
approximately 1,400 holders of record of our common stock.




The table
below sets forth the quarterly high and low sales prices of our common stock on
the NYSE for the periods indicated.




**Fiscal
      Year 2004**
    
    
    **Low**
    
    **High**March
      19-March 31, 2004
    
    
    $
    12.50
    
    $
    13.50Second
      Quarter
    
    
    
    9.57
    
    
    13.04Third
      Quarter
    
    
    
    9.10
    
    
    11.70Fourth
      Quarter
    
    
    
    10.62
    
    
    12.92





**Dividend
Policy and Distributions**




In order
to qualify as a REIT, we must distribute to our stockholders an amount at least
equal to:




·
    90%
      of our REIT taxable income (determined before the deduction for dividends
      paid and excluding any net capital gain); plus




·
    90%
      of the excess of our net income from foreclosure property over the tax
      imposed on such income by the Code; less




·
    any
      excess non-cash income (as determined under the
Code).




To the
extent that we distribute at least 90%, but less than 100% of our REIT taxable
income, we are subject to corporate income tax on our undistributed taxable
income.




In
addition, we are subject to a 4% nondeductible excise tax on the amount, if any,
by which certain distributions paid by us with respect to any calendar year are
less than the sum of (i) 85% of our ordinary income for that year, (ii) 95% of
our capital gain net income for that year, and (iii) 100% of our undistributed
taxable income from prior years.




We intend
to continue to make quarterly distributions to holders of our common stock in
amounts sufficient to avoid corporate income tax and the 4% excise tax. Since
our initial public offering, we have declared three quarterly distributions to
holders of our common stock, as follows:




**Quarter
      Ended**
    
    **Dividend
      Payment Date**
    
    **Dividend
      per Share**September
      30, 2004
    
    
    October
      15, 2004
    
    
    $
    0.10December
      31, 2004
    
    
    January
      14, 2005
    
    
    
    0.15March
      31, 2005
    
    
    April
      15, 2005
    
    
    
    0.18





Distributions
are authorized by our board of directors and declared by us, out of assets
legally available, based upon a variety of factors deemed relevant by our
directors, including the following:




·
    actual
      results of operations;




·
    debt
      service requirements;




·
    our
      taxable income;




·
    the
      annual distribution requirement under the REIT provisions of the Code;




23




·
    our
      operating expenses; and




·
    other
      factors that our board of directors may deem relevant.




No
assurance can be given that our distribution policy will not change in the
future. Our ability to pay distributions to our stockholders depends, in part,
upon receipt of required payments on our loans, lease payments on our
properties, payments on securities we hold, advisory fees and other revenues.
Distributions to our stockholders are generally taxable to our stockholders as
ordinary dividend income to the extent we have current or accumulated earnings
and profits. To the extent not inconsistent with maintaining our REIT status, we
may maintain accumulated earnings of our taxable REIT subsidiaries in such
entities.




24




**Item
6.** **Selected
Financial Data** **.**




The
following selected historical financial information for the five years ended
December 31, 2004 is derived from our audited consolidated financial statements
and those of our predecessor, Caplease, LP (the successor-in-interest to Capital
Lease Funding, LLC) and its consolidated subsidiaries. The data should be read
in conjunction with the consolidated financial statements, related notes, and
other financial information included in this Form 10-K.




**Year
      ended December 31,****2004**
    
    **2003**
    
    **2002**
    
    **2001**
    
    **2000***(in
      thousands, except per share amounts)****Statement
      of operations data***Revenues:Interest
      income from mortgage loans and securities
    
    $
    13,589
    
    $
    7,317
    
    $
    8,092
    
    $
    9,313
    
    $
    15,480Gain-on-sales
      of mortgage loans and securities
    
    
    794
    
    
    11,652
    
    
    10,051
    
    
    21,565
    
    
    2,106Rental
      revenue
    
    
    4,287
    
    
    —
    
    
    —
    
    
    —
    
    
    264Property
      expense recoveries
    
    
    1,608
    
    
    —
    
    
    —
    
    
    —
    
    
    —Other
      revenue
    
    
    726
    
    
    151
    
    
    343
    
    
    321
    
    
    57Total
      revenues
    
    
    21,004
    
    
    19,120
    
    
    18,486
    
    
    31,199
    
    
    17,907Expenses:Interest
      expense
    
    
    2,768
    
    
    1,220
    
    
    2,142
    
    
    5,882
    
    
    13,247Interest
      expense to affiliates
    
    
    —
    
    
    838
    
    
    659
    
    
    1,273
    
    
    442Property
      expenses
    
    
    1,761
    
    
    —
    
    
    —
    
    
    —
    
    
    —Net
      loss on derivatives and short sales of securities
    
    
    724
    
    
    3,129
    
    
    7,729
    
    
    11,954
    
    
    11,985Loss
      on securities
    
    
    247
    
    
    —
    
    
    —
    
    
    —
    
    
    —Provision
      for loss on mortgage loans
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    2,000Impairment
      on investment in Bedford
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    1,669General
      and administrative expenses
    
    
    8,833
    
    
    7,186
    
    
    6,966
    
    
    7,794
    
    
    7,372General
      and administrative expenses - stock based compensation
    
    
    3,825
    
    
    —
    
    
    —
    
    
    —
    
    
    —Depreciation
      and amortization expense on realproperty
    
    
    1,281
    
    
    —
    
    
    —
    
    
    —
    
    
    —Loan
      processing expenses
    
    
    196
    
    
    114
    
    
    158
    
    
    232
    
    
    153Total
      expenses
    
    
    19,635
    
    
    12,487
    
    
    17,654
    
    
    27,135
    
    
    36,868Income
      (loss) before provision for income taxes
    
    
    1,369
    
    
    6,633
    
    
    832
    
    
    4,064
    
    
    (18,961
    )Provision
      for income taxes
    
    
    9
    
    
    —
    
    
    —
    
    
    —
    
    
    —Net
      income (loss)
    
    $
    1,360
    
    $
    6,633
    
    $
    832
    
    $
    4,064
    
    $
    (18,961
    )Earnings
      per share (pro forma for all years other than 2004):Net
      income (loss) per share, basic and diluted
    
    $
    0.06
    
    $
    1.61
    
    $
    0.20
    
    $
    0.99
    
    $
    (4.62
    )Weighted
      average number of shares outstanding, basic and diluted
    
    
    22,125
    
    
    4,108
    
    
    4,108
    
    
    4,108
    
    
    4,108Dividends
      declared per share
    
    $
    0.25
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    —***Other
      data***Cash
      flows from operating activities
    
    $
    10,716
    
    $
    (10,743
    )
    $
    3,774
    
    $
    234,057
    
    $
    (172,227
    )Cash
      flows from investing activities
    
    
    (349,656
    )
    
    (69
    )
    
    846
    
    
    (1,084
    )
    
    36Cash
      flows from financing activities
    
    
    363,139
    
    
    11,948
    
    
    (10,773
    )
    
    (224,265
    )
    
    169,771




25








**As
      of December 31,****2004**
    
    **2003**
    
    **2002**
    
    **2001**
    
    **2000***(in
      thousands)****Balance
      sheet******data***Cash
      and cash equivalents
    
    $
    30,721
    
    $
    6,522
    
    $
    5,386
    
    $
    11,539
    
    $
    2,831Securities
      available for sale
    
    
    87,756
    
    
    40,054
    
    
    20,348
    
    
    13,963
    
    
    20,342Structuring
      fees receivable
    
    
    4,426
    
    
    5,223
    
    
    4,794
    
    
    5,231
    
    
    111Mortgage
      loans held for sale
    
    
    —
    
    
    71,757
    
    
    77,716
    
    
    83,883
    
    
    311,919Mortgage
      loans held for investment
    
    
    207,347
    
    
    —
    
    
    —
    
    
    —
    
    
    —Real
      estate investments, net
    
    
    194,541
    
    
    —
    
    
    —
    
    
    —
    
    
    —Real
      estate investments consolidatedunder
      FIN 46
    
    
    48,000
    
    
    —
    
    
    —
    
    
    —
    
    
    —Total
      assets
    
    
    581,702
    
    
    125,773
    
    
    112,276
    
    
    129,473
    
    
    444,077Repurchase
      agreement obligations
    
    
    133,831
    
    
    88,087
    
    
    76,116
    
    
    86,658
    
    
    304,692Mortgages
      on real estate investments
    
    
    111,539
    
    
    —
    
    
    —
    
    
    —
    
    
    —Stockholders’
      equity/members’ capital
    
    
    253,264
    
    
    34,045
    
    
    27,775
    
    
    25,066
    
    
    5,428







26










**Item
7.** **Management’s
Discussion and Analysis of Financial Condition and Results of
Operations.**


*The
following discussion should be read in conjunction with the consolidated
financial statements and the notes to those financial statements, included
elsewhere in this filing. Where appropriate, the following discussion includes
analysis of our predecessor entity.*




**General**




We are a
net lease company focused on investing in commercial real estate assets that are
leased typically on a long-term basis primarily to high credit quality
corporate, government and not-for-profit tenants. These assets will include
mortgage loans and mortgage backed net lease securities (debt) and direct
investments in real estate (equity). We began our business in 1995 through
private equity capital. In March 2004, we completed an initial public offering
and our common stock began trading on the New York Stock Exchange under the
symbol “LSE.” We intend to elect to be taxed as a REIT for federal income tax
purposes.




Prior to
our initial public offering, we operated primarily as a first mortgage lender
using a gain on sale business model, where we sold the loans without retaining
any interest in them after origination, either through securitization or
whole-loan sales. Our mortgage loans have included traditional long-term credit
tenant first mortgage loans (typically 15 to 25 years), 10-year credit tenant
loans and a few development type loans and recapitalized loans. Prior to our
initial public offering, we historically retained a small number of loans and
securities on our balance sheet, though in general, loans had only been held in
our portfolio for a short period of time prior to sale. During this period, we
derived our revenues primarily from interest payments on the loans we originated
prior to sale and from the sale of those loans to third parties. Our borrowings
were on a short-term basis, and the interest expense on those borrowings was
tied to short-term floating interest rates, which are typically lower than
long-term fixed-rates.




Upon
completion of our initial public offering in March 2004, we changed our strategy
from that of a gain on sale originator of net lease loans, to a long-term holder
of debt, equity and mezzanine net lease assets for portfolio investment, though
we do still engage in some gain on sale activities. An important component of
our portfolio investment strategy is to borrow, or leverage, against our assets
in order to enable us to originate a larger portfolio of assets and to enhance
our returns on invested equity capital. This strategy entails financing our
mostly fixed rate net lease investments by using our existing warehouse
facilities on a reasonably short term basis and, as soon as practicable
thereafter, financing the majority of these assets on a secured long-term fixed
rate basis, both through collateralized debt obligations, or CDOs, and through
traditional first mortgage debt obtained from third party lenders, and other
mechanisms. We typically employ hedging strategies to mitigate interest rate
risk while our fixed rate assets are financed in our floating rate warehouse
facilities. We expect our leverage to average 70% to 85% of our assets in
portfolio. All of our financing transactions are now and we expect that they
will continue to be, held on balance sheet. We believe that the combination of
assets backed by long-term leases with high quality tenants coupled with
long-term fixed rate financing will produce stable risk-adjusted returns on our
equity base.




In
connection with our initial public offering, we raised net proceeds after all
related expenses of approximately $221.8 million on top of an existing book
equity of approximately $34.0 million. As of December 31, 2004, we had invested
those proceeds into approximately $494.1 million of net lease assets and have
begun to leverage our existing portfolio utilizing our existing floating rate
warehouse credit facilities and fixed rate first mortgage debt. Subsequent to
December 31, 2004, we closed our first fixed rate long-term CDO offering with a
principal amount of approximately $300.0 million. We issued five classes of
notes with an aggregate face amount of $285.0 million and preferred stock with a
principal amount of $15.0 million. We retained $31.5 million in face amount of
the notes offered, comprised of the entire face amount of the three most junior
note classes and the preferred shares. We received net proceeds in the
transaction of approximately $263.1 million, approximately $206.0 million of
which was used to repay our borrowings under our short-term credit facility with
Wachovia Bank, N.A.




Since our
initial public offering we have been undergoing a period of rapid growth as we
continue to add assets to the balance sheet. This rapid growth in assets is
fueling rapid growth in total recurring revenues, net profit and funds from
operations. We believe that we are well positioned in the net lease market and
expect that our growth will continue in 2005 as we continue to leverage our
existing equity capital into a growing portfolio of net lease investments. We
are continuing to see a solid flow of potential net lease transactions and
continue to believe that the debt and equity markets will remain favorable to us
during the year ahead and allow us to access this pipeline of deals in an
economic fashion. While we believe that conditions will remain favorable for the
coming year, there are many factors, most of which are beyond our immediate
control, that could impact our ability to sustain our rapid growth.




27


Please
see “Market and Other Challenges” below for a discussion of various factors that
could impact our ability to continue to implement our strategy.




While we
had success across almost all of our product lines, we were particularly
successful in our property acquisition efforts going from no properties on the
balance sheet as of the date of our initial public offering, to eight properties
totaling approximately 1.1 million square feet for an aggregate book value of
approximately $194.5 million on December 31, 2004.




**Summary
of Key Transactions in 2004**




During
the year ended December 31, 2004, we completed the following transactions in
excess of $40.0 million:




·
    Acquired
      an office building net leased to Aon Corporation in Glenview, Illinois
      totaling 416.2 thousand square feet for an aggregate purchase price of
      $85.8 million. Subsequent to the acquisition, we financed the property
      with a $64.8 million mortgage from Wachovia Bank and an approximately
      $10.0 million corporate credit note from our subsidiary, Caplease, LP,
      which note has been included in our CDO.




·
    Provided
      long term first mortgage financing on two stores located in Chicago,
      Illinois: (i) $13.0 million secured by a Best Buy store totaling 45.7
      thousand square feet and (ii) $48.3 million secured by a Kohl’s department
      store totaling 133 thousand square feet. The loans are cross defaulted and
      cross collateralized with one another.




·
    Acquired
      three adjacent office buildings net leased primarily to Choice Hotels
      International in Silver Springs, Maryland totaling 223.9 thousand square
      feet for an aggregate purchase price of $43.5 million. Subsequent to the
      acquisition, we financed the property with a $32.6 million mortgage from
      Wachovia Bank.




**Market
and Other Challenges**




The
following are factors that could impact our ability to continue to implement our
strategy. These factors could have a material adverse effect on our revenues,
net income or cash flows.




·
    We
      rely on our ability to price asset investments at a spread over our
      financing cost. These spreads are based on market conditions. Various
      factors that are beyond our control could cause the spreads to converge,
      making it harder for us to make profitable investments. These factors
      include increases in long-term interest rates, weakening economic
      conditions, United States military activities and terrorist activities,
      ineffectiveness of our hedging strategies, increases in spreads over
      United States Treasuries for our debt, and market dislocations caused by
      the failure or financial difficulties of a large financial institution or
      institutions.




·
    In
      order to grow our asset portfolio, we must raise additional capital. Our
      capital raising ability will be influenced by market conditions, including
      investors’ continued appetite for REIT investments and the continued
      health of the capital markets.




·
    Our
      revenues and cash flows come largely from rental payments from the tenants
      underlying our net lease asset investments. Moreover, the long-term
      financing cost for our assets is based on the financial health of these
      tenants at the time the financing is put in place. Adverse developments in
      the financial condition of our tenants could have an adverse impact on our
      revenues, financing costs (and thus net income) and cash
      flows.




In the
last quarter of 2004 and early 2005, we have begun to see weakness in our loan
origination business. We are generally seeing fewer transactions and tighter
pricing of transactions by our competitors, particularly by conduit lenders such
as banks and insurance companies. We will continue to maintain our disciplined
investment approach within this business, and believe that the recent increase
in interest rates may improve loan volumes.




**Winn-Dixie
Bankruptcy**




On
February 21, 2005, Winn-Dixie Stores Inc. filed for bankruptcy protection under
Chapter 11 of the federal bankruptcy laws. While our balance sheet does not
include any property leased to Winn-Dixie or any loan on a Winn-Dixie property,
we do own securities from our past securitization transactions with exposure to
loans on Winn-Dixie properties and, therefore, the Winn-Dixie
bankruptcy.




28


These
securities are exposed to an aggregate of five Winn-Dixie stores through loans
made on those properties and 14 Winn-Dixie warehouses/distribution and/or
manufacturing facilities and the Winn-Dixie headquarters building through a
pass-through certificate representing an interest in another securitization
transaction. Winn-Dixie rejected the lease on one of the five stores and
announced its intention to close two of the warehouses. We have also been
advised that the borrower on the loan secured by the rejected store lease does
not plan to make the payments due under the loan. As a result, during fiscal
year ended December 31, 2004, we reduced our carry value on the bottom class
security in this securitization transaction by $0.25 million to reflect our
estimate of our loss. While we have also been advised the borrowers under the
loans secured by the two warehouses do not plan to make payments due under the
related loans, we have not recognized any losses on these or our other security
holdings because we are unable to estimate the impact of the foregoing events on
our carry value and yields at this time. Our ultimate losses as a result of the
Winn-Dixie bankruptcy will depend upon various factors beyond our control,
including the liquidation value of the underlying properties and the unpaid
principal amount on the related loans, the costs to foreclose and sell the
properties, and the availability of other collateral or reserves to absorb the
losses on the properties. To the extent there are losses on any W inn-Dixie
properties, those losses will be applied to the face amount of the bonds we hold
and will impact our yield to maturity on that investment which will be reflected
in a reduction in carry value. We cannot assure you that Winn-Dixie will not
reject the leases on the other properties we have exposure to.




The
following table summarizes our exposure to the Winn-Dixie
bankruptcy:




**As
      of December 31, 2004**
      **(in
      thousands)****Securitization**
    **Classes
      Owned**
    **Nature
      of Exposure**
    **2004
      Asset**
      **Write-downs**
    **Aggregate
      Face Amount**
    **Aggregate
      Carry Value**BSCMS
      1999-CLF1
    E
      and F
    Loans
      on two properties with an aggregate current unpaid principal balance of
      approximately $7.9 million. Winn-Dixie has rejected one of the underlying
      leases, and the loan on that property has a current unpaid principal
      balance of $3.8 million. The securitization trust includes an expense
      reserve account of approximately $0.40 million as of February 2005, that
      can be utilized by bond holders for realized losses. The expense reserve
      account is funded monthly at a rate of approximately $6,000. At the
      expected maturity of the securitization trust, we expect the reserve
      account to be further funded by a total of approximately $1.1 million
      (assuming a zero percent reinvestment rate).
    $0.25
      million write-down of Class F security.
    $5,820
    $3,531CMLBC
      2001-CMLB-1
    E,
      G, H, J and K
    $22.4
      million pass-through trust certificate with exposure to 14 Winn-Dixie
      warehouse/distribution and/or manufacturing facilities and the Winn-Dixie
      headquarters building. Winn-Dixie has announced its intention to close two
      of the warehouses.The
      remaining certificate balances of all classes in the trust aggregate
      approximately $370.1 million. All classes in the pass-through trust share
      losses on a pro rata basis. We estimate that for every dollar of loss
      incurred by the pass through trust, we would incur a loss of approximately
      $0.014 on the carry value of our securities.
      
      Loan
      on one property with a current aggregate unpaid principal balance of
      approximately $3.3 million.
    None;
      however, we determined not to write up our investment despite our receipt
      of a higher market quote at year-end.
    $42,869
    $34,677CALFS
      1997-CTL-1
    D
    Loans
      on two properties with a current aggregate unpaid principal balance of
      approximately $6.4 million.
    None.
    $3,000
    $2,951





29


**Application
of Critical Accounting Policies**




Our
discussion and analysis of financial condition and results of operations is
based upon our consolidated financial statements, which have been prepared in
accordance with United States generally accepted accounting principles, or GAAP.
The preparation of financial statements in conformity with GAAP requires the use
of judgments, estimates and assumptions that could affect the reported amounts
of assets and liabilities, the disclosure of contingent assets and liabilities
and the reported amounts of revenues and expenses. Actual results could differ
from these estimates. The following is a summary of our accounting policies that
are most affected by judgments, estimates and assumptions.




*Mortgage
Loans and Other Assets Held for Investment.*




Prior to
our initial public offering, our investments in mortgage loans were treated as
investments held for sale and carried on our balance sheet at the lower of cost
or market. Subsequent to our public equity offering and in the future, our
investments in mortgage loans will be treated and accounted for as long term
investments, to the extent that we have the ability and intent to hold the loans
for the foreseeable future or until maturity. Otherwise, the loans will continue
to be accounted for as held for sale in accordance with SFAS No. 65,
“ *Accounting
for Certain Mortgage Banking Activities* .”
Differences between the carrying amount of the loan and its outstanding
principal balance are recognized as an adjustment to our yield by the effective
interest method. We are required to periodically evaluate each of our assets
held for investment for possible impairment. Impairment is indicated when it is
deemed probable that we will be unable to collect all amounts due according to
the contractual terms of the asset. Upon determination of impairment, we must
establish a specific valuation allowance with a corresponding charge to
earnings. Significant judgment is required both in determining impairment and in
estimating the resulting loss allowance. In determining impairment and any loan
loss allowance, we evaluate our assets, historical and industry loss experience,
economic conditions and trends, collateral values and quality, and other
relevant factors. At December 31, 2004, we had no loss allowances on any of the
loans in our portfolio.




*Purchase
Accounting for Acquisition of Real Estate.*




We
allocate the fair value of real estate acquired to the acquired tangible assets,
consisting of land, building and improvements, and identified intangible assets
and liabilities, consisting of the value of above-market and below-market
leases, other value of in-place leases and value of tenant relationships, based
in each case on their fair values.




We
determine the fair value of the tangible assets of an acquired property (which
includes land, building and improvements) by valuing the property as if it were
vacant, and the "as-if-vacant" value is then allocated to land, building and
improvements based upon our determination of relative fair values of these
assets. Factors considered by management in performing these analyses include an
estimate of carrying costs during the expected time it would take management to
find a tenant to lease the space for the existing lease term (a “lease-up”
period), considering current market conditions and costs to execute similar
leases. In estimating carrying costs, we include real estate taxes, insurance
and other operating expenses and estimates of lost rental revenue during the
expected lease-up periods based on current market demand. We also estimate costs
to execute similar leases including leasing commissions.




In
allocating the fair value of the identified intangible assets and liabilities of
an acquired property, we record above-market and below-market in-place lease
values based on the difference between the current in-place lease rent and an
estimate of current market rents.




The
aggregate value of other acquired intangible assets, consisting of in-place
leases and tenant relationships, is measured by the excess of (i) the purchase
price paid for a property over (ii) the estimated fair value of the property as
if vacant, determined as set forth above. This aggregate value is allocated
between in-place lease values and tenant relationships based on management's
evaluation of the specific characteristics of each tenant's lease. The value of
in-place leases and customer relationships are amortized to expense over the
remaining non-cancelable periods of the respective leases.




Depreciation
is determined by the straight-line method over the remaining estimated economic
useful lives of the properties. We generally depreciate buildings and building
improvements over periods not exceeding 40 years. Direct costs incurred in
acquiring properties are capitalized. Expenditures for maintenance and repairs
are charged to operations as incurred. Significant renovations which extend the
useful life of the properties are capitalized.




*Securities
Available for Sale*




We treat
our real estate securities as available for sale and account for them in
accordance with SFAS No. 115, “ *Accounting
for Certain Investments in Debt and Equity Securities* .” As
such, they are carried at fair value with net unrealized gains or losses
reported on our balance sheet as a component of other comprehensive income or
loss. Fair value is based primarily upon our estimates of value, based upon
broker quotations where available, yields on assets of similar credit quality
and duration, or good faith estimates of those yields. The indicated quotations
may be subject to significant variability based on market conditions, including
interest rates and spreads. While a liquid market for these securities typically
exists, the securities may not be frequently traded and, therefore, we may not
be able to sell them at our estimates of value. Changes in market conditions, as
well as changes in the assumptions or methodology used to determine fair value,
could result in a significant increase or decrease in the equity on our balance
sheet. We must also assess whether unrealized losses on securities, if any,
reflect a decline in value, which is other than temporary. If so, we must write
the impaired security down to its value through a charge to our statement of
operations. Significant judgment is required in this analysis. In determining
whether a decline in value is other than temporary, we consider whether the
decline is due to factors such as changes in interest rates (typically
temporary) or credit downgrades or credit defaults (typically other than
temporary). As of December 31, 2004, we recorded a $0.25 million write-down on
one of our real estate securities, reflecting our estimate of our loss on that
security as a result of the recent Winn-Dixie bankruptcy. See “Winn-Dixie
Bankruptcy” above.




30


Income on
these securities is recognized using a level yield methodology based upon a
number of assumptions that are subject to uncertainties and contingencies. These
assumptions include the expected disposal date of such security and the rate and
timing of principal and interest receipts (which may be subject to prepayments,
delinquencies and defaults). These uncertainties and contingencies are difficult
to predict and are subject to future events, and economic and market conditions,
which may alter the assumptions.




*Derivative
Instruments and Other Risk Management Transactions.*




Our
derivative instruments and other risk management transactions, which we hold for
hedging or other risk management purposes, are carried at fair value pursuant to
SFAS No. 133, “ *Accounting
for Derivative Instruments and Hedging Activities* ,” as
amended. Fair value is based on market quotations. Fair values of these
derivatives are subject to significant variability based on many of the same
factors as the securities discussed above. The results of such variability could
be a significant increase or decrease in our earnings. Further, if we fail to
qualify for hedge accounting treatment, our results of operations may suffer
because losses on the derivatives we enter into may not be offset by a change in
the fair value of the related hedged transaction.




Prior to
our conversion to a REIT on March 24, 2004, we used derivatives and other risk
management transactions to hedge the interest rate risk of our fixed rate
mortgage loans. Since March 24, 2004, we have used and in the future we expect
to continue to use derivative transactions designated primarily as cash flow
hedges to hedge our risk of changes in the interest-related cash flows on our
forecasted future borrowings.




*Revenue
Recognition.*




As part
of our 10-year credit tenant loan program, we originate a loan and bifurcate the
loan into two notes, a real estate note and a corporate credit note. We
generally sell the real estate note to a third party and retain the corporate
credit note in our portfolio. During 2004, we sold three real estate notes for
aggregate proceeds of $25.4 million, and recognized gains of $794,000. We
compute our gain by comparing our sales proceeds on the note to its cost basis.
We compute our cost basis on the note by allocating our entire basis in the loan
among the two notes based on the present value of expected cash flows on each
note. In computing present values, we estimate a discount rate based on a
benchmark rate plus a market spread based on the underlying credit. Our
estimates reflect market rates and we believe they are reasonable. However, the
use of different estimates could have an impact on our gain on sale
revenue.




**Results
of Operations**




During
the fourth quarter of 2004, we continued to execute on our business plan as a
long-term holder of debt, equity and mezzanine investments in net lease assets.
Our focus during the quarter was on: (i) closing the long-term mortgage loans in
our pipeline, (ii) completing the net lease property acquisitions in our
pipeline, (iii) preparing our first collateralized debt obligation, (iv)
continuing to leverage our net lease portfolio, and (v) continuing to implement
our marketing plan to communicate to the market about our expanded
capabilities.





31





**Comparison
of Year Ended December 31, 2004 to the Year Ended December 31,
2003**




The
following discussion compares our operating results for the year ended December
31, 2004 to the comparable period in 2003.




*Revenue.*




Total
revenue increased $1.9 million, or 10%, to $21.0 million. The increase was
primarily attributable to increases in interest income from mortgage loans and
securities and increases in rental income, offset by a decrease in gain on sale
of mortgage loans.




Interest
income increased $6.3 million, or 86%, to $13.6 million. The increase was due to
larger overall asset investments, including both mortgage loans and CMBS
investments.




Gain on
sale of mortgage loans and securities decreased from $11.7 million to $0.8
million. The decrease was due to curtailment on our loan sale activity during
2004, as we transitioned from a gain on sale to held for investment strategy
upon completion of our initial public offering.




Rental
income and property expense recoveries, in the aggregate, increased $5.9 million
to $5.9 million, as we did not own any investments in real estate during
2003.




Other
revenue increased $0.6 million to $0.7 million, primarily as a result of
receiving $0.4 million (after related expenses) as a deal cancellation fee on a
potential property acquisition.




*Expenses.*




Total
expenses increased $7.1 million, or 57%, to $19.6 million. The increase in
expenses was primarily attributable to higher levels of general and
administrative expenses as a result of our status as a public company, property
related expenses, offset by a reduction in loss on derivatives and short sales
of securities.




Interest
expense, including interest expense to affiliates, increased $0.7 million, or
35%, from $2.1 million to $2.8 million. This primarily consisted of $0.9 million
of interest expense related to property mortgages originated or assumed in 2004.
In addition, interest expense on our borrowings under our secured warehouse
lines of credit (repurchase agreement obligations), decreased $0.2 million, or
9%, from $2.1 million to $1.9 million. This was the result of lower average
borrowing levels in 2004. After the completion of our initial public offering in
March 2004, we repaid all of the amounts outstanding under our credit
facilities. We began borrowing under these facilities again during August
2004.




Loss on
derivatives and short sales of securities decreased $2.4 million, or 77%, from
$3.1 million to $0.7 million. This was primarily the result of the change in the
way we hedge interest rates upon the completion of our initial public offering.
Prior to our initial public offering, we employed fair value hedges of our
assets, along with derivatives and short sales of securities that did not
qualify for hedge accounting treatment. After our initial public offering date,
we terminated all of the outstanding fair value hedges, derivative and short
sale positions, and converted to cash flow hedges against our expected future
financings.




Loss on
securities was $0.2 million for a write-down on one of our real estate
securities, reflecting our estimate of loss on that security as a result of the
recent Winn-Dixie bankruptcy.




General
and administrative expense increased $1.6 million, or 22%, from $7.2 million to
$8.8 million, due primarily to increased expenses associated with our change to
operating as a public company, including liability insurance.




General
and administrative expense-stock based compensation of $3.8 million was
recognized during the 2004 period. This includes, $2.4 million related to the
vesting of stock issued under our stock plan to our employees simultaneous with
our initial public offering and $1.4 million recognized during the quarter ended
March 31, 2004 related to stock sold to certain current and former employees
during November 2003 at a discount to the initial public offering price.
Deferred compensation expense related to unvested shares granted is included on
our Consolidated Balance Sheets under “Deferred compensation expense” and will
be charged to our Statement of Operations ratably over the remaining vesting
period which ends during March 2006.




32


Depreciation
and amortization expense on real property increased $1.3 million to $1.3
million, as we did not own any investments in real estate during
2003.




*Net
income.*




Net
income decreased from $6.6 million to $1.4 million, as a result of the factors
discussed above.




**Comparison
of Year Ended December 31, 2003 to Year Ended December 31,
2002**




The
following discussion compares our operating results for the year ended December
31, 2003 to the comparable period in 2002.




*Revenue.*




Total
revenue increased $0.6 million, or 3%, to $19.1 million. The net increase was
attributable to an increase in gain-on-sale of mortgage loans, partially offset
by a decrease in interest income and a decrease in other revenue.




Interest
income decreased $0.8 million, or 10%, to $7.3 million. The decrease was
primarily attributable to a decrease in the average size of our portfolio and a
lower interest rate environment.




Gain-on-sale
of mortgage loans and securities increased $1.6 million, or 16%, to $11.7
million. The increase was due to higher margins on our loan sale activity during
the period. We sold $167.0 million of loans in the 2003 period as compared to
$160.0 million of loans for the comparable period in 2002.




Other
revenue decreased $0.2 million, or 56%, to $0.2 million. This decrease was
primarily due to a decline in advisory revenue between the comparative periods.




*Expenses.*




Total
expenses decreased $5.2 million, or 29%, to $12.5 million. The net decrease in
expenses was primarily attributable to a decrease in interest expense and a
decrease in expense associated with risk management and hedging transactions.




Interest
expense on our borrowings under our secured warehouse lines of credit
(repurchase agreement obligations), including interest paid to members,
decreased $0.7 million, or 27%, to $2.1 million. This decrease was primarily
attributable to a decrease in the underlying LIBOR rate and a decrease in our
average loan portfolio during 2003. Average one-month LIBOR rates during the
year ended December 31, 2003 were 1.22% as compared to 1.77% for the 2002
comparative period.




Loss on
derivatives and short sales of securities decreased $4.6 million, or 60%, to
$3.1 million. This expense includes the “carry” expense incurred on open hedge
and other risk management positions, as well as gains or losses from hedging and
other risk management transactions related to sold loans. Carry expense is a
function of the difference between short-term and long-term interest rates, and
changes in the shape of the yield curve affect this item. Gains and losses on
derivatives and short sales of securities are generally a function of the change
in long-term interest rates, with losses generally resulting from declines in
long-term rates, and gains resulting from increases in long-term rates. The
decline in the overall expense was due to a lower average level of assets in our
portfolio during the period, less downward volatility in interest rates during
the period, and the accounting impact of gains and losses on derivatives not
designated as hedge transactions. For the year ended December 31, 2003, yields
on long term treasury rates (10 year notes) increased from 3.82% on December 31,
2002 to 4.25% on December 31, 2003. For the year ended December 31, 2002, yields
on 10-year treasury notes declined significantly from 5.05% to 3.82%. This
difference in rate change for the comparative periods contributed significantly
to the decline in the loss on derivatives and short sales of securities. Our
predecessor recognized hedge ineffectiveness expense of $14,000 and $277,000 for
the years ended December 31, 2003 and 2002, respectively.




General
and administrative expense increased $0.2 million, or 3%, to $7.2 million. The
increase was primarily due to an increase in compensation expense of $0.2
million.




*Net
income.*




Net
income increased $5.8 million, or 697%, to $6.6 million, as a result of the
factors discussed above.




33


**Business
Segments**




Beginning
with this Annual Report on Form 10-K, we have begun reporting our results
through two operating segments:




·
    lending
      investments; and




·
    operating
      net lease real estate.




Segment
data for 2004 are as follows:




**Lending
      Investments**
    
    **Operating
      NetLease Real Estate**
    
    **Corporate/Unallocated**
    
    **Total**(*in
      thousands*)Total
      revenue
    
    $
    14,045
    
    $
    6,356
    
    $
    603
    
    $
    21,004Total
      expenses
    
    
    3,569
    
    
    4,206
    
    
    11,869
    
    
    19,644Net
      income (loss)
    
    
    10,476
    
    
    2,150
    
    
    (11,266
    )
    
    1,360Total
      assets
    
    
    302,923
    
    
    247,325
    
    
    31,454
    
    
    581,702





A
comparison of segment performance is not included herein as we had no real
property acquisition business prior to our initial public offering in March
2004, and our net lease mortgage debt business was under a gain on sale (rather
than portfolio) business model prior to our initial public
offering.




**Funds
from Operations**




Funds
from operations, or FFO, is a non-GAAP financial measure. We believe FFO is a
useful additional measure of our performance because it facilitates an
understanding of our operating performance after adjustment for certain non-cash
expenses, such as real estate depreciation, which assumes that the value of real
estate assets diminishes predictably over time. In addition, we believe that FFO
provides useful information to the investment community about our financial
performance as compared to other REITs, since FFO is generally recognized as an
industry standard for measuring the operating performance of a REIT. FFO does
not represent cash generated from operating activities in accordance with GAAP
and is not indicative of cash available to fund cash needs. FFO should not be
considered as an alternative to net income or earnings per share determined in
accordance with GAAP as an indicator of our operating performance or as an
alternative to cash flow as a measure of liquidity. Since all companies and
analysts do not calculate FFO in a similar fashion, our calculation of FFO may
not be comparable to similarly titled measures reported by other
companies.




We
calculate FFO in accordance with standards established by the National
Association of Real Estate Investment Trusts (“NAREIT”) which defines FFO as net
income (computed in accordance with GAAP) excluding gains (or losses) from sales
of property, plus depreciation and amortization, and after adjustments for
unconsolidated partnerships and joint ventures.




The
following table reconciles our net income to FFO for the year ended December 31,
2004. FFO is not a relevant measure for us for years prior to 2004 because we
were not a REIT during those periods.




**2004****Total**
    
    **Per
      Share(1)***(in
      thousands, except per share amounts)*Net
      income
    
    $
    1,360
    
    $
    0.06Adjustments:Add:
      Depreciation and amortization expense on real property
    
    
    1,281
    
    
    0.06Funds
      from operations
    
    $
    2,641
    
    $
    0.12
  (1)The
      weighted average number of shares outstanding for 2004 was 22,125 (basic
      and diluted).





We had
gains on sales of mortgage loans (included in net income and FFO) of $794,000 in
2004.




34


**Liquidity
and Capital Resources**




As of
December 31, 2004, we had $30.7 million in available cash and cash equivalents.
As a REIT, we will be required to distribute at least 90% of our taxable income
to our stockholders on an annual basis, and we intend to distribute all or
substantially all of our REIT taxable income in order to comply with the
distribution requirements of the Code and to avoid federal income tax and the
nondeductible excise tax. We declared total dividends of $0.25 per share during
the year ended December 31, 2004, including $0.10 in the third quarter and $0.15
in the fourth quarter.




We
believe that our working capital and cash provided by operations are sufficient
to fund our operations and pay our distributions necessary to enable us to
continue to qualify as a REIT. However, our strategy contemplates additional net
lease investments, and we believe we will reach our targeted leverage level in
the next three to six months, at which point we will need to raise additional
debt or equity capital, or both, in order to continue to implement our strategy.
We intend to file a shelf registration statement to register additional debt and
equity capital in the early part of the second quarter of 2005. We may issue
public or private debt or equity capital, or both, to satisfy our liquidity
needs. We expect to raise capital in the second or third quarter of 2005,
although the precise timing will be impacted by our investment activities for
the remainder of 2005 and market conditions. Our ability to raise capital is
influenced by market conditions, and we cannot assure you conditions for raising
capital will be favorable for us at any time. See “Market and Other Challenges”
above.




*Short-Term
Liquidity and Financing.*




We expect
to meet our short-term liquidity requirements generally through our available
cash and cash equivalents, cash provided by operations, as well as existing
secured credit facilities.




During
September 2004, we entered into a master repurchase agreement with Wachovia
Bank, N.A. to finance our asset investments on a short-term basis prior to
obtaining long-term financing. The master repurchase agreement replaces our
existing credit facilities with Wachovia Bank. Under the agreement, Caplease, LP
and certain of our other subsidiaries will sell assets to Wachovia Bank and
agree to repurchase those assets on a date certain at a repurchase price
generally equal to the original purchase price plus accrued but unpaid interest.
Each asset financed under the facility will be purchased by Wachovia Bank at a
percentage of the asset’s value on the date of origination (the purchase rate)
and we will pay interest to Wachovia Bank at prevailing short-term interest
rates plus a pricing spread. We have agreed to a schedule of purchase rates and
pricing spreads with Wachovia Bank generally based upon the class and credit
rating of the asset financed. The facility is recourse to us and Capital Lease
Funding, Inc. has agreed to guarantee all obligations of its subsidiaries under
the agreement. For financial reporting purposes, we characterize all of our
borrowings under the facility as on balance sheet financing transactions,
meaning the assets financed will remain on our balance sheet.




The
repurchase agreement is a $250.0 million uncommitted facility, meaning Wachovia
Bank must agree to each asset financed under the agreement. The facility may be
increased to $450.0 million if we request and Wachovia Bank agrees.




The
agreement expires on September 21, 2005, but may be extended for not more than
two successive 364-day periods if we request and Wachovia agrees.




We can
finance each of our existing primary products under the agreement, including
commercial real estate whole loans, commercial mortgage backed securities
(“CMBS”) and acquisitions of commercial real estate. Commercial real estate
acquisitions will be financed through mortgage loans made by Caplease to a
subsidiary of Caplease formed for the purpose of owning the real property
acquired followed by the sale of such mortgage loans to Wachovia under the terms
of the facility. Unless otherwise agreed to by Wachovia, for any asset financed
under the facility for more than 240 days Wachovia may (a) require us to remove
the asset from the facility or (b) require all income generated by the asset be
applied to reducing the outstanding balance under the facility.




The
agreement includes sublimits on certain asset classes and credit or tenant
concentrations.




If at any
time (i) the repurchase price of any financed asset exceeds its asset value (as
defined in the agreement), (ii) either Standard & Poor’s or Moody’s
downgrades any asset financed under the facility or (iii) the aggregate
repurchase price of all financed assets exceeds the maximum facility size,
Wachovia Bank may require us to repurchase assets or contribute additional cash
or other eligible assets to satisfy the difference. If required, these payments
could be material and could have a material adverse effect on our operations, or
on our ability to make further net lease investments.




35


We are
required to maintain the following financial covenants during the term of the
agreement:




·
    liquidity
      (as defined in the agreement) of at least $8.0 million;
  and




·
    consolidated
      tangible net worth (as defined in the agreement) of at least $100.0
      million (plus 75% of the aggregate net proceeds from future equity
      offerings or capital contributions).




If we are
unable to finance assets under this facility, our ability to continue to execute
our business plan could be materially adversely affected.




Wachovia
Investors, Inc., an affiliate of Wachovia Bank, owns approximately 3.7% of our
outstanding common stock. From time to time, we may sell net lease assets to, or
finance net lease assets on a long-term basis with, Wachovia Bank or its
affiliates on what we believe are fair market terms. Affiliates of Wachovia Bank
have performed investment banking services for us, including in connection with
our initial public offering and initial CDO transaction, and we expect they will
continue to do so in the future. In addition, Wachovia Bank acts as servicer of
our net lease loan assets and the transfer agent of our common
stock.




We had
$133.8 million outstanding as of December 31, 2004 under our Wachovia credit
facility, which borrowings were secured by commercial mortgage loans with an
aggregate principal balance of $136.5 million, and CMBS with a face amount of
$41.1 million. As of December 31, 2004, we had $116.2 million available under
our credit facilities, excluding our Bank of America facility which expired
unused on March 1, 2005.




As of
December 31, 2004, we were in compliance with the terms of the agreements with
our secured lenders. We do not currently anticipate any difficulty in
maintaining compliance with these terms in future periods. We believe our
relationship with Wachovia Bank is excellent. However, because our secured
credit facility with Wachovia Bank is uncommitted and is generally terminable at
will by the lender, we cannot make any assurance that this facility will
continue to be available to us.




*Long-Term
Liquidity and Financing.*




We expect
to meet our long-term liquidity requirements generally through cash provided by
operations, long-term financings on our net lease asset investments and
issuances of debt and equity securities.




We
finance our investments through short-term financing arrangements and, as soon
as practicable thereafter, we obtain long-term financing for these investments,
generally on a secured basis. Long-term financing can be in the form of
traditional mortgage debt, CDOs or other debt mechanisms. As of December 31,
2004, we have financed an aggregate of $153.7 million of assets in portfolio on
a long-term basis through the issuance or assumption of long-term debt of $110.7
million. All of our long-term debt obligations as of that date represent
traditional mortgage debt. We completed our first CDO financing in March 2005.
For a discussion of this transaction, see “Business—Recent
Developments—Long-Term Financings.” We expect our leverage to average 70% to 85%
of our assets in portfolio.




In a
traditional mortgage debt financing, we enter into one or more promissory notes
at a fixed rate of interest. The notes typically mature over a long-term period
of approximately ten years and debt service is payable monthly. The notes are
generally non-recourse to us but are secured by a mortgage on the property and
an assignment of the underlying lease and rents on the property. The notes
generally include non-recourse exceptions for certain losses, damages or
expenses to the lender, including those incurred as a result of the
following:




·
    waste
      to the mortgaged property or damage to the mortgaged property as a result
      of our intentional misconduct or gross
negligence;




·
    the
      existence of hazardous substances or radon on the mortgaged property or
      the failure to comply with environmental laws or regulations with respect
      to the mortgaged property; and




·
    a
      fraud or material misrepresentation committed by us or any person
      authorized to act on our behalf or the failure of us or anyone authorized
      to make statements on our behalf to disclose a material
    fact.




The notes
may become fully recourse if we fail to comply with certain covenants
prohibiting us from transferring or further encumbering the mortgaged property
or requiring us to take (or refrain from taking) various actions in order to
preserve the status of our borrower as a single-purpose entity, or the mortgaged
property becomes an asset in a bankruptcy proceeding of the
borrower.




36


The notes
may be fully amortizing or require a balloon payment at maturity. To the extent
the loan requires a balloon payment at maturity, we would expect to refinance
that payment at maturity. The notes are typically subject to customary events of
default, including the failure to pay principal and/or interest or the
determination that any representation or warranty made in the loan documents is
false or misleading in any material respect. Upon an event of default, the notes
will generally become immediately due and payable, at the option of the
payee.




In a
typical CDO financing, we will borrow money through a trust or other entity (the
CDO) and post or sell assets as collateral, giving the CDO investors a first
priority claim on the collateral posted and the right to foreclose on the
collateral upon an event of default. In turn, the CDO will issue securities to
investors to fund our borrowing. Our borrowing will bear a fixed rate of
interest. We will continue to own the assets financed through a CDO and will be
entitled to receive cash flows from the assets to the extent they exceed debt
service on the CDO. Once the CDO has been established, changes in interest
rates, credit spreads or the credit quality of collateral will generally have no
impact on cash flows on the CDO collateral or our financing cost under the CDO.
We expect that the term of the CDOs we will use will be approximately 10
years.




**Statement
of Cash Flows**




The net
cash flow provided by (used in) operating activities increased from $(10.7)
million in the year ended December 31, 2003, to $10.7 million for the year ended
December 31, 2004, and decreased from $3.8 million for the year ended December
31, 2002, to $(10.7) million for the year ended December 31, 2003. Our net cash
provided by operating activities in 2004 reflects adjustments for non-cash items
of expenses for amortization of stock-based compensation ($3.8 million) and
depreciation and amortization ($1.4 million, including $1.3 million on real
property). The change from 2003 to 2004 was primarily a result of our transition
to a portfolio business model in the first quarter of 2004. Prior to our initial
public offering, our loan and security investment activity was classified as
operating activities. Under our current strategy, these investments are treated
as investing activities. The change from 2002 to 2003 resulted primarily from
greater investments in securities and slightly lower net loan investments
(proceeds from loan sales less principal advanced on loans) in
2003.




Investing
activities used $349.7 million during the year ended December 31, 2004, which
primarily resulted from net investments in real estate of $174.6 million, net
investments in mortgage loans of $132.7 million and net investments in CMBS and
corporate bonds of $39.6 million. Investing activities used $0.1 million during
the year ended December 31, 2003, and provided $0.8 million during the year
ended December 31, 2002.




Cash
provided by financing activities during the year ended December 31, 2004 was
$363.1 million, reflecting net proceeds from our initial public offering of
$222.8 million (before prepaid offering expenses of approximately $1.0 million)
and net borrowings under long-term mortgage financings ($97.3 million) and
repurchase agreements ($45.7 million), partially offset by dividends paid of
$2.7 million. We used $88.1 million of our net proceeds from the initial public
offering to repay our debt obligations under our repurchase agreements. As of
December 31, 2004, we have fully invested the proceeds from our initial public
offering, and we have begun to use our credit facilities to continue to fund our
investment activities. As of December 31, 2004, our borrowings under these
credit facilities totaled $133.8 million. Cash provided by financing activities
during the year ended December 31, 2003 was $11.9 million and were primarily the
result of net borrowings under our secured warehouse credit facilities.
Financing activities used $10.8 million during the year ended December 31, 2002,
primarily reflecting net repayments under our secured warehouse
facilities.




See our
consolidated statements of cash flows included in the historical consolidated
financial statements included elsewhere in this filing for a reconciliation of
our cash position for the periods described above.




**Derivative
and Other Risk Management Transactions**




In
connection with our fixed-rate lending activities, we have entered into
derivative and other risk management transactions in order to insulate or hedge
the value of our future debt obligations from changes in underlying interest
rates during the period between origination and permanent financing of our loans
and other net lease assets. Historically, we have done so by entering into
Treasury and agency lock transactions, short sales of U.S. government and agency
obligations and interest rate swap transactions. In the future, we expect that
our derivative and other risk management activities will consist primarily of
interest rate swaps. This hedging and other risk management activity appears on
our statement of operations as a gain or loss on derivatives and short sales of
securities. In the year ended December 31, 2004, we had $0.7 million in loss on
short sales and derivative transactions, partially offset by a $0.8 million gain
on sales of net lease loans. In the year ended December 31, 2003, we had $3.1
million in loss on short sales and derivative transactions, offset by $11.7
million gain on the sale of net lease loans. Consistent with the reporting
requirements under SFAS No. 133, interest rate swaps are marked to fair value at
each reporting date, with a corresponding offset to Other Comprehensive Income
(a component of Stockholders’ Equity).




37


In
general, we expect to hedge our liabilities against changes in underlying
interest rates until the related assets have been financed on a long-term basis.
Some assets, including mezzanine loans and structured securities, may not be
hedged at all. We do not use the derivative and short sales of U.S. government
and agency obligations that are part of our hedge and other risk management
strategy for trading or speculative purposes and we only enter into contracts or
hedging arrangements with major financial institutions.




We settle
our derivative and other risk management transactions in cash. Therefore, upon
settlement, we will pay or receive cash for the net amount due. These amounts
could be material and could have a material impact (positive or negative) on our
liquidity. We seek to settle these transactions simultaneous with the closing of
our financing transaction for the related hedged asset to mitigate the possible
adverse impact on our liquidity.




**Contractual
Obligations**




The
following table outlines the timing of payment requirements related to our
contractual obligations as of December 31, 2004:




**Less
      than1 year**
    
    **2-3
      years**
    
    **4-5
      years**
    
    **After
      5 years**
    
    **Total**Mortgage
      notes payable
    
    $
    1,159
    
    $
    2,959
    
    $
    6,055
    
    $
    101,366
    
    $
    111,539Operating
      leases
    
    
    569
    
    
    241
    
    
    —
    
    
    —
    
    
    810Repurchase
      agreement obligations
    
    
    133,831
    
    
    —
    
    
    —
    
    
    —
    
    
    133,831Total
    
    $
    135,559
    
    $
    3,200
    
    $
    6,055
    
    $
    101,366
    
    $
    246,180





**Off-Balance
Sheet Arrangements**




As of
December 31, 2004, we had an off-balance sheet arrangement involving a letter of
credit that we have posted in connection with a securitization we completed in
1999. Upon the closing of the securitization, the collateral pool consisted of
170 fixed-rate corporate and United States Post Office net lease loans in the
aggregate principal balance of approximately $383.4 million, with ratings from
S&P on the underlying tenants (or guarantors or parents) ranging from AA to
not rated. As of December 31, 2004, the collateral pool’s loan balance had
amortized to approximately $336.0 million, and the pool consisted of
approximately 73% investment grade tenants, 22% below investment grade tenants
and 5% tenants not rated. The weighted average credit rating of the pool as of
December 31, 2004 was approximately equivalent to a BBB+ credit rating. Our
maximum potential liability under the letter of credit is $2.85 million. The
letter of credit expires on February 18, 2009. The trustee may draw the letter
of credit if there are realized losses on the mortgage loans that would create a
shortfall in the interest or principal on any investment grade certificate. The
letter of credit may be withdrawn when the ratings of the investment grade
certificates are no longer dependent upon the credit support provided by the
letter of credit. As of December 31, 2004, there had been no defaults and no
losses on any of the mortgage loans in the collateral pool. During February
2005, one of the mortgage loans on a property net leased to Winn-Dixie
defaulted, as a result of the bankruptcy of Winn-Dixie. However, management does
not expect any draw on the letter of credit as a result of this mortgage default
or otherwise.






**Item
7A.** **Quantitative
and Qualitative Disclosures About Market Risk.**




Market
risk refers to the risk of loss from adverse changes in the level of one or more
market prices, rate indices or other market factors. We will be exposed to
market risk primarily from changes in interest rates, credit spreads, tenant
credit ratings and equity prices. We attempt to mitigate certain of these risks
by entering into hedge and other risk management transactions during the
short-term and fixed-rate financings for the long-term. We seek to obtain
long-term fixed rate financing as soon as practicable after we make an asset
investment. There can be no assurance, however, that such mitigation strategies
will be completely or even partially successful. The level of our exposure to
market risk is subject to factors beyond our control, including political risk
(including terrorism), monetary and tax policy, general economic conditions and
a variety of other associated risks.




38


*Interest
Rate Exposure.*




Substantially
all of our assets have exposures to long-term interest rate movements, primarily
the yields on long-term U.S. Treasuries. This includes our mortgage loans and
real estate securities. Our hedge and other risk management transactions will
also have exposures to movements in interest rates. Changes in the general level
of interest rates can affect our net interest income, which is the difference
between the interest income earned on interest-bearing assets and the interest
expense incurred in connection with our interest-bearing liabilities. Changes in
interest rates can also affect our net income from any investments that we make
in net leased real estate, which is the difference between the rental income
earned and the interest expense on the liabilities associated with the
properties. Changes in the level of interest rates may also affect, among other
things, our ability to originate or acquire mortgage loans and securities, real
estate properties, and the value of our mortgage loans and other
assets.




*Credit
Spread Curve Exposure.*




Our
mortgage loans and real estate securities are subject to spread risk. The
majority of these assets are fixed-rate assets, which are valued based on a
market credit spread over the rate payable on fixed-rate U.S. Treasuries of like
maturity. In other words, their value is dependent on the yield demanded on such
assets by the market based on their credit relative to U.S. Treasuries. Changes
in the general credit markets can lead to changes in the required yield on these
assets, which would result in a higher or lower value for our mortgage loans and
real estate securities. If the required market yields increase as a result of
these general credit-market changes, the value of our fixed-rate assets would
decline relative to U.S. Treasuries. Conversely, if the required market yields
decrease as a result of these general credit-market changes, the value of our
fixed-rate assets would increase relative to U.S. Treasuries. These changes in
the market value of our fixed-rate asset portfolio may affect the equity on our
balance sheet or our results of operations directly through provisions for
losses on mortgage loans or through unrealized losses on available-for-sale
securities. These value changes may also affect our ability to borrow and access
capital.




Furthermore,
shifts in the U.S. Treasury yield curve, which represents the market’s
expectations of future interest rates, would also affect the yield required on
our fixed-rate assets. This would have similar effects on the fair value of our
fixed-rate assets, our financial position and results of operations, as would a
change in general credit spreads.




*Tenant
Credit Rating Exposure.*




Our
mortgage loans and real estate securities are subject to risks due to credit
rating changes of the tenants under the related net lease obligations. The
credit quality of a particular net lease asset is highly dependent on the credit
rating of the related tenant obligor of the net lease. Deterioration in the
tenant’s credit rating can lead to changes in the required yield on the related
asset, which would result in a lower value for our net lease assets. This would
have similar effects on the fair value of our fixed-rate assets, our financial
position and results of operations, as would a change in general credit spreads.
In addition, precipitous declines in the credit rating of a particular tenant
prior to our obtaining long-term financing may significantly impede or eliminate
our ability to finance the asset. We manage this risk by maintaining diversity
among our credits and assessing our aggregate exposure to ratings classes, in
particular lower rated classes.




*Equity
Price Risk Exposure.*




We may
seek to raise capital by sale of our common stock. Our ability to do so is
dependent upon the market price of our common stock.




*Fair
Values.*




For
certain of our financial instruments, fair values are not readily available
since there are no active trading markets as characterized by current exchanges
between willing parties. Accordingly, we derive or estimate fair values using
various valuation techniques, such as computing the present value of estimated
future cash flows using discount rates commensurate with the risks involved.
However, the determination of estimated cash flows may be subjective and
imprecise. Changes in assumptions or estimation methodologies can have a
material affect on these estimated fair values. The fair values indicated below
are indicative of the interest rate and credit spread environment as of December
31, 2004, and may not take into consideration the effects of subsequent interest
rate, credit spread fluctuations, or changes in the ratings of the tenants under
related net leases.





39





The
following summarizes certain data regarding our interest rate sensitive
instruments:




**Carrying
      Amount**
    
    **Notional
      Amount**
    
    **Weighted
      Average Effective Interest Rate**
    
    **Maturity
      Date**
    
    **Fair
      Value****12/31/04**
    
    **12/31/03**
    
    **12/31/04**
    
    **12/31/03**
    
    **12/31/04**
    
    **12/31/04**
    
    **12/31/04**
    
    **12/31/03***(dollars
      in thousands)***Assets:**Mortgage
      loans held for investment(1)
    
    $
    207,893
    
    
    —
    
    $
    206,735
    
    
    —
    
    
    6.56
    %
    
    Various
    
    $
    215,330
    
    
    —Mortgage
      loans held for sale(2)
    
    
    —
    
    $
    71,973
    
    
    —
    
    $
    72,370
    
    
    —
    
    
    —
    
    
    —
    
    $
    73,208Securities
      available for sale-CMBS(3)
    
    
    87,756
    
    
    40,054
    
    
    101,771
    
    
    55,873
    
    
    9.79
    %
    
    2019-2028
    
    
    87,756
    
    
    40,054Structuring
      fees receivable(3)
    
    
    4,426
    
    
    5,223
    
    
    N/A
    
    
    N/A
    
    
    8.10
    %
    
    2010-2020
    
    
    4,426
    
    
    5,223Derivative
      assets(4)
    
    
    42
    
    
    —
    
    
    4,868
    
    
    —
    
    
    N/A
    
    
    N/A
    
    
    42
    
    
    —**Liabilities:**Repurchase
      agreements(5)
    
    
    133,831
    
    
    88,087
    
    
    133,831
    
    
    88,087
    
    
    3.26
    %
    
    Short
      term
    
    
    133,831
    
    
    88,087Mortgage
      notes payable(6)
    
    
    111,539
    
    
    —
    
    
    110,732
    
    
    —
    
    
    5.39
    %
    
    2013-2018
    
    
    111,539
    
    
    —Derivative
      liabilities(4)
    
    
    7,335
    
    
    484
    
    
    228,182
    
    
    39,400
    
    
    N/A
    
    
    N/A
    
    
    7,355
    
    
    484
  (1)
    With
      the exception of one loan, this portfolio of mortgage loans bears interest
      at fixed rates. We have estimated the fair value of this portfolio of
      loans based on sales of loans with similar credit and structural
      characteristics where available, and management’s estimate of fair values
      where comparable sales information is not available. The maturity dates
      for the mortgage loans range from 2007 through
2033.
  (2)
    In
      connection with our initial public offering in March 2004, we changed from
      a gain on sale to a hold for investment strategy. The fair value
      assumptions described in footnote 1 also apply to mortgage loans held for
      sale.
  (3)
    Securities
      available for sale represent subordinate interests in securitizations
      previously completed by us (CMBS), as well as pass-through certificates
      representing senior mortgage debt. Structuring fees receivable represent
      cash flows receivable by us from the sale of loans to third-party
      purchasers. The notional values for the CMBS are shown at their respective
      face amounts. Fair value for the CMBS is based on third-party quotations,
      where obtainable, or our estimate of fair value, based on yields of
      comparably rated securities in the CMBS market. Fair value for the
      structuring fees receivable is shown at our amortized cost for these
      items. For the securities available for sale, we receive current monthly
      interest coupon payments, and contractual principal payments as scheduled.
      Payments of principal are being received only on our investments in the
      Yahoo and CVS pass-through certificates. Scheduled principal payments on
      our other CMBS investments begin in 2019.
  (4)
    These
      instruments represent hedging and risk management transactions involving
      interest rate swaps. They have been valued by reference to market
      quotations.
  (5)
    Our
      repurchase agreements bear interest at floating rates, and we believe that
      for similar financial instruments with comparable credit risks, the
      effective rates approximate market value. Accordingly, the carrying
      amounts outstanding are believed to approximate fair
value.
  (6)
    We
      estimate the fair value of mortgage notes payable using a discounted cash
      flow analysis, based on our estimates of market interest rates. For
      mortgages where we have an early payment right, we also consider the
      prepayment amount to evaluate the fair
value.





Our
generally higher level of interest rate sensitive instruments at December 31,
2004 reflects our greater level of assets and liabilities as a result of our
initial public offering in March 2004 and change to an investment strategy upon
completion of our initial public offering.





40





Scheduled
maturities of interest rate sensitive instruments as of December 31, 2004 are as
follows:




**Expected
      Maturity Dates****2005**
    
    **2006**
    
    **2007**
    
    **2008**
    
    **2009**
    
    **thereafter***(in
      thousands, notional amounts where appropriate,**otherwise
      carrying amounts)*Mortgage
      loans held for investment
    
    $
    10,939
    
    $
    13,409
    
    $
    13,393
    
    $
    4,552
    
    $
    13,487
    
    $
    150,955Securities
      available for sale-CMBS
    
    
    960
    
    
    980
    
    
    1,020
    
    
    1,067
    
    
    1,100
    
    
    96,644Structuring
      fees receivable
    
    
    563
    
    
    609
    
    
    659
    
    
    713
    
    
    772
    
    
    1,110Derivative
      assets
    
    
    42
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —Repurchase
      agreements
    
    
    133,831
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —Mortgage
      notes payable
    
    
    1,066
    
    
    1,235
    
    
    1,550
    
    
    2,749
    
    
    3,144
    
    
    100,988Derivative
      liabilities
    
    
    7,355
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —





The
expected maturity dates shown for mortgage loans, securities available for sale
and structuring fees receivable are based on the contractual terms of the
underlying assets. These assets, based on our current operating strategy, are
held for investment. Our liabilities with respect to repurchase agreements and
derivative obligations are short-term in nature and, accordingly, are listed in
the current period. The material assumptions used to determine fair value are
included in footnotes 1 through 6 in the immediately preceding
table.




**Risk
Factors**




*Set
forth below and elsewhere in this annual report on Form 10-K and in other
documents we file or furnish with the SEC are risks and uncertainties that could
cause actual results to differ materially from the results contemplated by the
forward looking statements contained in this report.*




***Risks
Related to Operations***




**We
may fail to continue to originate and/or acquire net lease
assets.**




Origination
of additional net lease loans and acquisition of additional net lease real
properties is critical to the success of our business strategy. The net lease
market is highly competitive and we cannot assure you that we will be able to
identify net lease opportunities that meet our underwriting and return criteria.
If we are unable to continue to originate net lease loans and purchase net lease
real properties that are acceptable to us, we may be unable to execute our
business plan, which could have a material adverse affect on our operating
results and financial condition.




**We
may fail to originate or acquire profitable assets.**




Our
investment strategy is based on originating and purchasing profitable assets, as
determined by our returns on those assets less our related financing cost. We
originate or purchase long-term fixed rate assets and generally seek to finance
those assets with lower coupon long-term fixed rate debt, thus earning a profit
or spread.




We
generally obtain long-term financing for our assets after we acquire them.
Therefore, we price our assets at origination or acquisition based on our
assumption about our expected future financing cost.




If our
cost to finance our assets increases over our assumptions between the time we
commit to purchase the asset and when we obtain long-term financing, the profit
or spread we expected to earn on the asset and our overall portfolio will erode.
Various factors could cause our financing cost to increase,
including:




·
    increases
      in long-term interest rates;




·
    weakening
      economic conditions;




·
    United
      States military activity and terrorist
activities;




·
    ineffectiveness
      of our hedging strategies;




·
    a
      decline in the credit rating of the underlying tenant;
  and




41




·
    market
      dislocations caused by the failure or financial difficulties of a large
      financial institution or institutions.




Our
failure to originate and acquire profitable assets would have a material adverse
effect on our cash flows, results of operations and financial
condition.




**We
conduct a significant part of our business with Wachovia Bank, N.A. and its
affiliates and their continued business with us is not
guaranteed.**




We rely
on Wachovia Bank, N.A. and its affiliates in various aspects of our business.
For example:




·
    Wachovia
      Bank, N.A. provides us with short-term financing through a $250.0 million
      repurchase facility.




·
    Through
      December 31, 2004, we obtained $97.4 million of long-term mortgage
      financings from Wachovia Bank.




·
    Affiliates
      of Wachovia Bank, N.A. have performed investment banking services for us,
      including in connection with our initial public offering and our initial
      CDO transaction.




·
    Wachovia
      Bank, N.A. acts as servicer of our net lease asset investments and as
      transfer agent for our common stock.




These
parties are not obligated to do business with us and any adverse developments in
their business or in our relationship with them could result in these parties
choosing not to do business with us or a significant reduction in our business
with them. Termination of our business with Wachovia Bank, N.A. or its
affiliates or a significant reduction in our business with these parties could
have a material adverse effect on our business, operating results and financial
condition.




**We
may be unable to generate sufficient cash flow to make distributions to our
stockholders.**




As a
REIT, we are required to distribute at least 90% of our taxable income each year
to our stockholders. If we are unable to execute our business plan successfully
or in the event of future downturns in our operating results and financial
performance, we may be unable to declare or pay distributions to our
stockholders. The timing and amount of distributions are in the sole discretion
of our board of directors, which will consider, among other factors, our
financial performance, debt service requirements, and capital expenditure
requirements. We cannot assure you that we will generate sufficient cash to fund
distributions required to maintain our REIT tax status or to fund any
distributions.




**Our
management has limited experience operating a REIT or a public company or
executing our business plan.**




Our
management has limited experience operating a REIT or a public company or in
executing our business plan. Therefore, you should be cautious in drawing
conclusions about the ability of our management team to do so.




***Risks
Related to Net Lease Assets***




**An
adverse change in the financial condition of one or more tenants underlying our
net lease investments could have a material adverse impact on
us.**




The
credit quality of the tenant underlying a net lease asset is at the core of our
underwriting process. An adverse change in the tenant’s financial condition,
including a bankruptcy of the tenant, could have a material adverse impact on
us. For example:




·
    We
      rely on rent payments from the tenants underlying our net lease
      investments for our cash flows, and any bankruptcy, insolvency or failure
      to make rental payments when due could result in a material reduction of
      our cash flows and material losses to our
company.




·
    An
      adverse change in the financial condition of one or more tenants
      underlying our net lease investments or a decline in the credit rating of
      one or more tenants underlying our net lease investments could result in a
      margin call if the related asset is being financed on our short-term
      repurchase facilities, and could make it more difficult for us to arrange
      long-term financing for that asset.




42




·
    The
      value of our net lease loan and real estate securities investments are
      primarily driven by the credit quality of the underlying tenant or
      tenants, and an adverse change in the subject tenant’s financial condition
      or a decline in the credit rating of such tenant may result in a decline
      in the value of our net lease investments and a charge to our statement of
      operations.




**The
occurrence of material adverse events with respect to tenants to whom we have a
high degree of exposure or a downturn in their industries could have a material
adverse impact on us.**




Of our
assets in portfolio as of December 31, 2004, approximately $85.8 million, or
17.4%, involve properties leased to, or leases guaranteed by, Aon Corporation.
In addition, two other corporations lease or guarantee leases underlying
investments we have made which represent over 5% (but are less than 10%) of our
assets in portfolio. Any financial difficulty or bankruptcy of one or more of
such tenants or guarantors resulting in nonpayment or delay in payment of rental
payments and other amounts due under the related leases could, as a result of
this concentration, have a greater adverse effect on us than a similar problem
with a less significant tenant.




In
addition, our assets in portfolio as of December 31, 2004 involve properties
leased to, or leases guaranteed by, CVS Corporation, Walgreen Co. and other
companies in the retail drug industry. Approximately $39.8 million, or 8.1%, of
our assets in portfolio as of December 31, 2004, involve properties leased to,
or leases guaranteed by, companies in the retail drug industry. Any downturn in
the retail drug industry or in any other industry in which we have a large
investment could have a material and adverse effect on our financial condition
and operating results. Among other risks, the retail drug industry is subject to
the risks of:




·
    reductions
      in third-party reimbursements of prescription drugs;




·
    the
      growth of mail-order prescription
providers;




·
    increases
      in governmental regulation;




·
    introduction
      of new brand and generic prescriptions
drugs;




·
    inability
      to attract and retain qualified pharmacists and management personnel; and




·
    competition.




**We
may be subject to geographic concentrations that could make us more susceptible
to adverse events in these areas.**




As of
December 31, 2004, an aggregate $169.4 million, or 34.3%, of our assets in
portfolio were investments in properties located in Chicago, Illinois and its
neighboring suburbs. An economic downturn or other adverse events or conditions
such as terrorist attacks or natural disasters in this area, or any other area
where we have significant credit concentration in the future, could have a
material adverse effect on our financial condition and operating
results.




**We
may make errors in analyzing the data of certain of our net lease tenants and
intend to make loans on properties leased to non-investment grade
tenants.**




Approximately
$52.5 million, or 10.6%, of our assets in portfolio as of December 31, 2004,
involve properties leased to, or leases guaranteed by, companies without a
publicly available credit rating. A portion of our assets is expected to
continue to involve tenants who do not have publicly available credit ratings.
We expect to obtain a private rating for these assets after origination or
acquisition and prior to obtaining long-term financing. When we make an
investment in an asset where the underlying tenant has no publicly available
credit rating, we prepare an internally generated credit analysis, after a
review of available financial data. We may misinterpret or incorrectly analyze
this data. These mistakes may cause us to make investments we would not have
otherwise made and may ultimately result in losses on one or more of our
investments.




In
addition, approximately $78.7 million, or 15.9%, of our assets in portfolio as
of December 31, 2004, involve properties leased to, or leases guaranteed by,
companies whose credit rating is below investment grade. These investments will
have a greater risk of default and bankruptcy than investments on properties net
leased exclusively to investment grade tenants.




43


Our
balance sheet, as of December 31, 2004, also includes a $1.1 million investment
in a structured interest that is unrated. The lack of such a rating generally
reflects the fact that the underlying collateral is weaker than what would be
found in a rated interest, and therefore, this investment has a greater risk of
default than an investment in a rated interest.




**We
may be unable to obtain financing, and our existing secured warehouse facility
may be unavailable to us.**




We expect
to borrow money under short-term secured warehouse credit facilities to fund our
acquisitions and originations of net lease assets. We currently have a secured
warehouse facility with Wachovia Bank, N.A. Our warehouse facility is
uncommitted as Wachovia Bank must agree to each asset contributed to the
facility. We cannot assure you that we may be able to draw funds under this
facility at any given time.




Under the
terms of this facility, we sell commercial mortgage assets to Wachovia Bank as
security in exchange for funds to finance our net lease investments. Wachovia
Bank owns the assets that we sell to it as security for our borrowings and holds
those assets subject to our right or obligation to repurchase later. In the
event that Wachovia Bank files for bankruptcy or becomes insolvent, our assets
subject to our repurchase rights or obligations may become subject to the
bankruptcy or insolvency proceedings, thus depriving us, at least temporarily,
of the benefit of these assets. In addition, in the event of our bankruptcy,
Wachovia Bank may qualify for special treatment under the bankruptcy code,
giving it the ability to avoid the automatic stay provisions of the Bankruptcy
Code. In that case, our bankruptcy estate might include our repurchase rights,
but would not include our assets held by Wachovia Bank subject to our repurchase
rights.




**In
the event of a bankruptcy of one of our borrowers or an affiliate of one of our
borrowers, our financial condition and operating results may
suffer.**




Although
we generally use bankruptcy-remote structures when we fund a loan, one of our
borrowers may become a debtor in a bankruptcy case as a result of liabilities
unrelated to ownership and operation of its net leased real property or, if an
affiliate of one of our borrowers becomes the debtor in a bankruptcy case, a
court may order that our borrower’s assets and liabilities be substantively
consolidated with those of its affiliate. Either of these events could delay or
reduce payments on our loan assets, delay our ability to foreclose on the net
leased property and may have an adverse affect on our financial condition and
operating results.




***Risks
Related to Borrowings***




**We
expect to borrow a significant amount of debt to finance our portfolio, which
may subject us to increased risk of loss.**




We expect
to incur significant indebtedness in our operations. We expect that
substantially all of our assets will be pledged as collateral for our borrowings
(on average 70% to 85% of our assets in portfolio). Required debt service will
reduce cash and net income available for operations or distribution to our
stockholders. If the income on assets financed with borrowed funds fails to
cover the cost of the borrowings, we may experience net losses on assets not yet
financed with long-term debt or lower net profits. If we default on our debt
service obligations, we would be at risk of losing some or all of our assets as
our lenders will have a first priority claim on the collateral we pledge and the
right to foreclose.




Our
ability to achieve our investment objectives depends to a significant extent on
our ability to borrow money in sufficient amounts and on sufficiently favorable
terms, thus earning incremental returns. We may not be able to achieve the
degree of leverage we believe to be optimal due to decreases in the proportion
of the value of our assets against which we can borrow, decreases in the market
value of our assets, increases in interest rates (to the extent we have assets
financed with variable rate debt, including our secured warehouse lines of
credit), changes in the availability of financing in the market, conditions in
the lending market and other factors. This may cause us to experience losses or
less profit than would otherwise be the case.




We intend
to continue to finance our net lease assets over the long-term through a variety
of means, including through the use of CDOs and mortgage financing. Our ability
to execute this strategy will depend on various conditions in the markets for
financing in this manner which are beyond our control, including the liquidity
of these markets and maintenance of attractive credit spreads. We cannot assure
you that these markets will remain an efficient source of long-term financing
for our net lease assets. If our strategy is not viable, we will have to find
alternative forms of long-term financing for our net lease assets, as our
secured warehouse lines will not accommodate long-term financing. This could
subject us to more recourse indebtedness and the risk that debt service on less
efficient forms of financing would require a larger portion of our cash flows,
thereby reducing cash available for distribution to our stockholders, funds
available for operations, as well as for future net lease investments, and could
result in net losses and the erosion of our equity.




44


**Hedging
transactions may not effectively protect us against anticipated risks and may
subject us to certain other risks and costs.**




Our
current policy is to enter into hedging transactions primarily to protect us
from the effect of interest rate fluctuations on our portfolio of net lease
assets from the date on which we commit a rate or price to a borrower or seller
and until the date the asset is pledged to secure long-term financing or is
sold. Our hedging policy exposes us to certain risks, among them the
following:




·
    Our
      hedging strategy may not have the desired beneficial impact on our results
      of operations or financial condition.




·
    No
      hedging activity can completely insulate us from the risks associated with
      changes in interest rates.




·
    There
      will be many market risks against which we may not be able to hedge
      effectively, including changes in the spreads of corporate bonds, CMBS or
      CDOs over the underlying U.S. Treasury rates.




·
    We
      may or may not hedge any risks with respect to CMBS or CDOs that we may
      purchase or hold for investment.




·
    Our
      hedging strategy may serve to reduce the returns which we could possibly
      achieve if we did not hedge certain risks.




·
    Because
      we intend to structure our hedging transactions in a manner that does not
      jeopardize our status as a REIT, we will be limited in the type of hedging
      transactions that we may use.




·
    Hedging
      costs increase as the period covered by the hedging increases and during
      periods of rising and volatile interest rates. We may increase our hedging
      activity and thus increase our hedging costs during periods when interest
      rates are volatile or rising.




·
    The
      enforceability of agreements underlying derivative transactions may depend
      on compliance with applicable statutory and commodity and other regulatory
      requirements and, depending on the identity of the counterparty,
      applicable international requirements.




·
    A
      default by a party with whom we enter into a hedging transaction may
      result in the loss of unrealized profits and force us to cover our resale
      commitments, if any, at the then current market price.




·
    Although
      generally we will seek to reserve the right to terminate our hedging
      positions, it may not always be possible to dispose of or close out a
      hedging position without the consent of the hedging counterparty, and we
      may not be able to enter into an offsetting contract in order to cover our
      risk.




·
    There
      can be no assurance that a liquid secondary market will exist for hedging
      instruments purchased or sold, and we may be required to maintain a
      position until exercise or expiration, which could result in
      losses.




**We
may fail to qualify for hedge accounting treatment.**




We record
derivative and hedge transactions in accordance with United States generally
accepted accounting principles, specifically Statement of Financial Accounting
Standards No. 133, *Accounting
for*  *Derivative
Instruments and Hedging Activities* (“SFAS
133”). Under these standards, we may fail to qualify for hedge accounting
treatment for a number of reasons, including, if we use instruments that do not
meet the SFAS 133 definition of a derivative (such as short sales), we fail to
satisfy SFAS 133 hedge documentation and hedge effectiveness assessment
requirements or our instruments are not highly effective. If we fail to qualify
for hedge accounting treatment, our operating results may suffer because losses
on the derivatives we enter into may not be offset by a change in the fair value
of the related hedged transaction.




**If
we fail to secure long-term financing for a substantial portion of our net lease
assets, our financial condition and operating results may suffer.**




We expect
to rely upon our ability to finance our net lease assets with long-term
indebtedness in order to generate cash proceeds for repayment of our secured
warehouse lines of credit and to originate and acquire additional and other net
lease assets. We cannot assure you, however, that we will continue to be
successful in securing long-term financing for a substantial portion of the net
lease assets that we originate or acquire. For example, a decline in the credit
quality of a tenant underlying a net lease asset investment could inhibit our
ability to secure long-term financing for that asset. In the event that it is
not possible or economical for us to secure long-term financing for a
substantial portion of our net lease assets, we may exceed our capacity under
our secured warehouse credit facilities and be unable or limited in our ability
to originate and acquire future net lease assets, which would have a material
adverse effect on our financial condition and operating results. If we determine
that we should sell our net lease assets rather than finance them, there could
be significant adverse effects on our operating results and stockholder
distributions as a result of the treatment of any gains from such sales under
the tax laws governing REITs.




45


**Our
short-term financings may expose us to interest rate risks, margin calls and
term risks.**




Our
borrowings under our repurchase facility is currently at variable rates and will
be adjusted monthly relative to market interest rates. If interest rates on our
borrowings rise at a faster pace than yields on our assets increase, our net
interest expense will likely increase, causing our net income to decrease.




The
amount available to us under our repurchase facility with Wachovia Bank depends
in large part on the lender’s valuation of the assets that secure our
financings. The facility provides Wachovia Bank the right, under certain
circumstances, to re-evaluate the collateral that secures our outstanding
borrowings at any time. In the event Wachovia Bank determines that the value of
the collateral has decreased (for example, in connection with a decline in the
credit rating of the underlying tenant), it has the right to initiate a margin
call. A margin call would require us to provide Wachovia Bank with additional
collateral or to repay a portion of the outstanding borrowings at a time when we
may not have a sufficient inventory of assets or cash to satisfy the margin
call. Any failure by us to meet a margin call could cause us to default on our
repurchase facility and otherwise have a material adverse effect on our
financial condition and operating results.




In
addition, Wachovia Bank has no obligation to renew our short-term borrowings. If
we are unable to obtain long-term financing or our shorter-term financings are
not renewed, our liquidity could be materially adversely affected.




**The
use of CDO financings with coverage tests may have a negative impact on our
operating results and cash flows.**




We expect
to purchase subordinate classes of bonds in our CDO financings. We also expect
that the terms of CDOs issued by us will include coverage tests that will be
used primarily to determine whether and to what extent principal and interest
proceeds on the underlying assets may be used to pay principal of and interest
on the subordinate classes of bonds in the CDO. In the event the coverage tests
are not satisfied, interest and principal that would otherwise be payable on the
subordinate classes may be re-directed to pay principal on the senior bond
classes. Therefore, failure to satisfy the coverage tests could adversely affect
our operating results and cash flows.




***Risks
Related to Mortgage Assets***




**Our
investments in commercial mortgage-backed securities and collateralized debt
obligations are subject to losses.**




When we
acquire structured interests in net lease assets, we generally invest in the
subordinate or interest-only classes of CMBS or CDOs or take a subordinate
interest in the net lease asset or assets. Losses on an asset securing a
mortgage loan included in a securitization or other structured interest are
generally borne first by the equity holder of the property, then by a cash
reserve fund or letter of credit, if any, and then by the “first loss”
subordinated security holder. In the event of default of an underlying asset or
assets and the exhaustion of any equity support, reserve fund, letter of credit
and any classes of securities or interests junior to those in which we invest,
if any, we may not be able to recover our investment in the securities or
structured interests we purchase. In addition, if the underlying asset portfolio
has been overvalued by the originator, or if the values subsequently decline
and, as a result, less collateral is available to satisfy interest and principal
payments due on the related structured interests, the structured interests in
which we invest may effectively become the “first loss” position behind the more
senior interests, which may result in significant losses to us.




The
prices of lower credit quality structured interests are generally less sensitive
to interest rate changes than more highly rated investments, but they are more
sensitive to adverse economic downturns or individual issuer developments. A
projection of an economic downturn, for example, could cause a decline in the
price of lower credit quality interests because the ability of tenants or the
obligors of mortgages underlying the structured interests to make required
payments may be impaired. In such event, existing credit support in the
structure may be insufficient to protect us against loss of our principal on
these interests.




46


**Fluctuating
interest rates may adversely affect the quantity and value of our net lease
assets.**




Because
we currently finance our net lease assets on a short-term basis with variable
rate financing, increases in short-term interest rates may increase our net
interest expense and decrease the net income generated by our net lease assets.
Fluctuations in interest rates may also affect us in other ways, including that:




·
    higher
      interest rates may reduce overall demand for net lease loans and
      accordingly reduce our production of loan assets, which could have a
      material adverse effect on our financial condition and operating results;
      and




·
    increases
      or decreases in short- or long-term interest rates may reduce the value of
      assets on our balance sheet.




**We
may experience losses on our mortgage loans.**




We
originate mortgage loans (in particular, net lease loans) as part of our
investment strategy. As a holder of mortgage loans, we are subject to risks of
borrower defaults, tenant defaults, bankruptcies, fraud, losses and special
hazard losses that may not be covered by standard hazard insurance. Also, the
costs of originating, financing and hedging the mortgage loans (including the
debt service on CDOs secured by the mortgage loans, and expenses related to the
CDO transaction, including third-party fees payable to trustees, servicers,
document custodians, and credit enhancement providers) could exceed the income
on the mortgage assets. In the event of any default under mortgage loans, we
will bear the risk of loss of principal to the extent of any deficiency between
the value of the mortgage collateral and the principal amount of the mortgage
loan plus all interest thereon and other costs payable before principal. To the
extent we acquire subordinate CMBS or CDO interests or other subordinate
structured interests in net lease assets, we will be subject to these risks in a
concentrated form with respect to the underlying net lease assets.




The
typical net lease requires casualty insurance (which may be provided through
self insurance) to be maintained on the underlying property (generally by the
borrower or the tenant), with such coverages and in such amounts as are
customarily insured against with respect to similar properties, for fire,
vandalism and malicious mischief, extended coverage perils, physical loss
perils, commercial general liability, flood (when the underlying property is
located in whole or in material part in a designated flood plain area) and
worker injury. There are, however, certain types of losses (such as from
earthquakes or wars) that may be either uninsurable or not economically
insurable. Should an uninsured loss occur, we could lose both our capital
invested in, and anticipated profits from, one or more net lease properties.




**We
could be subject to the risks incident to ownership of real property if the
tenants underlying our net lease loans fail to make their lease payments.**




Net lease
loans are generally non-recourse to the property owner and in the event of
default the lender thereunder is entirely dependent on the loan collateral. Rent
payment by the underlying tenant is the primary source of payment of these
loans. To the extent the tenant does not make its lease payments, repayment of
the net lease loan will depend upon the liquidation value of the underlying real
property. The liquidation value of a commercial property may be adversely
affected by risks generally incident to interests in real property, including
changes in general or local economic conditions and/or specific industry
segments, declines in real estate values, increases in interest rates, real
estate tax rates and other operating expenses including energy costs, changes in
governmental rules, regulations and fiscal policies, including environmental
legislation, acts of God, and other factors which are beyond our or our
borrower’s control. There can be no assurance that our remedies with respect to
the loan collateral will provide us with a recovery adequate to recover our
investment.




**Development
loans involve greater risk of loss than loans secured by income producing
properties.**




We expect
to expand our extension of development financing to real estate developers.
These types of loans involve a higher degree of risk than long-term senior
mortgage loans secured by income-producing real property, due to a variety of
factors, including dependence for repayment on successful completion and
operation of the project, difficulties in estimating construction or
rehabilitation costs, loan terms that often require little or no amortization,
and the possibility that a foreclosure by the holder of the senior loan could
result in a substantial decrease in the value of our collateral. Accordingly, in
the event of a borrower default, we may not recover some or all of our
investment in our development loans.




**Unscheduled
principal payments on our loans could adversely affect our financial condition
and operating results.**




The rate
and timing of unscheduled payments and collections of principal on our net lease
loans is impossible to predict accurately and will be affected by a variety of
factors, including the level of prevailing interest rates, restrictions on
voluntary prepayments contained in the loans, the availability of credit
generally and other economic, demographic, geographic, tax and legal factors. In
general, however, if prevailing interest rates fall significantly below the
interest rate on a loan, the borrower is more likely to prepay the then
higher-rate loan than if prevailing rates remain at or above the interest rate
on the loan.




47


Loans we
originate or acquire generally prohibit prepayment or only permit prepayment in
conjunction with payment of a prepayment premium to maintain the yield to
investors. Our mortgage loans are typically prepayable, however, without payment
of any prepayment premium, in the event of certain events of casualty or
condemnation with respect to the related mortgaged property. From time to time,
we may originate a loan that is prepayable under other circumstances without
payment of any prepayment premium. We cannot assure you that our prepayment
prohibitions will be enforceable in all jurisdictions in which we make loans.
Further, a mortgage loan may effectively prepay in the event of a default, in
which event a prepayment premium may not be recovered.




Unscheduled
principal prepayments could adversely affect our financial condition and
operating results to the extent we are unable to reinvest the funds we receive
at an equivalent or higher yield rate, if at all. In addition, a large amount of
prepayments, especially prepayments on loans with interest rates that are high
relative to the rest of our portfolio, will likely decrease the net income we
anticipate receiving from our assets.




**We
may be required to repurchase assets that we have sold or to indemnify holders
of our CDOs.**




If any of
the assets we originate or acquire and sell or pledge to obtain long-term
financing do not comply with representations and warranties that we make about
certain characteristics of the assets, the borrowers and the underlying
properties, we may be required to repurchase those assets or replace them with
substitute assets. In addition, in the case of assets that we have sold, we may
be required to indemnify persons for losses or expenses incurred as a result of
a breach of a representation or warranty. Repurchased assets typically require a
significant allocation of working capital to carry on our books, and our ability
to borrow against such assets is limited. Any significant repurchases or
indemnification payments could materially and adversely affect our financial
condition and operating results.




**The
success of our net lease loan business will depend upon our ability to service
effectively, or to obtain effective third-party servicing for, the loans we
invest in.**




We have
entered into a servicing arrangement with Wachovia Bank, N.A. for servicing of
our net lease loans. We may in the future undertake to retain the servicing of
our loan assets in a taxable subsidiary of ours. We have no experience servicing
a large portfolio of loans for an extended period of time. We cannot assure you
that our third-party contractor or we will be able to service the loans
according to industry standards. Failure to service the loans properly could
harm our financial condition and operating results.




**The
success of our net lease equity business will depend on our ability to obtain
third-party management for the real properties we
purchase.**




For our
equity investments in real property where the underlying lease is not a bondable
or triple net lease, we typically enter into management arrangements with third
parties to perform our property owner obligations. We rely on these managers to
perform our obligations under the net lease. A failure of these managers to
perform could trigger the tenant’s right to terminate the lease or abate rent.
In addition, if the managers fail to perform our obligations in a cost-effective
manner, our net cash flows from the property and hence our operating results and
cash flows could be adversely affected.




**An
interruption in or breach of our information systems could impair our ability to
originate assets on a timely basis and may result in lost
business.**




We rely
heavily upon communications and information systems to conduct our business. Any
failure or interruption or breach in security of our information systems or the
third-party information systems on which we rely could cause underwriting or
other delays and could result in reduced efficiency in asset servicing. We
cannot assure you that any failures or interruptions will not occur or, if they
do occur that we or the third parties on whom we rely will adequately address
them. The occurrence of any failures or interruptions could significantly harm
our financial condition and operating results.




**Our
network of independent mortgage brokers and investment sale brokers may sell our
investment opportunities to our competitors.**




An
important source of our investments comes from independent mortgage brokers and
investment sale brokers. These brokers are not contractually obligated to do
business with us. Further, our competitors also have relationships with many of
these brokers and actively compete with us in our efforts to obtain investments
from these brokers. As a result, we may lose potential transactions to our
competitors, which could negatively affect the volume and pricing of our
investments, which would have a material adverse effect on our financial
condition and operating results.




48


**We
may be unsuccessful in executing our 10-year credit tenant loan program.**




Like our
other loan products, our 10-year credit tenant loans are secured by a first
mortgage on the underlying real estate and an absolute assignment of the
underlying lease and rents. However, we bifurcate our 10-year credit tenant
loans into two notes, a real estate note and a corporate credit note, and
allocate the security among the notes. The real estate note is entitled to a
first priority claim against the underlying real estate and the corporate credit
note is entitled to a first priority claim against the lease assignment. Any
excess recovery on one note is paid over to the other note. We typically sell
the real estate note, which represents 70% to 80% of the loan, to a CMBS conduit
promptly following origination and retain the corporate credit note in our
portfolio. If we are unable to continue to sell the first note, we will be
subject to all risks incident to holding the debt, including the risks of
borrower defaults, tenant defaults, bankruptcies, fraud, losses and special
hazard losses that may not be covered by standard hazard insurance. In addition,
if the tenant underlying the loan becomes insolvent or bankrupt, that tenant or
its bankruptcy trustee can reject the lease. In such an event, our claim, as
holder of the corporate credit note, against the real estate will be junior to
the real estate note holder’s claim. Further, while we will have a first
priority claim on the lease assignment, our claim for damages will be limited to
an amount defined under the Bankruptcy Code. Either of these contingencies could
result in a material adverse effect on our financial condition and operating
results.




**Maintenance
of our Investment Company Act of 1940 exemption imposes limits on our
operations.**




We intend
to continue to conduct our business in a manner that allows us to avoid
registration as an investment company under the Investment Company Act of 1940
(the “1940 Act”). Under Section 3(c)(5)(C) of the 1940 Act, entities that are
primarily engaged in the business of purchasing or otherwise acquiring
“mortgages and other liens on and interests in real estate” are not treated as
investment companies. The position of the SEC staff generally requires us to
maintain at least 55% of our assets directly in qualifying real estate interests
in order for us to rely on this exemption (the “55% Requirement”). To constitute
a qualifying real estate interest under this 55% Requirement, a real estate
interest must meet various criteria. Mortgage securities that do not represent
all of the certificates issued with respect to an underlying pool of mortgages
may be treated as securities separate from the underlying mortgage loans and,
thus, may not qualify for purposes of the 55% Requirement. Our ownership of
these mortgage securities, therefore, is limited by the provisions of the 1940
Act and SEC staff interpretations. We cannot assure you that efforts to pursue
our investment strategy will not be adversely affected by operation of these
provisions and interpretations.




***Risks
Related to Ownership of Real Estate***




**Our
real estate investments are subject to risks particular to real property.**




As an
owner of real property (including property securing our net lease loans that we
may acquire upon foreclosure), we are subject to the risks generally incident to
the ownership of the real estate. These risks may include those listed below:




·
    civil
      unrest, acts of God, including earthquakes, floods and other natural
      disasters, which may result in uninsured losses, and acts of war or
      terrorism, including the consequences of the terrorist attacks, such as
      those that occurred on September 11, 2001;




·
    adverse
      changes in national and local economic and market conditions;




·
    changes
      in interest rates and in the availability, cost and terms of debt
      financing, including mortgage obligations and the possibility of
      foreclosure;




·
    the
      costs of complying or fines or damages as a result of non-compliance with
      the Americans with Disabilities Act and with environmental laws;




·
    changes
      in governmental laws and regulations, fiscal policies and zoning
      ordinances and the related costs of compliance with laws and regulations,
      fiscal policies and ordinances;




·
    costs
      of remediation and liabilities associated with environmental conditions
      such as indoor mold;




·
    changes
      in traffic patterns and neighborhood characteristics;




49




·
    the
      potential for uninsured or underinsured property losses;




·
    the
      ongoing need for capital improvements, particularly in older structures;




·
    changes
      in real property tax rates and other operating expenses;




·
    the
      relative illiquidity of real estate investments; and




·
    other
      circumstances beyond our control.




Should
any of these events occur, our financial condition and operating results could
be adversely affected.




**Single
tenant leases involve significant risks of tenant default.**




We focus
our real estate acquisition activities on properties that are net leased to
single tenants. Therefore, a default by the sole tenant is likely to cause a
significant or complete reduction in the operating cash flow generated by the
property leased to that tenant and a reduction in the value of that property.




**Tenant
defaults could adversely affect our financial condition and operating results.**




The
tenants underlying our net lease investments may default on their lease
obligations. Our ability to manage our assets is also subject to federal
bankruptcy laws and state laws that limit creditors’ rights and remedies
available to real property owners to collect delinquent rents. If a tenant
becomes insolvent or bankrupt, we cannot be sure that we could recover the
premises from the tenant promptly or from a trustee or debtor-in-possession in
any bankruptcy proceeding relating to that tenant. We also cannot be sure that
we would receive rent in the proceeding sufficient to cover our expenses with
respect to the premises. If a tenant becomes bankrupt, the federal bankruptcy
code (and possibly state laws relating to debtor relief) will apply and, in some
instances, may restrict the amount and recoverability of our claims against the
tenant. A tenant’s default on its obligations to us could adversely affect our
financial condition and results of operations.




**The
ability of tenants to reject leases in a bankruptcy could adversely affect the
value of our investments and our financial condition and operating results.**




If the
tenant underlying our net lease investments becomes insolvent or bankrupt, that
tenant or its bankruptcy trustee could reject the lease. Lease enhancements do
not cover risks attendant to tenant bankruptcies. If a lease were rejected,
rental payments would terminate, leaving the owner without the rental payments
to support its debt service and other obligations under loans and with a claim
for damages under section 502(b)(6) of the Bankruptcy Code. A claim by the owner
for damages resulting from the rejection by a debtor of a lease of real property
is limited to an amount equal to the rent reserved under the lease, without
acceleration, for the greater of one year or 15 percent (but not more than three
years) of the remaining term of the lease, plus rent already due but unpaid.
There can be no assurance that any such claim for damages (or any recovery on
the underlying mortgaged real estate) would be sufficient to provide for the
repayment of amounts then due under the lease or any debt encumbering the
property.




**We
may have obligations to comply with covenants under certain of our equity
investments in real property.**




Under
certain of our equity investments in real property, we, as owner of the
property, retain obligations with respect to the property, including the
responsibility for real estate taxes, insurance, operating expenses, maintenance
and repair of the property, provision of adequate parking, maintenance of common
areas and compliance with other affirmative covenants in the lease. If we were
to fail to meet such obligations, the tenant may be permitted to abate rent or
terminate the lease, which may result in a loss of our capital invested in, and
anticipated profits from, such property.




**Rising
operating expenses could reduce our cash flow and funds available for future
dividends.**




Our
properties are subject to operating risks common to real estate in general, any
or all of which may negatively affect us. If any property is not fully occupied
or if rents are being paid in an amount that is insufficient to cover operating
expenses, we could be required to expend funds for that property’s operating
expenses. Our properties are also subject to increases in real estate and other
tax rates, utility costs, operating expenses, insurance costs, repairs and
maintenance and administrative expenses.




50


While
most of our properties are subject to a net lease, renewals of leases or future
leases may not be negotiated on that basis, in which event we will have to pay
the expenses associated with maintaining the property. In addition, real estate
taxes on our properties and any other properties that we acquire in the future
may increase as property tax rates change and as those properties are assessed
or reassessed by tax authorities. Many U.S. states and localities are
considering increases in their income and/or property tax rates (or increases in
the assessments of real estate) to cover revenue shortfalls. If we are unable to
lease properties on a net lease basis, or if tenants fail to pay required tax,
utility and other impositions, we could be required to pay those costs, which
could have a material adverse effect on our operating results and financial
condition, as well as our ability to pay dividends to stockholders at historical
levels or at all.




**We
may not be able to renew our leases or re-lease our
properties.**




Upon the
expiration of leases on our properties, we may not be able to re-let all or a
portion of that property, or the terms of re-letting (including the cost of
concessions to tenants) may be less favorable to us than current lease terms. If
we are unable to re-let promptly all or a substantial portion of our properties
or if the rental rates upon re-letting are significantly lower than the current
rates, our financial condition and operating results will be adversely affected.
There can be no assurance that we will be able to retain tenants upon the
expiration of their leases.




**Illiquidity
of real estate may limit our ability to change our
portfolio.**




Real
estate investments are relatively illiquid. Our ability to vary our portfolio by
selling and buying properties in response to changes in economic and other
conditions will be limited. In addition, the Internal Revenue Code of 1986, as
amended, or the Code, limits our ability to sell our properties by imposing a
penalty tax of 100% on the gain derived from prohibited transactions, which are
defined as sales of property held primarily for sale to customers in the
ordinary course of a trade or business. The frequency of sales and the holding
period of the property sold are two primary factors in determining whether a
property sold fits within this definition. These considerations may limit our
opportunities to sell our properties. If we must sell a property, we cannot
assure you that we will be able to dispose of the property in the time period we
desire or that the sales price of the property will recoup or exceed our cost
for the property.




**Noncompliance
with environmental laws could adversely affect our financial condition and
operating results.**




The real
properties we own, including those that we may acquire by foreclosure in
connection with our net lease loans, are subject to various federal, state and
local environmental laws. Under these laws, courts and government agencies have
the authority to require the current owner of a contaminated property to clean
up the property, even if the owner did not know of and was not responsible for
the contamination. F or
example, liability can be imposed upon a property owner based on activities of a
tenant. In addition to the costs of cleanup, environmental contamination can
affect the value of a property and, therefore, an owner’s ability to borrow
funds using the property as collateral or to rent or sell the property. Under
the environmental laws, courts and governmental agencies also have the authority
to require that a person who sent waste to a waste disposal facility, such as a
landfill or an incinerator, to pay for the clean-up of that facility if it
becomes contaminated and threatens human health or the environment. A person
that arranges for the disposal of, or transports for disposal or treatment of, a
hazardous substance to a property owned by another may be liable for the costs
of removal or remediation of the hazardous substances released into the
environment at that property.




Furthermore,
various court decisions have established that third parties may recover damages
for injury caused by property contamination. Also, some of these environmental
laws restrict the use of a property or place conditions on various activities.
An example would be laws that require a business using chemicals to manage them
carefully and to notify local officials that the chemicals are being used. We
may be responsible for environmental liabilities created by our tenants
irrespective of the terms of any lease.




We could
be responsible for the costs discussed above. The costs incurred to clean up a
contaminated property, to defend against a claim, or to comply with
environmental laws could be material and could adversely affect our financial
condition and operating results.




Prior to
acquisition of or foreclosure on a property, we obtain Phase I environmental
reports and, in some cases, a Phase II environmental report. However, these
reports may not reveal all environmental conditions at a property and we may
incur material environmental liabilities of which we are unaware. Future laws or
regulations may impose material environmental liabilities on us or our tenants
and the current environmental condition of our properties may be affected by the
condition of the properties in the vicinity of our properties (such as the
presence of leaking underground storage tanks) or by third parties unrelated to
us.




51


***Risks
Related to Lease Enhancements***




**Our
lease enhancement mechanisms may fail.**




We have
developed certain lease enhancement mechanisms designed to reduce the risks
inherent in our net lease investments. These lease enhancement mechanisms
include:




·
    casualty
      and condemnation insurance policies that protect us from any right the
      tenant may have to terminate the underlying net lease or abate rent as a
      result of a casualty or condemnation;




·
    with
      respect to a double net lease, borrower reserve funds that protect us from
      any rights the tenant may have to terminate the underlying net lease or
      abate rent as a result of the failure of the property owner to maintain
      and repair the property or related common areas;
and




·
    residual
      value insurance policies on net lease loans which have an amortization
      period that extends beyond the initial term of the underlying net lease,
      that insure against the risk that the borrower defaults and the property
      is worth less than the balloon balance at
maturity.




These
lease enhancement mechanisms may not protect us against all losses. For example,
our casualty and condemnation policies typically contain exclusions relating to
war, insurrection, rebellion, revolution or civil riot and radioactive matter,
earthquakes (in earthquake zones) and takings (other than by condemnation) by
reason of danger to public health, public safety or the environment. In
addition, amounts in the borrower reserve fund may be insufficient to cover the
cost of maintenance or repairs, and the borrower may fail to perform such
maintenance or repairs at its own expense. The failure of our lease enhancement
mechanisms may result in the loss of our capital invested in, and profits
anticipated from, our investment, and could adversely affect our financial
condition and operating results.




**We
depend on our insurance carriers to provide and honor lease enhancements.**




We
presently obtain specialized lease enhancement insurance policies from two
carriers. The limited number of insurance carriers available to provide lease
enhancements restricts our ability to replace such insurers. Any of the
following developments with respect to our carriers may have a material adverse
effect on our financial condition and operating results:




·
    a
      deterioration in our relationship with one or both of our carriers;




·
    a
      bankruptcy or other material adverse financial development with respect to
      one or both of our carriers; and




·
    a
      dispute as to policy coverage with one or both of our
      carriers.




**We
may fail to analyze leases adequately or apply appropriate lease enhancement
mechanisms.**




Our net
lease assets are generally secured by rent payments on the underlying net lease.
Therefore, continued rent payments are critical to the value of our assets. In
determining whether a lease enhancement mechanism is appropriate, we examine the
costs and benefits of the lease enhancement mechanism in light of our analysis
of the risks associated with the underlying net lease. As a result of this
analysis, we may decline to apply a lease enhancement mechanism that would
otherwise protect us. Our failure to analyze leases adequately or apply
appropriate lease enhancement mechanisms could cause a decline in the value of
our net lease asset and adversely affect our financial condition and operating
results.




***Risks
Related to Business Strategy and Policies***




**We
face significant competition that could harm our business.**




We are
subject to significant competition in seeking asset investments. We compete with
other specialty finance companies, insurance companies, investment banks,
savings and loan associations, banks, mortgage bankers, mutual funds,
institutional investors, pension funds, other lenders, governmental bodies and
individuals and other entities, including REITs. We may face new competitors
and, due to our focus on net lease properties located throughout the United
States, and because many of our competitors are locally and/or regionally
focused, we may not encounter the same competitors in each region of the United
States. Many of our competitors will have greater financial and other resources
and may have other advantages over our company. Our competitors may be willing
to accept lower returns on their investments, may have access to lower cost
capital and may succeed in buying the assets that we target for acquisition. We
may incur costs on unsuccessful acquisitions that we will not be able to
recover. Our failure to compete successfully could have a material adverse
effect on our financial condition and operating results.




52


**Our
ability to grow our business will be limited by our ability to attract debt or
equity financing, and we may have difficulty accessing capital on attractive
terms.**




We expect
to fund future investments primarily from debt or equity capital. Therefore, we
are dependent upon our ability to attract debt or equity financing from public
or institutional lenders. The capital markets have been, and in the future may
be, adversely affected by various events beyond our control, such as the United
States’ military involvement in the Middle East and elsewhere, the terrorist
attacks on September 11, 2001, the ongoing War on Terrorism by the United States
and the bankruptcy of major companies, such as Enron Corp. Events such as an
escalation in the War on Terrorism, new terrorist attacks, or additional
bankruptcies in the future, as well as other events beyond our control, could
adversely affect the availability and cost of capital for our business. As a
REIT, we will also be dependent upon the availability and cost of capital in the
REIT markets specifically, which can be impacted by various factors such as
interest rate levels, the strength of real estate markets and investors’
appetite for REIT investments. We cannot assure you that we will be successful
in attracting sufficient debt or equity financing to fund future investments, or
at an acceptable cost.




**Future
offerings of debt and equity may adversely affect the market price of our common
stock.**




We expect
in the future to increase our capital resources by making additional offerings
of equity and debt securities, which would include classes of preferred stock,
common stock and senior or subordinated notes. All debt securities and other
borrowings, as well as all classes of preferred stock, will be senior to our
common stock in a liquidation of our company. Additional equity offerings could
dilute our stockholders’ equity, reduce the market price of shares of our common
stock, or be of preferred stock having a distribution preference that may limit
our ability to make distributions on our common stock. We are unable to estimate
the amount, timing or nature of additional offerings as they will depend upon
market conditions and other factors.




**We
may fail to manage our anticipated growth.**




As of
December 31, 2004, our company had 23 employees. If we grow rapidly, we may
experience a significant strain on our management, operational, financial and
other resources. Our ability to manage growth effectively will require us to
continue to improve our operational and financial systems, to expand our
employee base and train and manage our employees and to develop additional
management expertise. Management of growth is especially challenging for us due
to our limited financial resources. Failure to increase our business and manage
growth effectively could have a material adverse effect on our financial
condition and operating results.




**Temporary
investment in short-term investments may adversely affect our results.**




Our
results of operations may be adversely affected during the period in which we
are implementing our investment, leveraging and hedging strategies or during any
period after which we have received the proceeds of a financing or asset sale
but have not invested the proceeds. During this time, we may be invested in
short-term investments, including CMBS or CDO bonds, corporate bonds, commercial
paper, money market funds and U.S. agency debt.




**The
concentration of our company’s ownership may adversely affect the ability of new
investors to influence our company’s policies.**




As of
December 31, 2004, our directors and executive officers owned approximately
12.2% in the aggregate of the outstanding shares of our common stock.
Accordingly, these owners collectively have significant influence over our
company and may determine to vote their shares together. This influence may
result in company decisions that may not serve the best interest of all
stockholders.




**Our
board of directors may change our investment and operational policies without
stockholder consent.**




Our board
of directors determines our investment and operational policies and may amend or
revise our policies, including our policies with respect to our REIT status,
investment objectives, acquisitions, growth, operations, indebtedness,
capitalization and distributions, or approve transactions that deviate from
these policies without a vote of or notice to our stockholders. Investment and
operational policy changes could adversely affect the market price of our common
stock and our ability to make distributions to our stockholders.




53


**The
federal income tax laws governing REITs are complex, and our failure to qualify
as a REIT under the federal tax laws will result in adverse tax consequences.**




We intend
to operate in a manner that will allow us to qualify as a REIT under the federal
income tax laws. The REIT qualification requirements are extremely complex,
however, and interpretations of the federal income tax laws governing
qualification as a REIT are limited. Accordingly, we cannot be certain that we
will be successful in qualifying as a REIT. At any time, new laws,
interpretations, or court decisions may change the federal tax laws or the
federal income tax consequences of our qualification as a REIT.




If we
fail to qualify as a REIT in any taxable year, we will be subject to federal
income tax on our taxable income. Our taxable income would be determined without
deducting any distributions to our stockholders. We might need to borrow money
or sell assets in order to pay any such tax. If we cease to qualify as a REIT,
we no longer would be required to distribute most of our taxable income to our
stockholders. Unless the federal income tax laws excused our failure to qualify
as a REIT, we could not re-elect REIT status until the fifth calendar year after
the year in which we failed to qualify as a REIT.




**Even
if we qualify as a REIT, we may face other tax liabilities that reduce our cash
flow or limit our ability to sell or securitize our assets.**




*Failure
to make required distributions would subject us to tax.*




In order
to qualify as a REIT, each year we must distribute to our stockholders at least
90% of our taxable income, other than any net capital gain. To the extent that
we satisfy this distribution requirement, but distribute less than 100% of our
taxable income, we will be subject to federal corporate income tax on our
undistributed taxable income. In addition, we will be subject to a 4%
nondeductible excise tax if the actual amount that we pay out to our
stockholders in a calendar year is less than a minimum amount specified under
federal tax laws. Under some circumstances, we may need to borrow money or sell
assets to distribute enough of our taxable income to satisfy the distribution
requirement and to avoid corporate income tax and the 4% nondeductible excise
tax in a particular year.




*The
formation of taxable REIT subsidiaries increases our overall tax
liability.*




Our
taxable REIT subsidiaries will be subject to federal and state income tax on
their taxable income, which will consist of gains from any loan sales and
financial advisory services fees, net of the general and administrative expenses
associated with these businesses. Accordingly, although our ownership of the
taxable REIT subsidiaries allows us to participate in additional operating
income, that operating income is fully subject to corporate income tax. The
after-tax net income of our taxable REIT subsidiaries is available for
distribution to us as dividends, but we may choose to retain earnings in the
taxable REIT subsidiary and not pay dividends.




We will
incur a 100% tax on transactions with our taxable REIT subsidiaries that are not
conducted on an arm’s-length basis.




*The
tax on prohibited transactions will limit our ability to engage in transactions,
including certain methods of securitizing our loans, that would be treated as
sales for federal income tax purposes.*




A REIT’s
net income from prohibited transactions is subject to a 100% tax. In general,
prohibited transactions are sales or other dispositions of property, other than
foreclosure property, but including mortgage loans, held primarily for sale to
customers in the ordinary course of business. We might be subject to this tax if
we were to sell a loan or securitize loans in a manner that was treated as a
sale for federal income tax purposes. Therefore, in order to avoid the
prohibited transactions tax, we may choose not to engage in certain sales of
loans other than through our taxable REIT subsidiaries and may limit the
structures that we utilize for our securitization transactions even though such
sales or structures might otherwise be beneficial for us.




**Complying
with REIT requirements may cause us to forego otherwise attractive
opportunities.**




To
qualify as a REIT for federal income tax purposes we must continually satisfy
tests concerning, among other things, the sources of our income, the nature and
diversification of our assets, the amounts we distribute to our stockholders and
the ownership of our stock. We may be required to make distributions to
stockholders at disadvantageous times or when we do not have funds readily
available for distribution. Thus, compliance with the REIT requirements may
hinder our ability to operate solely on the basis of maximizing profits.




54


**Complying
with REIT requirements may limit our ability to hedge effectively.**




The REIT
provisions of the Code may limit our ability to hedge our operations by
requiring us to limit our income in each year from qualified hedges, together
with any other income not generated from qualified real estate assets, to no
more than 25% of our gross income. In addition, we must limit our aggregate
income from non-qualified hedging transactions, from our provision of services
and from other non-qualifying sources to no more than 5% of our annual gross
income. As a result, we may have to limit our use of advantageous hedging
techniques. This could result in greater risks associated with changes in
interest rates than we would otherwise want to incur. If we were to violate one
or both of the REIT gross income tests, we would be subject to a penalty tax
generally equal to the greater of the amounts by which we failed the two gross
income tests, multiplied by a fraction intended to reflect our profitability. If
we fail to satisfy the REIT gross income tests, unless our failure was due to
reasonable cause and not due to willful neglect, we could lose our REIT status
for federal income tax purposes.




**Our
ownership limitations may restrict or prevent you from engaging in certain
transfers of our common stock.**




In order
to maintain our REIT qualification, no more than 50% in value of our outstanding
stock may be owned, directly or indirectly, by five or fewer individuals (as
defined in the federal income tax laws to include various kinds of entities)
during the last half of any taxable year. To preserve our REIT qualification,
our charter provides that, unless exempted by our board of directors, no person
may directly or indirectly own more than 9.9% of the number or value (whichever
is more restrictive) of our outstanding shares of stock. We refer to this
limitation as the “Aggregate Stock Ownership Limit.” In addition, our charter
provides that, unless exempted by our board of directors, no person may directly
or indirectly own more than 9.9% of the aggregate number or value (whichever is
more restrictive) of the outstanding shares of our common stock. We refer to
this limitation as the “Common Stock Ownership Limit.” Generally, any shares of
our stock owned by affiliated owners will be combined for purposes of the
Aggregate Stock Ownership Limit, and any shares of common stock owned by
affiliated owners will be combined for purposes of the Common Stock Ownership
Limit.




If anyone
transfers shares in a way that would violate our ownership limits, or prevent us
from continuing to qualify as a REIT under the federal income tax laws, we will
consider the transfer to be null and void from the outset and the intended
transferee of those shares will be deemed never to have owned the shares or
those shares instead will be transferred to a trust for the benefit of a
charitable beneficiary and will be either redeemed by us or sold to a person
whose ownership of the shares will not violate our ownership limits. Anyone who
acquires shares in violation of our ownership limits or the other restrictions
on transfer in our charter bears the risk of suffering a financial loss when the
shares are redeemed or sold if the market price of our stock falls between the
date of purchase and the date of redemption or sale.




**Provisions
of our charter and Maryland law may limit the ability of a third-party to
acquire control of our company.**




*Our
charter contains restrictions on stock ownership and transfer.*




Our
charter contains the Aggregate Stock Ownership Limit and the Common Stock
Ownership Limit, and these restrictions on transferability and ownership may
delay, defer or prevent a transaction or a change of control of our company that
might involve a premium price for our common stock or otherwise be in the best
interest of our stockholders.




*Our
board of directors may issue additional stock without stockholder
approval.* ******




Our
charter authorizes our board of directors to amend the charter to increase or
decrease the aggregate number of shares of stock we have authority to issue,
without any action by the stockholders. Issuances of additional shares of stock
may delay, defer or prevent a transaction or a change of control of our company
that might involve a premium price for our common stock or otherwise be in the
best interest of our stockholders.




*Other
provisions of our charter and bylaws may delay or prevent a transaction or
change of control.*




Our
charter and bylaws also contain other provisions that may delay, defer or
prevent a transaction or a change of control of our company that might involve a
premium price for our common stock or otherwise be in the best interest of our
stockholders. For example, our charter and bylaws provide that: a two-thirds
vote of stockholders is required to remove a director, vacancies on our board
may only be filled by the remaining directors, the number of directors may be
fixed only by the directors, our bylaws may only be amended by our directors and
a majority of shares is required to call a special stockholders
meeting.




55


**The
market price of our common stock may vary substantially.**




The
trading prices of equity securities issued by REITs historically have been
affected by changes in market interest rates. One of the factors that may
influence the price of our common stock in public trading markets is the annual
yield from distributions on our common stock as compared to yields on other
financial instruments. An increase in market interest rates, or a decrease in
our distributions to stockholders, may lead prospective purchasers of our common
stock to demand a higher annual yield, which could reduce the market price of
our common stock.




Upon
completion of our initial public offering, we issued an aggregate of 3,968,800
shares of our common stock to the former owners of our predecessor, Capital
Lease Funding, LLC, and we have agreed to register the resale of these shares
and certain additional shares issued to certain of our executive officers and
other key employees. We plan to file a registration statement registering the
resale of these shares in the immediate future. Upon registration of resale of
these shares, the owners may freely resell the shares into the public market
without restriction. In addition, on November 17, 2004, an aggregate of 139,134
shares of our common stock issued to certain of our current and former employees
prior to our initial public offering became eligible for sale under Rule 144 of
the Securities Act of 1933, as amended. The resale of any of these shares into
the public market, or the perception that such resale may occur, could adversely
affect the market price of our common stock.




Other
factors that could affect the market price of our common stock include the
following:




·
    actual
      or anticipated variations in our quarterly results of
      operations;




·
    changes
      in market valuations of companies in the real estate or mortgage loan
      industries;




·
    changes
      in expectations of future financial performance or changes in estimates of
      securities analysts;




·
    fluctuations
      in stock market prices and volumes;




·
    the
      addition or departure of key personnel; and




·
    announcements
      by us or our competitors of acquisitions, investments or strategic
      alliances.




**We
depend on our key personnel.**




We depend
on the efforts and expertise of our senior management to manage our day-to-day
operations and strategic business direction. Our senior management is comprised
of Paul H. McDowell, William R. Pollert, Shawn P. Seale, Robert C. Blanz and
Michael J. Heneghan. We also depend on the business relationships that our staff
has with borrowers, tenants, mortgage brokers, investment sale brokers, lenders,
institutional investors and other net lease market participants. Although we
have entered into employment agreements with each member of our senior
management, there is no guarantee that any of them will remain employed with our
company for the term of their respective agreements. We do not maintain key
person life insurance on any of our management team members. If any member of
our senior management team were to die, become disabled or otherwise leave our
employ, we may not be able to replace him with a person of equal skill, ability
and industry expertise.




56


**Item
8.** **Financial
Statements and Supplementary Data.**


****


**Index
to Financial Statements**
 **and
Financial Statement Schedules**
  Report of Independent Registered Public
      Accounting Firm
    58Consolidated
      Balance Sheets as of December 31, 2004 and 2003
    59Consolidated
      Income Statements for the years ended December 31, 2004, 2003 and
      2002
    60Consolidated
      Statements of Changes in Stockholders’ Equity/Members’ Capital for the
      years ended December 31, 2004, 2003 and 2002
    61Consolidated
      Statements of Cash Flows for the years ended December 31, 2004, 2003 and
      2002
    62Notes
      to Consolidated Financial Statements
    63Schedule III - Schedule of Real Estate
      and Accumulated Depreciation at December 31, 2004
    85Schedule IV - Schedule of Mortgage
      Loans on Real Estate at December 31, 2004
    87
 
 
   
 57
 
 **Report
of Independent Registered Public Accounting Firm**
  To the
Stockholders of
 Capital
Lease Funding, Inc.
  We have
audited the accompanying consolidated balance sheets of Capital Lease Funding,
Inc. and subsidiaries (the “Company”) as of December 31, 2004 and 2003 and the
related consolidated statements of income, stockholders’ equity/members’
capital, and cash flows for each of the three years in the period ended December
31, 2004.  Our audits also included the financial statement schedules
listed in the Index at Item 8.  These financial statements and schedules
are the responsibility of the Company’s management.  Our responsibility is
to express an opinion on these financial statements and schedules based on our
audits.
  We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement.  We were not
engaged to perform an audit of the Company’s internal control over financial
reporting.  Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company’s internal control over financial
reporting.  Accordingly, we express no such opinion.  An audit also
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation.  We believe that our audits provide a
reasonable basis for our opinion.
  In our
opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Capital Lease Funding,
Inc. and subsidiaries at December 31, 2004 and 2003, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2004, in conformity with U.S. generally accepted
accounting principles.  Also, in our opinion, the related financial
statement schedules, when considered in relation to the basic financial
statements taken as a whole, present fairly in all material respects the
information set forth therein.
 
  /s/ Ernst & Young
      LLPNew York, New
      York
      March 8,
      2005except for Note 22, as to which the date is March 10,
      2005
   58
   Capital
Lease Funding, Inc. and Subsidiaries
 Consolidated
Balance Sheets
 As of
December 31, 2004 and 2003
 *(in
      thousands)*
    
    As
      of December 31,2004
    
    
    2003AssetsCash
      and cash equivalents
    
    $
    30,721
    
    $
    6,522Mortgage
      loans held for sale
    
    
    –
    
    
    71,757Mortgage
      loans held for investment
    
    
    207,347
    
    
    –Real
      estate investments, net
    
    
    194,541
    
    
    –Securities
      available for sale
    
    
    87,756
    
    
    40,054Structuring
      fees receivable
    
    
    4,426
    
    
    5,223Real
      estate investments consolidated under FIN46
    
    
    48,000
    
    
    –Prepaid
      expenses and other assets
    
    
    7,941
    
    
    1,962Amounts
      due from affiliates and members
    
    
    81
    
    
    44Accrued
      rental income
    
    
    507
    
    
    –Derivative
      assets
    
    
    42
    
    
    –Furniture,
      fixtures and equipment, net
    
    
    340
    
    
    211Total
      Assets
    
    $
    581,702
    
    $
    125,773Liabilities
      and Members' Capital/Stockholders' equityAccounts
      payable and accrued expenses
    
    $
    3,479
    
    $
    2,635Deposits
      and escrows
    
    
    10,725
    
    
    175Due
      to servicer and dealers
    
    
    4,357
    
    
    347Repurchase
      agreement obligations
    
    
    133,831
    
    
    28,765Repurchase
      agreement obligation due to affiliates
    
    
    –
    
    
    59,322Mortgages
      on real estate investments
    
    
    111,539
    
    
    –Derivative
      liabilities
    
    
    7,355
    
    
    484Intangible
      liabilities on real estate investments
    
    
    7,028
    
    
    –Dividends
      payable
    
    
    4,124
    
    
    –Mortgage
      on real estate investments consolidated under FIN46
    
    
    4,815
    
    
    –Total
      Liabilities
    
    
    287,253
    
    
    91,728Minority
      interest in real estate investments consolidated under
    FIN46
    
    
    41,185
    
    
    –Commitments
      and contingencies
    
    
    –
    
    
    –Stockholders'
      equity/members' capital:Preferred
      stock, $.01 par value, 100,000,000 shares authorized, no shares  
      issued and outstanding at December 31, 2004
    
    
    –
    
    
    –Common
      stock, $0.01 par value, 500,000,000 shares authorized,  
      27,491,700 shares issued and outstanding at December 31, 2004
    
    
    275
    
    
    –Additional
      paid in capital
    
    
    253,437
    
    
    –Accumulated
      other comprehensive income
    
    
    1,203
    
    
    –Deferred
      compensation expense
    
    
    (1,651
    )
    
    –Retained
      earnings
    
    
    –
    
    
    –Members'
      capital
    
    
    –
    
    
    34,045Total
      Stockholders' Equity/Members' Capital
    
    
    253,264
    
    
    34,045Total
      Liabilities and Stockholders' Equity/Members' Capital
    
    $
    581,702
    
    $
    125,773
 
 See notes
to consolidated financial statements
  
 59
 
 Capital
Lease Funding, Inc. and Subsidiaries
 Consolidated
Income Statements
 For the
years ended December 31, 2004, 2003 and 2002
 *(in
      thousands, except per share data)*
    
    
    Year
      ended December 31,2004
    
    
    2003
    
    
    2002Revenues:Interest
      income from mortgage loans and securities
    
    $
    13,589
    
    $
    7,317
    
    $
    8,092Gain
      on sales of mortgage loans and securities
    
    
    794
    
    
    11,652
    
    
    10,051Rental
      revenue
    
    
    4,287
    
    
    –
    
    
    –Property
      expense recoveries
    
    
    1,608
    
    
    –
    
    
    –Other
      revenue
    
    
    726
    
    
    151
    
    
    343Total
      revenues
    
    
    21,004
    
    
    19,120
    
    
    18,486Expenses:Interest
      expense
    
    
    2,768
    
    
    1,220
    
    
    2,142Interest
      expense to affiliates
    
    
    –
    
    
    838
    
    
    659Property
      expenses
    
    
    1,761
    
    
    –
    
    
    –Net
      loss on derivatives and short sales of securities
    
    
    724
    
    
    3,129
    
    
    7,729Loss
      on securities
    
    
    247
    
    
    –
    
    
    –General
      and administrative expenses
    
    
    8,833
    
    
    7,186
    
    
    6,966General
      and administrative expenses-stock based compensation
    
    
    3,825
    
    
    –
    
    
    –Depreciation
      and amortization expense on real property
    
    
    1,281
    
    
    –
    
    
    –Loan
      processing expenses
    
    
    196
    
    
    114
    
    
    158Total
      expenses
    
    
    19,635
    
    
    12,487
    
    
    17,654Income
      before provision for income taxes
    
    
    1,369
    
    
    6,633
    
    
    832Provision
      for income taxes
    
    
    9
    
    
    –
    
    
    –Net
      income
    
    $
    1,360
    
    $
    6,633
    
    $
    832Earnings
      per share (pro forma for 2003 and 2002)Net
      income per share, basic and diluted
    
    $
    0.06
    
    $
    1.61
    
    $
    0.20Weighted
      average number of common shares outstanding, basic and
      diluted
    
    
    22,125
    
    
    4,108
    
    
    4,108Dividends
      declared per common share
    
    $
    0.25
    
    $
    –
    
    $
    –
   See notes
to consolidated financial statements
   
 60
 
 Capital
Lease Funding, Inc. and Subsidiaries
 Consolidated
Statements of Changes in Stockholders’ Equity/Members’ Capital
 For the
years ended December 31, 2004, 2003 and 2002
 Capital
      Lease Funding, LLC
    
    
    Capital
      Lease Funding, Inc.*(in
      thousands)*
    
    
    Members'
      Capital
    
    
    Accumulated
      Other
      Comprehensive
      Income
      (Loss)
    
    
    Common
      Stock
      at
      Par
    
    
    Additional
      Paid-In
      Capital
    
    
    Accumulated
      Other
      Comprehensive
      Income
      (Loss)
    
    
    Deferred
      Compensation
      Expense
    
    
    Retained
      Earnings
      (Deficit)
    
    
    TotalMembers'
      capital at December 31, 2001
    
    $
    24,492
    
    $
    574
    
    $
    –
    
    $
    –
    
    $
    –
    
    $
    –
    
    $
    –
    
    $
    25,066Net
      income for the year ended December 31, 2002
    
    
    832
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    832Unrealized
      change in value on securities available for sale
    
    
    –
    
    
    1,877
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    1,877Members'
      capital at December 31, 2002
    
    
    25,324
    
    
    2,451
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    27,775Net
      income for the year ended December 31, 2003
    
    
    6,633
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    6,633Unrealized
      change in value on securities available for sale
    
    
    –
    
    
    (363
    )
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    (363
    )Issurance
      of stock-founders' shares
    
    
    –
    
    
    –
    
    
    1
    
    
    13
    
    
    –
    
    
    –
    
    
    –
    
    
    14Members'
      capital at December 31, 2003
    
    $
    31,957
    
    $
    2,088
    
    $
    1
    
    $
    13
    
    $
    –
    
    $
    –
    
    $
    –
    
    $
    34,059Acquisition
      of Caplease LP
    
    
    (31,957
    )
    
    (2,088
    )
    
    40
    
    
    31,917
    
    
    2,088
    
    
    –
    
    
    –
    
    
    –Issuance
      of stock-initial public offering
    
    
    –
    
    
    –
    
    
    230
    
    
    241,270
    
    
    –
    
    
    –
    
    
    –
    
    
    241,500Initial
      public offering costs
    
    
    –
    
    
    –
    
    
    –
    
    
    (19,723
    )
    
    –
    
    
    –
    
    
    –
    
    
    (19,723
    )Issuance
      of stock-incentive stock plan at offering date
    
    
    –
    
    
    –
    
    
    4
    
    
    4,026
    
    
    –
    
    
    (2,669
    )
    
    –
    
    
    1,361Adjust
      initial management share purchases to market value
    
    
    –
    
    
    –
    
    
    –
    
    
    1,447
    
    
    –
    
    
    –
    
    
    –
    
    
    1,447Incentive
      stock plan compensation expense-March 25- December 31,
2004
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    1,018
    
    
    –
    
    
    1,018Net
      income
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    1,360
    
    
    1,360Dividends
      declared
    
    
    –
    
    
    –
    
    
    –
    
    
    (5,513
    )
    
    –
    
    
    –
    
    
    (1,360
    )
    
    (6,873
    )Unrealized
      change in value on securities available for sale
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    8,121
    
    
    –
    
    
    –
    
    
    8,121Unrealized
      loss on derivatives
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    (7,312
    )
    
    –
    
    
    –
    
    
    (7,312
    )Net
      realized loss on cash flow hedges
    
    
    –
    
    
    –
    
    
    –
    
    
    –
    
    
    (1,694
    )
    
    –
    
    
    –
    
    
    (1,694
    )Balance
      at December 31, 2004
    
    $
    –
    
    $
    –
    
    $
    275
    
    $
    253,437
    
    $
    1,203
    
    $
    (1,651
    )
    $
    –
    
    $
    253,264
 
 See notes
to consolidated financial statements
   
 61
 
 Capital
Lease Funding, Inc. and Subsidiaries
 Consolidated
Statements of Cash Flows
 For the
years ended December 31, 2004, 2003 and 2002
 *(in
      thousands)*
    
    
    Year
      ended December 31,2004
    
    
    2003
    
    
    2002**Operating
      activities**Net
      income
    
    $
    1,360
    
    $
    6,633
    
    $
    832Adjustments
      to reconcile net income to cash provided by
      (used in) operating activities:Depreciation
      and amortization
    
    
    1,386
    
    
    150
    
    
    121Amortization
      of stock based compensation expense
    
    
    3,825
    
    
    –
    
    
    –Gain
      on sale of mortgage loans and securities
    
    
    (794
    )
    
    (11,652
    )
    
    (10,051
    )Change
      in provision for loss on mortgage loans
    
    
    –
    
    
    (1,917
    )
    
    (83
    )Loss
      on derivatives and short sales of securities
    
    
    724
    
    
    3,129
    
    
    7,729Change
      in accrued rental income
    
    
    (507
    )
    
    –
    
    
    –Changes
      in operating assets and liabilities:Proceeds
      from sale of mortgage loans
    
    
    –
    
    
    159,915
    
    
    154,327Net
      principal advanced to borrowers
    
    
    –
    
    
    (141,185
    )
    
    (137,572
    )Funds
      used in hedging and risk management activities
    
    
    (4,462
    )
    
    (4,219
    )
    
    (7,866
    )Loan
      origination costs
    
    
    –
    
    
    (61
    )
    
    (354
    )Securities
      held for sale
    
    
    –
    
    
    (20,175
    )
    
    (4,363
    )Structuring
      fees receivable
    
    
    797
    
    
    (429
    )
    
    437Amounts
      due from dealers for short sales of securities
    
    
    –
    
    
    –
    
    
    12,402Short
      sale of securities
    
    
    –
    
    
    –
    
    
    (11,266
    )Prepaid
      expenses and other assets
    
    
    (7,018
    )
    
    (957
    )
    
    219Accounts
      payable and accrued expenses
    
    
    843
    
    
    602
    
    
    (245
    )Deposits
      and escrows
    
    
    10,550
    
    
    (515
    )
    
    (195
    )Due
      to servicer and dealer
    
    
    4,012
    
    
    (62
    )
    
    (298
    )Net
      cash provided by (used in) operating activities
    
    
    10,716
    
    
    (10,743
    )
    
    3,774**Investing
      activities**Proceeds
      from sale of mortgage loans
    
    
    25,422
    
    
    –
    
    
    –Principal
      advanced to borrowers
    
    
    (167,009
    )
    
    –
    
    
    –Principal
      received from borrowers
    
    
    8,520
    
    
    –
    
    
    –Loan
      origination costs
    
    
    331
    
    
    –
    
    
    –Purchase
      of securities available for sale
    
    
    (95,449
    )
    
    –
    
    
    –Sale
      of securities available for sale
    
    
    55,868
    
    
    –
    
    
    –Purchases
      of real estate investments
    
    
    (174,605
    )
    
    –
    
    
    –Deposit
      on potential equity investment
    
    
    (2,500
    )
    
    –
    
    
    1,000Purchases
      of furniture, fixtures and equipment
    
    
    (234
    )
    
    (69
    )
    
    (154
    )Net
      cash (used in) provided by investing activities
    
    
    (349,656
    )
    
    (69
    )
    
    846**Financing
      activities**Borrowing
      under repurchase agreements
    
    
    135,411
    
    
    47,974
    
    
    84,034Repayments
      under repurchase agreements
    
    
    (30,344
    )
    
    (71,103
    )
    
    (107,549
    )Borrowing
      under repurchase agreements to affiliates
    
    
    –
    
    
    62,865
    
    
    15,657Repayments
      under repurchase agreements to affiliates
    
    
    (59,322
    )
    
    (27,765
    )
    
    (2,684
    )Borrowings
      from mortgages on properties
    
    
    97,547
    
    
    –
    
    
    –Repayments
      of mortgages on properties
    
    
    (198
    )
    
    –
    
    
    –Net
      proceeds from equity offering
    
    
    222,818
    
    
    –
    
    
    –Dividends
      paid
    
    
    (2,749
    )
    
    –
    
    
    –Reverse
      merger
    
    
    14
    
    
    –
    
    
    –Repayments
      under notes payable
    
    
    –
    
    
    (275
    )
    
    –Changes
      in amounts due from (to) affiliates and member
    
    
    (38
    )
    
    252
    
    
    (231
    )Net
      cash provided by (used in) financing activities
    
    
    363,139
    
    
    11,948
    
    
    (10,773
    )**Net
      (decrease) increase in cash**
    
    
    24,199
    
    
    1,136
    
    
    (6,153
    )Cash
      and cash equivalents at beginning of period
    
    
    6,522
    
    
    5,386
    
    
    11,539Cash
      and cash equivalents at end of period
    
    $
    30,721
    
    $
    6,522
    
    $
    5,386**Supplemental
      disclosure of cash flow information**Cash
      paid during the year for interest expense
    
    $
    2,647
    
    $
    2,176
    
    $
    2,574Cash
      paid during the year for income taxes
    
    $
    –
    
    $
    89
    
    $
    64Dividends
      declared but not paid
    
    $
    4,124
    
    $
    –
    
    $
    –**Supplemental
      disclosure of noncash operating, investing and financing
      activities**Prepaid
      expenses and other assets reclassified to public offering
      costs
    
    $
    1,040
    
    $
    –
    
    $
    –Mortgage
      notes payable assumed on properties acquired
    
    $
    14,190
    
    $
    –
    
    $
    –Value
      of in-place leases and above-market leases acquired
    
    $
    13,222
    
    $
    –
    
    $
    –Value
      of below-market leases acquired
    
    $
    7,028
    
    $
    –
    
    $
    –Real
      estate investments consolidated under FIN46
    
    $
    48,000
    
    $
    –
    
    $
    –Mortgage
      on real estate investments consolidated under FIN46
    
    $
    4,815
    
    $
    –
    
    $
    –Unrealized
      loss on cash flow hedges
    
    $
    7,312
    
    $
    –
    
    $
    –
 
 See notes
to consolidated financial statements
   
 62
 Capital
Lease Funding, Inc. and Subsidiaries
 Notes to
Consolidated Financial Statements
 (Dollar
amounts in thousands)
 
 December
31, 2004, 2003 and 2002
 **1.**
    **Organization**
 
 Capital
Lease Funding, Inc. (“CLF, Inc.” and collectively with its wholly-owned
subsidiaries, the “Company”) was incorporated in the State of Maryland during
October 2003, and was formed for the purpose of continuing the existing business
operations and acquiring the assets and liabilities of Caplease, LP (“LP” or the
Predecessor”).  CLF, Inc. completed this acquisition through a reverse
merger and its initial public offering during March 2004.  The Company
invests in real estate mortgage loans, equity interests in real estate
properties, real estate securities and other real estate assets.  The
Company’s investments primarily consist of real estate related assets that are
backed by commercial properties typically subject to long-term net leases from
investment grade and near investment grade tenants.
  The
accompanying financial statements include the historical results of operations
of the Predecessor prior to its acquisition by CLF, Inc.
  The
Predecessor’s principal activity was the origination and sale or securitization
of commercial mortgage loans.  Since 1995, the Predecessor was primarily
engaged in the business of originating, underwriting and securitizing mortgage
loans to owners of real properties subject to long term leases to high credit
quality tenants. These loans were typically secured by a first lien on the
leased property and an assignment of the leases and all rents due under the
lease.
  In March
2004, CLF, Inc. sold 23 million shares of its common stock in an initial public
offering at a price to the public of $10.50 per share, for net proceeds of
approximately $222 million.  CLF, Inc. had 27,491,700 shares of common
stock outstanding at December 31, 2004.
  CLF, Inc.
is organized and conducts its operations to qualify as a real estate investment
trust ("REIT") for federal income tax purposes.  As such, it will generally
not be subject to federal income tax on that portion of its income that is
distributed to stockholders if it distributes at least 90% of its REIT taxable
income to its stockholders by prescribed dates and complies with various other
requirements.  On September 14, 2004, CLF, Inc. declared a dividend of
$0.10 per common share, payable on October 15, 2004, to stockholders of record
as of September 30, 2004.  On December 20, 2004, CLF, Inc. declared a
dividend of $0.15 per common share, payable on January 14, 2005, to stockholders
of record as of December 31, 2004. The dividend declared in December was paid on
January 14, 2005.
  **2.**
    **Summary
      of Significant Accounting Policies**
  *Basis
of Presentation and Principles of Consolidation*
  The
accompanying consolidated financial statements include the assets, liabilities,
and results of operations of the Predecessor prior to March 24, 2004 and CLF,
Inc. and its wholly-owned subsidiaries, thereafter.  All significant
intercompany transactions, balances and accounts have been eliminated in
consolidation.
  *Use
of Estimates*
  Management
of the Company has made a number of estimates and assumptions relating to the
reporting of assets and liabilities, revenues and expenses and the disclosure of
contingent assets and liabilities to prepare these consolidated financial
statements in conformity with accounting principles generally accepted in the
United States of America.  Actual results could differ from those
estimates.
  *Risks
and Uncertainties*
  In the
normal course of business, the Company encounters primarily two significant
types of economic risk: credit and market.  Credit risk is the risk of
default on the Company’s loans, leases and securities that results from a
borrower’s, lessee’s or derivative counterparty’s inability or unwillingness to
make contractually required payments.  Market risk reflects changes in the
value of investments in loans and real estate or in hedging instruments due to
changes in interest rates or other market factors, including the value of the
collateral underlying loans and the valuation of real estate held by the
Company.  Management believes that the carrying values of its investments
are reasonable taking into consideration these risks along with estimated
collateral values, payment histories, and other borrower
information.
  63
 Capital
Lease Funding, Inc. and Subsidiaries
 Notes to
Consolidated Financial Statements
 (Dollar
amounts in thousands)
 
 December
31, 2004, 2003 and 2002
  *Investments
in Mortgage Loans*
  Mortgage
loans are secured by an assignment of the long-term real property leases (the
majority of whose tenants are investment grade) and mortgages on the underlying
real estate.  Mortgage loans held for investment are carried at cost
(unpaid principal balance adjusted for unearned discount and deferred expenses),
and are amortized using the effective interest method.  Mortgage loans held
for sale without a designated hedge are reported at the lower of cost (unpaid
principal balance adjusted for unearned discount and deferred expenses) or
market value.  Mortgage loans held for sale with a designated hedge are
reported at cost, with adjustments to cost for the change in fair value
attributable to the hedged risk.
  *Purchase
Accounting for Acquisition of Real Estate*
  The fair
value of rental real estate acquired subject to existing leases is allocated to
the following based on fair values:
  ·
    the
      acquired tangible assets, consisting of land, building and improvements;
      and
  ·
    identified
      intangible assets and liabilities, consisting of the value of above-market
      and below-market leases, the value of in-place leases and the value of
      tenant relationships, based in each case on their fair
    values.
  In
estimating the fair value of the tangible and intangible assets acquired, the
Company considers information obtained about each property as a result of its
due diligence activities and other market data, and utilizes various valuation
methods, such as estimated cash flow projections utilizing appropriate discount
and capitalization rates, estimates of replacement costs, and available market
information.  The fair value of the tangible assets of an acquired property
considers the value of the property as if it were vacant.
  Above-market
and below-market lease values for acquired properties are recorded based on the
present value (using a discount rate which reflects the risks associated with
the leases acquired) of the differences between (i) the contractual amounts to
be paid pursuant to each in-place lease and (ii) management’s estimate of fair
market lease rates for each corresponding in-place lease, measured over a period
equal to the remaining term of the lease for above-market leases and the initial
term plus the term of any below-market rate renewal options for below-market
leases.  The capitalized above-market lease values are amortized as a
reduction of base rental revenue over the remaining term of the respective
leases, and the capitalized below-market lease values are amortized as an
increase to base rental revenue over the remaining initial terms plus the terms
of any below-market fixed rate renewal options of the respective
leases.
  Other
intangible assets acquired include amounts for in-place lease values and tenant
relationship values which are based on management's evaluation of the specific
characteristics of each tenant's lease and the Company’s overall relationship
with the respective tenant.  Factors considered by management in its
analysis of in-place lease values include an estimate of carrying costs during
the hypothetical expected time it would take management to find a tenant to
lease the space for the existing lease term (a “lease-up period”) considering
current market conditions, and costs to execute similar leases.  Management
estimates carrying costs, including such factors as real estate taxes, insurance
and other operating expenses during the expected lease-up period, considering
current market conditions and costs to execute similar leases.  In
estimating costs to execute similar leases, management considers leasing
commissions, legal and other related expenses.  Characteristics considered
by management in valuing tenant relationships include the nature and extent of
the Company’s existing business relationships with the tenant, growth prospects
for developing new business with the tenant, the tenant's credit quality and
expectations of lease renewals.  The value of in-place leases is amortized
to expense over the remaining initial terms of the respective leases.  The
value of tenant relationship intangibles is amortized to expense over the
anticipated life of the relationships.
  64
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 Depreciation
is determined by the straight-line method over the remaining estimated economic
useful lives of the properties.  The Company generally depreciates
buildings and building improvements over periods not exceeding 40 years. 
Direct costs incurred in acquiring properties are capitalized. 
Expenditures for maintenance and repairs are charged to operations as
incurred.  Significant renovations which extend the useful life of the
properties are capitalized.
  *Securities
Available for Sale*
  Securities
are classified as available-for-sale securities and are reported at fair value
on the Company’s balance sheet, with unrealized gains and losses included in
other comprehensive income, and other than temporary impairments included in
current earnings on the income statement, in accordance with the Financial
Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards
(“SFAS”) No. 115, *Accounting
for Certain Investments in Debt and Equity Securities.* The
Company has also adopted the disclosure requirements of EITF Issue No. 03-01
regarding disclosures to be made when held-to-maturity or available-for-sale
investments are impaired at the balance sheet date but for which an “other than
temporary” loss has not been recognized.
  *Structuring
Fees Receivable*
  Structuring
fees receivable are initially recorded at the discounted value of expected cash
receipts, and periodically evaluated for impairment.  In accordance with
SAB 104, fee revenue is recognized as earned when the following criteria are
met: (i) evidence of an arrangement exists; (ii) services have been rendered;
(iii) the fee is fixed or determinable; and (iv) collectibility is reasonably
assured.  The Company amortizes the receivable balance as cash is
collected, allocating a portion of the cash received to principal and
interest.
  *Deferred
Origination Costs*
  In
accordance with SFAS No. 91, *Accounting
for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans
and Initial Direct Costs of Leases* , the
Company defers the recognition of fees and expenses associated with the
origination of its commercial mortgage loans held for investment.  These
items include lender fee income, rate lock income, certain legal fees, insurance
costs, rating agency fees and certain other expenses.  Deferred fees and
costs are recognized as an adjustment to the effective yield over the life of
the related asset.
  *Sale
of Commercial Mortgage Loans*
  As part
of the Company’s current business operations, the Company sells a limited number
of mortgage loans.  Prior to its initial public offering in March 2004, the
Company sold a majority of its mortgage loans.  The Company does not retain
servicing rights for sold loans.  In these instances, the Company will
derecognize assets sold, record assets received or retained and record a gain or
loss on sale.  The asset received is generally cash.  In certain sale
transactions, the Company retains a small cash flow interest in the loans being
sold.  The Company accounted for sales of mortgage loans in accordance with
SFAS No. 140, *Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities.*
  65
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 *Derivative
and Other Risk Management Transactions*
  The
Company accounts for derivatives in accordance with SFAS No. 133, *Accounting
for Derivative Instruments and Hedging Activities* (SFAS
133).  The Company measures derivative instruments at fair value and
records them as an asset or liability, depending on the Company’s rights or
obligations under the applicable derivative contract.  For derivatives
designated as fair value hedges, the changes in the fair value of both the
derivative instrument and the hedged item are recorded in earnings.  For
derivatives designated as cash flow hedges, the effective portions of the
derivative are reported in other comprehensive income ("OCI") and are
subsequently reclassified into earnings when the hedged item affects
earnings.  Changes in fair value of derivative instruments not designated
as hedging and ineffective portions of hedges are recognized in earnings in the
affected period.
  Prior to
the CLF, Inc.'s conversion to a REIT on March 24, 2004, the Company used
derivatives consisting of U.S. Treasury and Agency lock transactions ("Locks")
to hedge interest rate risk associated with owning fixed rate mortgage loan
assets financed by floating rate debt.  These Locks, to the extent that the
Company has designated them and they qualify as part of a hedging relationship,
are treated as fair value hedges in accordance with SFAS 133.
  Subsequent
to REIT conversion, the Company began using forward starting interest rate swaps
to hedge the variable of changes in the interest-related cash outflows on
forecasted future borrowings.  These interest rate swaps, to the extent
that the Company has designated them and they qualify as part of a hedging
relationship, are treated as cash flow hedges in accordance with SFAS
133.
  *Revenue
Recognition*
  Interest
income from mortgage loans (including mortgage loans with associated valuation
reserves), securities, and structuring fees receivable, are recognized on the
accrual basis of accounting.  Interest income from securities (including
interest-only strips) is recognized over the life of the investment using the
effective interest method.  The cost basis of interest-only strips is
adjusted to reflect any prepayments from underlying assets, using the initial
yield-to-maturity at the purchase date.
  Rental
revenue on real estate is recognized in accordance with SFAS No. 13, *Accounting
for Leases* . 
Rental revenue is recognized on a straight-line basis over the non-cancelable
term of the lease unless another systematic and rational basis is more
representative of the time pattern in which the use benefit is derived from the
leased property.
  Gains are
recognized on the sale of mortgage loans and securities in accordance with the
requirements of SFAS No. 140, *Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities* . 
As part of the Company’s 10-year credit tenant loan program, it originates a
loan and bifurcates the loan into two notes-a real estate note and a corporate
credit note.  The Company generally sells the real estate note to a third
party and retains the corporate credit note in portfolio.  The Company
computes gain on these sales by comparing the sales proceeds on the note to its
cost basis.  The Company computes its cost basis on the note by allocating
the entire basis in the loan between the two notes based on the present value of
expected cash flows on each note.  In computing present values, management
estimates a discount rate based on a benchmark rate plus a market spread based
on the underlying credit.  These estimates reflect market rates that
management believes are reasonable.  However, the use of different
estimates could have an impact on the calculation of gain on sale
revenue.
  Advisory
fees receivable are recognized upon the completion of the advisory services when
the amount is estimable and collection is probable.  The value of the
receivable is based on the present value of the expected cash flows and
amortized as advisory fee payments are received.
  The
Company may periodically receive breakup fees on contracts in connection with
its investments in real estate.  The Company recognizes revenues from
contract breakup fees when the contractual conditions have occurred to trigger
the receipt of such a fee, when the amounts of such revenue can be reasonably
determined, and when collection is probable.
  66
 
 Capital Lease Funding, Inc. and Subsidiaries
 Notes to
Consolidated Financial Statements
 (Dollar
amounts in thousands)
 
 December
31, 2004, 2003 and 2002
 Lease
Enhancement Mechanisms
 The
Company utilizes the following lease enhancement mechanisms, primarily as part
of its mortgage lending programs:
  ·
    casualty
      and condemnation insurance policies that protect the Company from any
      right the tenant may have to terminate the underlying net lease or abate
      rent as a result of a casualty or
condemnation;
  ·
    with
      respect to a double net lease, borrower reserve funds that protect the
      Company from any rights the tenant may have to terminate the underlying
      net lease or abate rent as a result of the failure of the property owner
      to maintain and repair the property or related common areas;
      and
  ·
    residual
      value insurance policies on net lease loans that have an amortization
      period that extends beyond the initial term of the underlying net lease
      that insure against the risk that the borrower defaults and the property
      is worth less than the balloon balance at
maturity.
  Costs
incurred by the Company for lease enhancement mechanisms are typically charged
to the borrowers. In instances where costs are not fully absorbed by the
borrower, costs are treated in accordance with SFAS No. 91, as a cost of
mortgage loan origination.
  *Provision
for Credit Losses*
  The
Company’s accounting policies require that an allowance for estimated credit
losses be maintained at a level that management, based upon an evaluation of
known and inherent risks in the portfolio, considers adequate to provide for
credit losses on its mortgage loan and securities portfolio.  Management
provides a portfolio reserve based upon its periodic evaluation and analysis of
the mortgage loans in portfolio, historical and industry loss experience,
economic conditions and trends, collateral values and quality, and other
relevant factors.  Valuation allowances are established for loans in the
amount by which the carrying value, before allowance for estimated losses,
exceeds the fair value of collateral on a portfolio basis.  Losses are
recognized through a loss provision on the balance sheet with a corresponding
charge to the provision for loss in the income statement.  At December 31,
2004, there was no provision for credit losses.
  *Impairment
of Long-Lived Assets*
  The
Company reviews its investment in long-lived assets for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable.  In August 2001, SFAS No. 144 “ *Accounting
for the Impairment or Disposal of Long-Lived Assets* ” was
issued. SFAS No. 144 supersedes SFAS No. 121 “ *Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of.* ” 
The adoption of SFAS No. 144 by the Company on January 1, 2002 did not have a
material effect on its results of operations or financial position.  There
were no impairment reserves taken for the years ended December 31, 2004, 2003
and 2002.
  *Marketing
and Advertising Costs*
  The
Company expenses marketing and advertising costs as incurred.  Marketing
and advertising expense totaled $688, $544, and $414 in 2004, 2003, and 2002,
respectively.
  *Income
Taxes*
  CLF, Inc.
is subject to federal income taxation at corporate rates on its "REIT taxable
income"; however, CLF, Inc. is allowed a deduction for the amount of dividends
paid to its stockholders, thereby subjecting the distributed net income of CLF,
Inc. to taxation at the stockholder level only.  CLF, Inc. intends to
operate in a manner consistent with and to elect to be treated as a REIT for tax
purposes.  The Company conducts a portion of its business through a taxable
REIT subsidiary (“TRS”), and the income from the activities at the TRS is
subject to federal and state taxation at the applicable corporate
rates.
  67
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
**
 *Other
Comprehensive Income*
  In
accordance with SFAS No. 130, *Reporting
Comprehensive Income* , the
Company recognizes the change in fair value of its securities held for sale
through other comprehensive income.  In accordance with SFAS No. 133, the
Company recognizes the change in fair value, and gains and losses from its cash
flow hedges through other comprehensive income.  Realized gains and losses
from cash flow hedges related to the Company’s debt issuances are amortized as a
component of interest expense over the term of the related financing, using the
constant interest method.
  *Earnings
per Share*
  In
accordance with the Statement of Financial Accounting Standards No. 128 ("SFAS
No. 128"), the Company presents both basic and diluted earnings per share
("EPS").  Basic EPS excludes dilution and is computed by dividing net
income allocable to common shareholders by the weighted average number of shares
outstanding for the period.  Diluted earnings per share reflects the
potential dilution that could occur if securities or other contracts to issue
common stock were exercised or converted into common stock, where such exercise
or conversion would result in a lower EPS amount.
  For the
year ended December 31, 2004, EPS and weighted average shares outstanding
include the 254,186 non-vested shares issued under CLF, Inc.’s stock incentive
plan.  For the year ended December 31, 2004, EPS is computed based on the
net income divided by the weighted average shares outstanding during the period
of 22,124,934.  For the years ended December 31, 2003 and 2002, EPS and
shares outstanding are presented on a pro forma basis, which assumes that
4,107,934 shares were outstanding during these periods.  This share number
represents 3,968,800 shares of common stock issued to the owners of the
Predecessor in exchange for their members’ capital, and 139,134 shares sold to
certain current and former employees of the Predecessor in November 2003. 
Pro forma EPS information is computed based on the net income divided by
4,107,934.  There were no potentially dilutive shares of common stock
outstanding for the years ended December 31, 2004, 2003 and 2002.
  *Recently
Issued Accounting Pronouncements*
  On
December 16, 2004, the FASB issued SFAS No. 153: *Exchanges
of Non-monetary Assets − An Amendment of APB Opinion No. 29* . 
The amendments made by SFAS No. 153 are based on the principle that exchanges of
non-monetary assets should be measured based on the fair value of the assets
exchanged.  Further, the amendments eliminate the narrow exception for
non-monetary exchanges of similar productive assets and replace it with a
broader exception for exchanges of non-monetary assets that do not have
“commercial substance.”  SFAS No. 153 is effective for non-monetary asset
exchanges occurring in fiscal periods beginning after June 15, 2005.  The
Company does not believe the adoption of SFAS No. 153 on June 15, 2005 will have
a material effect on the Company’s consolidated financial
statements.
  On
December 16, 2004, the FASB issued SFAS No. 123: (Revised 2004) − *Share-Based
Payment* (“SFAS
No. 123R”).  SFAS 123R replaces SFAS No. 123, which the Company adopted on
January 1, 2003.  SFAS No. 123R requires that the compensation cost
relating to share-based payment transactions be recognized in financial
statements and be measured based on the fair value of the equity or liability
instruments issued.  SFAS No. 123R is effective as of the first interim or
annual reporting period that begins after June 15, 2005.  The Company does
not believe that the adoption of SFAS No. 123R will have a material effect on
the Company’s consolidated financial statements.
  68
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 **
 *Reclassification*
  Certain
prior year amounts have been reclassified to conform to the current
presentation.
  **3.**
    **Cash
      and Cash Equivalents**
  The
Company defines cash equivalents as highly liquid investments purchased with
maturities of three months or less at date of purchase.  From time to time,
the Company’s account balance held at financial institutions exceeds Federal
Depository Insurance Corporation (“FDIC”) insurance coverage and, as a result,
there is a concentration of credit risk related to the balance on deposit in
excess of FDIC insurance coverage.  The Company believes that the risk of
loss is not significant.
  **4.**
    **Mortgage
      Loans**
  Mortgage
loans held for investment at December 31, 2004 and held for sale at December 31,
2003 consist predominantly of loans on properties subject to leases to
investment grade companies with credit ratings generally ranging from AA to BB
from Standard & Poor’s:
  December
      31,2004
    
    
    2003Principal
    
    $
    206,735
    
    $
    72,370Cost
      premium (unearned discount)
    
    
    1,158
    
    
    (740
    )Cost
      basis
    
    
    207,893
    
    
    71,630Mark
      to fair value on mortgage loans being hedged
    
    
    –
    
    
    343Carrying
      amount of mortgages
    
    
    207,893
    
    
    71,973Deferred
      origination fees, net
    
    
    (546
    )
    
    (216
    )Total
    
    $
    207,347
    
    $
    71,757
 At
December 31, 2004 and December 31, 2003, the mortgage loans carried interest
rates ranging from 4.71% to 10.00% and 4.71% to 8.10%, respectively.  At
December 31, 2004 and December 31, 2003, the weighted average effective interest
rate on the mortgage loans, as measured against our cost basis, was 6.56% and
6.36%, respectively.
  During
2000, the Company recorded a valuation provision of $2,000 related to a group of
mortgage loans with Rite Aid Corporation as the tenant under the related
leases.  During 2002, the provision was reduced by $83 due to the
prepayment of a Rite Aid loan. During 2003, the provision was eliminated in
connection with the sale of the remaining Rite aid loans held in portfolio.
 For the years ended December 31, 2003 and 2002 all scheduled principal and
interest payments remained current under the term of the Rite Aid mortgage
loans.  Interest income earned on the Rite Aid loans for the years ended
December 31, 2003 and 2002 was approximately $1,210 and $1,893,
respectively.  During 2003, the Company sold Rite Aid mortgage loans with
an aggregate principal amount of $24,920, and recorded a gain-on-sale of
$1,756.
  **5.**
    **Real
      estate investments**
  During
the year ended December 31, 2004, the Company acquired 9 real estate properties
for an aggregate purchase price of approximately $188 million. There were no
dispositions of real estate properties during 2004.
  69
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 
 Real
estate held for investment and related intangible liabilities on real estate
investments consisted of the following at December 31, 2004:
  December 31,2004Real
      estate investments, at cost:Land and improvements
    
    $
    28,226Building and improvements
    
    
    154,374Intangible assets under SFAS 141
    
    
    13,222Less: Accumulated depreciation
    
    
    (1,281
    )Real estate investments, net
    
    $
    194,541Intangible
      liabilities on real estate investments
    
    $
    7,028
 
 Some
leases provide for scheduled rent increases throughout the lease term. 
Such amounts are recognized on a straight-line basis over the terms of the
leases.  For the year ended December 31, 2004, the Company recognized $507
of such revenue.  At December 31, 2004, the balance of accrued rental
income was $507.  Amortization of intangible assets on real estate
investments totaled $295 for the year ended December 31, 2004 and is included in
“Depreciation and amortization expense” on the Company’s Consolidated Income
Statement.  Amortization of intangible liabilities on real estate
investments totaled $80 for the year ended December 31, 2004, and is included in
“Rental revenue” on the Company’s Consolidated Income Statement.
  Scheduled
amortization on existing intangible assets and liabilities on real estate
investments is as follows:
  Intangible
      Assets
    
    
    Intangible
      Liabilities2005
    
    $
    1,224
    
    $
    3962006
    
    
    1,224
    
    
    3962007
    
    
    1,224
    
    
    3962008
    
    
    1,224
    
    
    3962009
    
    
    1,224
    
    
    396Thereafter
    
    
    7,102
    
    
    5,048$
    13,222
    
    $
    7,028
 
 The
Company’s analysis of intangible assets and liabilities acquired in connection
with the acquisition of real estate properties is preliminary.
   70
 Capital
Lease Funding, Inc. and Subsidiaries
 Notes to
Consolidated Financial Statements
 (Dollar
amounts in thousands)
 
 December
31, 2004, 2003 and 2002
  **6.**
    **Securities
      and Structuring Fees Receivable**
  Securities
available for sale at December 31, 2004 and at December 31, 2003 consisted of
the following:
  Scheduled
    
    
    December
      31,Description
    
    
    Maturity
      Date
    
    
    2004
    
    
    2003Face
      amount-BSCMS 1999-CLF1, Class E (rated BB)
    
    
    Nov
      2023
    
    $
    3,326
    
    $
    3,326Face
      amount-BSCMS 1999-CLF1, Class F (rated B-)
    
    
    May
      2028
    
    
    2,494
    
    
    2,494Face
      amount-CALFS 1997-CTL1, Class D (rated BBB)
    
    
    Nov
      2018
    
    
    3,000
    
    
    –Face
      amount-CMLBC 2001-CMLB-1 Class E (rated BBB+)
    
    
    Nov
      2022
    
    
    9,526
    
    
    –Face
      amount-CMLBC 2001-CMLB-1 Class G (rated BBB-)
    
    
    Jul
      2023
    
    
    9,526
    
    
    –Face
      amount-CMLBC 2001-CMLB-1, Class H (rated BB)
    
    
    Jan
      2024
    
    
    11,907
    
    
    11,907Face
      amount-CMLBC 2001-CMLB-1, Class J (rated B)
    
    
    Aug
      2024
    
    
    7,144
    
    
    7,144Face
      amount-CMLBC 2001-CMLB-1, Class K (not rated)
    
    
    Oct
      2025
    
    
    4,766
    
    
    4,766Face
      amount-NLFC 1999 LTL1, Class D (rated BBB)
    
    
    Nov
      2022
    
    
    5,000
    
    
    5,000Face
      amount-NLFC 1999 LTL1, Class E (rated BB-)
    
    
    Apr
      2022
    
    
    11,081
    
    
    –Cost-NLFC
      1999 LTL1, Class X/IO (rated AAA)
    
    
    Jan
      2024
    
    
    9,908
    
    
    –Face
      amount-Yahoo, Inc. 6.65% Certificates (tenant rated BBB-)
    
    
    Aug
      2026
    
    
    16,999
    
    
    –Face
      amount-CVS Pass Through Certificates (tenant rated A-)
    
    
    Jan
      2023
    
    
    6,180
    
    
    –Face
      amount-BACMS 2002-2, Class V-1 (tenant is rated BBB)
    
    
    Sep
      2019
    
    
    361
    
    
    331Face
      amount-BACMS 2002-2, Class V-2 (tenant is rated BBB-)
    
    
    Jan
      2021
    
    
    553
    
    
    508Face
      amount-CREST 2001-1A, Class A (rated AAA)
    
    
    Nov
      2010
    
    
    –
    
    
    20,397Unearned
      discount
    
    
    
    
    
    (24,224
    )
    
    (17,907
    )Cost
      basis
    
    
    
    
    
    77,547
    
    
    37,966Unrealized
      appreciation on securities held for sale
    
    
    
    
    
    10,209
    
    
    2,088Total
    
    
    
    
    $
    87,756
    
    $
    40,054
 Unrealized
gains and losses on securities available for sale at December 31, 2004 and 2003
included as a component of other comprehensive income consisted of the
following:
  December
      31,2004
    
    
    2003Unrealized
      gains on securities available for sale
    
    
    10,266
    
    
    2,494Unrealized
      losses on securities available for sale
    
    
    (57
    )
    
    (406
    )
 At
December 31, 2004 and December 31, 2003, the effective interest rate (yield to
maturity on adjusted cost basis) on securities available for sale was 9.9% and
7.5%, respectively.  The investment in CREST 2001-1A bonds was made during
December 2003, and was subsequently sold during January 2004 at cost. 
There were no sales of securities during 2003 or 2002.  During the year
ended December 31, 2004, the Company sold $35.5 million of corporate securities
at cost that were held as temporary investments.
  Structuring
fees receivable of $4,426 and $5,223 at December 31, 2004 and December 31, 2003,
respectively, were earned by the Company in conjunction with the structuring and
subsequent sale of certain net lease loans.  Such fees are payable to the
Company monthly without interest through March 2020 and, accordingly, have been
discounted based on imputed interest rates estimated by management to
approximate market.  Structuring fees receivable are shown at their
amortized cost.
  At
December 31, 2004, the Company wrote-down its investment in BSCMS 1999-CLF1
Class F bonds to reflect an other-than-temporary impairment on this security, as
the result of the bankruptcy of Winn-Dixie during February 2005. 
Winn-Dixie is the tenant on two mortgage loans in the underlying CMBS
transaction.  One of the two stores and related mortgage loan was the
subject of a lease rejection by Winn-Dixie as part of its initial bankruptcy
filing in February 2005.  Management estimated the likely impact of the
lease rejection on the value of the Class F security, and as a result,
recognized a loss of $247, which is included in “Loss on securities” in the
Company’s Consolidated Income Statement.
   71
 Capital
Lease Funding, Inc. and Subsidiaries
 Notes to
Consolidated Financial Statements
 (Dollar
amounts in thousands)
 
 December
31, 2004, 2003 and 2002
  **7.**
    **Fair
      Value of Financial Instruments**
  For
certain of the Company’s financial instruments, fair values are not readily
available since there are no active trading markets as characterized by current
exchanges between willing parties.  Accordingly, the Company derives or
estimates fair values using various valuation techniques, such as computing the
present value of estimated future cash flows using discount rates commensurate
with the risks involved.  However, the determination of estimated cash
flows may be subjective and imprecise.  Changes in assumptions or
estimation methodologies can have a material effect on these estimated fair
values. In that regard, the derived fair value estimates may not be
substantiated by comparison to independent markets, and in many cases, may not
be realized in immediate settlement of the instrument.  The fair values
indicated below are indicative of the interest rate and credit spread
environment as of December 31, 2004, and may not take into consideration the
effects of subsequent interest rate, credit spread fluctuations, or changes in
the ratings of the tenant obligors under related credit tenant
leases.
  The fair
values of cash and cash equivalents, prepaid expenses and other assets (which
includes prepaid expenses, accrued interest receivable, and other assets),
accounts payable and accrued expenses, deposit and escrows, due to servicer and
dealers, and dividend payable approximate their carrying values due to the short
maturities of these items.
  The
carrying amounts and estimated fair values of the Company’s other financial
instruments at December 31, 2004 are as follows:
  CarryingAmount
    
    
    Notional
      Amount
    
    
    Estimated
      Fair
      ValueAssets:Mortgage
      loans held for investment
    
    $
    207,893
    
    $
    206,735
    
    $
    215,330Securities
      available for sale-CMBS
    
    
    87,756
    
    
    101,771
    
    
    87,756Structuring
      fees receivable
    
    
    4,426
    
    
    N/A
    
    
    4,426Derivative
      assets
    
    
    42
    
    
    4,868
    
    
    42Liabilities:Repurchase
      agreements
    
    
    133,831
    
    
    133,831
    
    
    133,831Mortgages
      on real estate investments
    
    
    111,539
    
    
    110,732
    
    
    110,574Derivative
      liabilities
    
    
    7,355
    
    
    228,182
    
    
    7,355
 
 The
methodologies used and key assumptions made to estimate fair values are as
follows:
  *Mortgage
loans held for investment* —The fair
value of our fixed-rate loan portfolio is estimated with a discounted cash flow
analysis, utilizing scheduled cash flows and discount rates estimated by
management to approximate those that a willing buyer and seller might
use.
  *Securities
available for sale* —The fair
value of securities available for sale is estimated by obtaining broker
quotations, where available, based upon reasonable market order indications or a
good faith estimate thereof.  For securities where market quotes are not
readily obtainable, management may also estimate values, and considers factors
including the credit characteristics and term of the underlying security, market
yields on securities with similar credit ratings, and sales of similar
securities, where available.
  72
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 *Structuring
fees receivable* —The fair
value of structuring fees receivable is estimated with a discounted cash flow
analysis, utilized scheduled cash flows and discount rates estimated by
management to approximate those that a willing buyer and seller might
use.
  *Repurchase
agreements* —Management
believes that the stated interest rates (all of which are floating rate, based
on short-term interest rates) approximate market rates (when compared to similar
credit facilities with similar credit risk).  As such, the fair value of
the repurchase agreements is estimated to equal the carrying amounts
(outstanding principal amounts) of the repurchase agreements.
  *Mortgages
on real estate investments* —The fair
value of mortgages payable on real estate investments is estimated using a
discounted cash flow analysis, based on management’s estimates of market
interest rates. For mortgages where the Company has an early prepayment right,
management also considers the prepayment amount to evaluate the fair
value.
  *Derivative
obligations and short sales of securities* —The fair
value of the Company’s derivative obligations and short sales of securities is
estimated using current market quotes and third-party quotations, where
available.
  **8.**
    **Repurchase
      Agreements**
  As of
December 31, 2004, the Company had repurchase agreements in place for short-term
liquidity requirements with Wachovia Bank, N.A. and Bank of America,
N.A.
  *Wachovia
Bank, N.A.*
  During
September 2004, the Company entered into a new master repurchase agreement with
Wachovia Bank, N.A. to finance its asset investments on a short-term basis prior
to obtaining long-term financing.  The master repurchase agreement replaced
the Company’s existing credit facilities with Wachovia Bank.  Under the
agreement, Caplease, LP and certain of the Company’s other subsidiaries will
sell assets to Wachovia Bank and agree to repurchase those assets on a date
certain at a repurchase price generally equal to the original purchase price
plus accrued but unpaid interest.  Wachovia Bank will purchase each asset
financed under the facility at a percentage of the asset’s value on the date of
origination (the purchase rate) and the Company will pay interest to Wachovia
Bank at prevailing short-term interest rates (one-month LIBOR) plus a pricing
spread.  The Company has agreed to a schedule of purchase rates and pricing
spreads with Wachovia Bank generally based upon the class and credit rating of
the asset financed.  The facility is recourse to the Company and CLF, Inc.
has agreed to guarantee all obligations of its subsidiaries under the
agreement.  For financial reporting purposes, the Company characterizes all
of the borrowings under the facility as on balance sheet financing
transactions.
  The
repurchase agreement is a $250 million uncommitted facility, meaning Wachovia
Bank must agree to each asset financed under the agreement.  The facility
may be increased to $450 million if requested by the Company and Wachovia Bank
agrees.
  The
agreement expires on September 21, 2005, but may be extended for not more than
two successive 364 day periods if requested by the Company and Wachovia
agrees.  The Company expects that it will request to renew the facility at
its 2005 expiration date.
  The
Company can finance each of its existing primary products under the agreement,
including commercial real estate whole loans, commercial mortgage backed
securities (“CMBS”) and acquisitions of commercial real estate.  Commercial
real estate acquisitions will be financed through mortgage loans made by
Caplease, LP to a subsidiary of Caplease, LP formed for the purpose of owning
the real property acquired followed by the sale of such mortgage loans to
Wachovia under the terms of the facility.  Unless otherwise agreed to by
Wachovia, for any asset financed under the facility for more than 240 days
Wachovia may  (a) require that the asset be removed from the facility or
(b) require all income generated by the asset be applied to reducing the
outstanding balance under the facility.
  73
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 
 The
agreement includes sublimits on certain asset classes and credit or tenant
concentrations.
  If at any
time (i) the repurchase price of any financed asset exceeds its asset value (as
defined in the agreement), (ii) either Standard & Poor’s or Moody’s
downgrades any asset financed under the facility or (iii) the aggregate
repurchase price of all financed assets exceeds the maximum facility size,
Wachovia Bank may require a repurchase of the assets or a contribution of
additional cash or other eligible assets to satisfy the difference.
  The
Company is required to maintain the following financial covenants during the
term of the agreement:
  ·
    liquidity
      (as defined in the agreement) of at least $8 million;
  and
  ·
    consolidated
      tangible net worth (as defined in the agreement) of at least $100 million
      (plus 75% of the aggregate net proceeds from future equity offerings or
      capital contributions).
  Wachovia
Investors, Inc., an affiliate of Wachovia Bank, owns approximately 3.7% of CLF,
Inc.’s outstanding common stock.  From time to time, the Company may sell
net lease assets to, or finance net lease assets on a long-term basis with,
Wachovia Bank or its affiliates on what management believes are fair market
terms.  In addition, Wachovia Bank acts as servicer of the Company’s net
lease loan assets and the transfer agent of CLF, Inc.’s common
stock.
  *Bank
of America, N.A.*
  Under the
terms of the Bank of America credit facility, the Company sells commercial
mortgage loans to Bank of America in exchange for funds to finance net lease
properties. Simultaneously with the sale of the loan, Bank of America sells the
Company a call option granting the Company the right to repurchase the
commercial mortgage loans from Bank of America. In addition, the Company has the
option to purchase Bank of America originated commercial mortgage loans and
contribute those loans to the credit facility. The interest rate on commercial
mortgage loans subject to the call option is set at one-month LIBOR plus
1.50%.
  As part
of this facility, Bank of America also may agree to finance the Company’s CMBS
investments. Each such CMBS financing matures after 30 days, but may be renewed
by Bank of America. Upon maturity of the financing, all related borrowings and
interest thereon must be repaid. The interest rate on CMBS borrowings is based
on the credit rating of the underlying bonds.
  As of
December 31, 2004, the Company had no amounts outstanding under its Bank of
America credit facility. On March 1, 2005, the facility expired
unused.
  74
 
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 
 Amounts
related to the Company’s credit facilities are as follows:
 December
      31, 2004
    
    
    December
      31, 2003BofA
      (a)
    
    
    Wachovia
    
    
    Total
    
    
    BofA
    
    
    Wachovia
    
    
    Total*Collateral
      face*Mortgage
      loans
    
    $
    22,800
    
    $
    136,477
    
    $
    159,277
    
    $
    29,562
    
    $
    42,808
    
    $
    72,370CMBS
    
    
    –
    
    
    41,130
    
    
    41,130
    
    
    5,000
    
    
    26,217
    
    
    31,217Total
    
    $
    22,800
    
    $
    177,607
    
    $
    200,407
    
    $
    34,562
    
    $
    69,025
    
    $
    103,587*Financing*Mortgage
      loans
    
    $
    –
    
    $
    102,288
    
    $
    102,288
    
    $
    26,702
    
    $
    34,734
    
    $
    61,436CMBS
    
    
    –
    
    
    31,543
    
    
    31,543
    
    
    2,063
    
    
    24,588
    
    
    26,651Total
    
    $
    –
    
    $
    133,831
    
    $
    133,831
    
    $
    28,765
    
    $
    59,322
    
    $
    88,087
 (a)
Collateral is pledged against interest rate swap positions with a national
amount of $73,025 at December 31, 2004
  Weighted average interest rates on the Company’s credit facilities for the
twelve months ended December 31, 2004 and 2003 are as follows:
 December
      31,2004
    
    
    2003Bank
      of America-mortgage loan repurchase agreements
    
    
    2.59
    %
    
    2.76
    %Bank
      of America-CMBS repurchase agreements
    
    
    1.90
    %
    
    2.01
    %Wachovia-mortgage
      loan repurchase agreements
    
    
    2.64
    %
    
    2.24
    %Wachovia-CMBS
      repurchase agreements
    
    
    2.48
    %
    
    3.21
    %
 As of
December 31, 2004 and 2003, the 1-month LIBOR rate was 2.40% and 1.12%,
respectively.  As of December 31, 2004, the Company was in compliance with
the terms of the repurchase agreements with its warehouse lenders.
  The
Company’s credit facilities generally carry maturities of less than one
year.  The Company does not anticipate any issues with renewing its
existing credit facility with Wachovia when it matures in September 2005. 
Regardless, however, the Company has a strong history of negotiating credit
facilities with lenders, and management is confident that it can find
replacement credit facilities if the need arises.
  **9.**
    **Risk
      Management Transactions**
  SFAS 133,
as amended and interpreted, establishes accounting and reporting standards for
derivative instruments, including certain derivative instruments embedded in
other contracts, and for hedging activities.  As required by SFAS 133, the
Company records all derivatives on the balance sheet at fair value.  The
accounting for changes in the fair value of derivatives depends on the intended
use of the derivative and the resulting designation.  Derivatives used to
hedge the exposure to changes in the fair value of an asset, liability, or firm
commitment attributable to a particular risk, such as interest rate risk, are
considered fair value hedges.  Derivatives used to hedge the exposure to
variability in expected future cash flows, or other types of forecasted
transactions, are considered cash flow hedges. A third category of derivatives,
hedges of net investments in foreign operations, is not used by the
Company.  The Company does not use derivatives for trading or speculative
purposes and does not currently have any derivatives that are not designated as
hedges.
  75
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 
 For
derivatives designated as fair value hedges, changes in the fair value of the
derivative and the hedged item related to the hedged risk are recognized in
earnings.  For derivatives designated as cash flow hedges, the effective
portion of changes in the fair value of the derivative is initially reported in
other comprehensive income (outside of earnings) and subsequently reclassified
to earnings when the hedged transaction affects earnings, and the ineffective
portion of changes in the fair value of the derivative is recognized directly in
earnings.  The Company assesses the effectiveness of each hedging
relationship by comparing the changes in fair value or cash flows of the
derivative hedging instrument with the changes in fair value or cash flows of
the designated hedged item or transaction.  Any hedge ineffectiveness is
recognized in the current period in loss on derivatives and short sales on the
statement of operations.
  The
Company’s objectives in using derivatives include adding stability to interest
expense and managing its exposure to interest rate movements.  For the
years ended December 31, 2004 and 2003, the Company has used risk management
transactions consisting of U.S. Treasury and Agency lock transactions (“Locks”),
and interest rate swaps.
  Prior to
CLF, Inc.’s conversion to a REIT on March 24, 2004, the Company used Locks to
hedge the interest rate risk associated with owning fixed rate mortgage loan
assets financed by floating rate debt.  Subsequent to REIT conversion, the
Company began using forward starting interest rate swaps to hedge the
variability of changes in the interest-related cash outflows on forecasted
future borrowings.  As of December 31, 2004, the Company was hedging its
exposure to such variability through February 2015.  In accordance with
SFAS 133, the Locks and interest rate swaps, to the extent that they have been
designated and qualify as part of a hedging relationship, are treated as fair
value hedges and cash flow hedges, respectively, for accounting
purposes.
  Interest
rate swaps are agreements between two parties to exchange, at particular
intervals, payment streams calculated on a specified notional amount.  The
interest rate swaps that the Company has entered into are single currency
interest rate swaps and, as such, do not require the exchange of a notional
amount.
  Amounts
related to open positions are as follows:
 December
      31, 2004
    
    December
      31, 2003*Description*
    
    
    Notional
      Amount
    
    
    Fair
      value
    
    
    Notional
      Amount
    
    
    Fair
      valueInterest
      rate swaps
    
    $
    228,182
    
    $
    (7,312
    )
    
    –
    
    
    –U.S.
      Treasury lock agreements
    
    
    –
    
    
    –
    
    
    10,700
    
    
    189U.S.
      Agency lock agreements
    
    
    –
    
    
    –
    
    
    28,700
    
    
    (673
    )Total
    
    $
    228,182
    
    $
    (7,312
    )
    $
    39,400
    
    $
    (484
    )
 At
December 31, 2004 and December 31, 2003, the Company had hedged the following
assets, firm commitments under rate lock agreements, and future
borrowings:
  December
      31,2004
    
    
    2003Mortgage
      loans held for sale (principal amount)
    
    $
    –
    
    $
    25,196Securities
      held for sale (principal amount)
    
    
    –
    
    
    331Future
      borrowings (principal amount)
    
    
    228,182
    
    
    –Total
    
    $
    228,182
    
    $
    25,527
  76
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 
 At
December 31, 2004 and 2003, respectively, derivatives with a fair value of
$7,355 and $484 were included in derivative liabilities on the Company’s balance
sheet.  At December 31, 2004, derivatives with a fair value of $42 were
included in derivative assets on the Company’s balance sheet.  The change
in net unrealized losses of $7,312 in 2004 for derivatives designated as cash
flow hedges is separately disclosed in the statement of changes in stockholders’
equity / members’ capital.
  The net
loss recognized in the loss on derivatives and short sales of securities in the
statement of operations for the year ended December 31, 2004 and December 31,
2003 related to hedge ineffectiveness was $0 and $4, respectively.  During
2004, the Company paid $2,375 to terminate an interest rate swap that was
hedging a future issuance of debt, which occurred after the termination of the
swap.  This amount had been deferred in accumulated other comprehensive
loss and will be reclassified into interest expense as the hedged interest
payments occur.  The Company reclassified $24 from accumulated other
comprehensive loss into interest expense in 2004 as hedged forecasted interest
payments related to the debt issuance actually occurred.  During 2005, the
Company estimates that an additional $1,057 will be reclassified as additional
interest expense.
  **10.**
    **Mortgages
      Notes on Real Estate Investments**
  Mortgage
notes payable collateralized by the respective properties (aggregating $153,690)
and assignment of leases at December 31, 2004 are as follows:
  Property
      Level Debt - Fixed Rate
    
    
    2004
    
    
    Interest
      Rate
    
    
    MaturityChoice,
      Silver Spring, MD
    
    $
    32,625
    
    
    5.30
    %
    
    May-13AON
      Corporation, Glenview, IL
    
    
    64,800
    
    
    5.23
    %
    
    Nov-14GSA,
      Ponce, PR (a)
    
    
    8,117
    
    
    6.47
    %
    
    Apr-16Walgreen
      Co., Pennsauken, NJ (b)
    
    
    2,347
    
    
    6.06
    %
    
    Oct-16Walgreen
      Co., Portsmouth, VA (c)
    
    
    3,650
    
    
    6.19
    %
    
    Jul-18Total
    
    $
    111,539
   (a) Face
amount of the debt outstanding at December 31 is $7,701, at a coupon of 7.30%.
The carrying amount on the financial statements reflects a prepayment premium of
$382 which was received from the seller at the time of purchase. The interest
rate shown in the above table reflects the effective interest rate to the
Company, as adjusted for the impact of the prepayment premium.
 
 (b) Face
amount of the debt outstanding at December 31 is $2,162, at a coupon of 7.65%.
The carrying amount on the financial statements reflects a premium based on the
fair value of the debt assumed at the purchase date. The interest rate shown in
the above table reflects the effective interest rate to the Company, as adjusted
for the impact of the fair value adjustment.
 
 (c) Face
amount of the debt outstanding at December 31 is $3,410, at a coupon of 7.20%.
The carrying amount on the financial statements reflects a premium based on the
fair value of the debt assumed at the purchase date. The interest rate shown in
the above table reflects the effective interest rate to the Company, as adjusted
for the impact of the fair value adjustment.
  Scheduled
principal amortization and balloon payments for mortgage notes payable for the
next five years and thereafter are as follows:
  Scheduled
      Amortization
    
    
    Balloon
      Payments
    
    
    Total2005
    
    $
    1,159
    
    $
    –
    
    $
    1,1592006
    
    
    1,323
    
    
    –
    
    
    1,3232007
    
    
    1,636
    
    
    –
    
    
    1,6362008
    
    
    2,832
    
    
    –
    
    
    2,8322009
    
    
    3,223
    
    
    –
    
    
    3,223Thereafter
    
    
    21,692
    
    
    79,674
    
    
    101,366$
    31,865
    
    $
    79,674
    
    $
    111,539
  77
 Capital
Lease Funding, Inc. and Subsidiaries
 Notes to
Consolidated Financial Statements
 (Dollar
amounts in thousands)
 
 December
31, 2004, 2003 and 2002
  **11.**
    **Related
      Party Transactions**
  Approximately
$81 was due from loans to employees as of December 31, 2004.
  Approximately
$41 was due from an affiliate of Hyperion Partners II L.P. (“HP”) as of December
31, 2003.  This amount was received in full during the year ended December
31, 2004.
  In 2000,
the Predecessor entered into a guarantee arrangement with HP, whereby HP agreed
to guarantee the Predecessor’s repurchase obligations with respect to twelve
mortgage loans with Rite Aid Corporation, with an aggregate balance of
approximately $34,700 and a carrying value of $33,800.  As part of the
financial guarantee from HP, the Predecessor agreed to reimburse HP for certain
of its costs incurred as a result of the financial guarantee.  During 2002,
the Company recorded a guarantee fee of $130 due to HP for the financial
guarantee.  The guarantee fee was paid to HP during 2003, and HP was
released from its guarantee during 2003.
  During
2001, certain executive officers of the Company purchased an equity interest in
a net lease property from a predecessor of the Company.  No gain or loss
was recorded on the transaction.  As of December 31, 2002, the Company held
a mortgage loan on that property, which carried a 6.95% interest rate. 
During 2003, the Company sold the mortgage loan into a Wachovia securitization
and realized a gain of $64.
  In
February 2001, the Company originated a net lease loan on a property owned by a
limited partnership in which certain executive officers of the Company have an
indirect ownership interest.  The loan was sold to Wachovia in February
2001, and the limited partnership agreed to pay the Company an advisory fee from
the rent payable by the tenant in the amount of approximately $66 a month until
November 2010.  The Company recognized a gain on the sale of the mortgage
loan of $4,963.  An affiliate of the limited partnership is also a party to
a management agreement with the tenant for the operation of the property, and
another affiliate of the limited partnership subleases a portion of the leased
building from the tenant at a nominal amount.  No failure to perform under
the management agreement or sublease entitles the tenant to any rent abatement
or termination under the lease.  Interest income earned on the structuring
fee receivable totaled approximately $312, $350, and $383, during the years
ended December 31, 2004, 2003, and 2002, respectively, and is included in
interest income in the accompanying income statements.
  On
November 1, 2004, Caplease, LP entered into two contracts of sale with HP. Under
the terms of the two contracts, the Company acquired HP’s beneficial interest in
two trusts.  Each trust’s sole asset is a free-standing Walgreen’s retail
store, one located in Portsmouth, Virginia and the second located in Pennsauken,
New Jersey.  Caplease, LP paid HP an aggregate purchase price of
approximately $7.2 million under the contracts, inclusive of the face amount of
debt assumed of approximately $5.6 million.  As required by the Company’s
conflict of interest policy, this transaction was approved by the Company’s
disinterested directors.  The Company recorded the mortgage loans assumed
in this purchase transaction at their respective fair values, totaling
approximately $6.0 million.
  For the
years ended December 31, 2003 and 2002, the Company classified Wachovia Bank as
a related party, because of its affiliate’s approximately 26.7% ownership in the
Predecessor.  Subsequent to the Company’s initial public offering, this
ownership was reduced to approximately 3.7%, and as such, the Company no longer
classifies Wachovia Bank as a related party. The Company has entered into a
servicing arrangement with Wachovia Bank.  Servicing fees paid to Wachovia
Bank during the years ended December 31, 2004, 2003, and 2002 were $32, $41, and
$33, respectively.  From time to time, the Company sells mortgage loans to
affiliates of Wachovia Bank.  Loans with aggregate face amounts of
approximately $0, $59,000 and $44,000 were sold to affiliates of Wachovia Bank
during the years ended December 31, 2004, 2003 and 2002, respectively. The
Company borrows from Wachovia Bank for mortgage loans on its real estate
investments.  Mortgage loans with aggregate face amounts of approximately
$97,425 were consummated with Wachovia Bank during the year ended December 31,
2004.  The Company has also entered into a repurchase agreement with
Wachovia (see Note 8 above).  During September 2004, the Company entered
into an agreement for an affiliate of Wachovia Bank to act as placement agent on
a secured debt issuance of approximately $268,500.
  78
 Capital
Lease Funding, Inc. and Subsidiaries
 Notes to
Consolidated Financial Statements
 (Dollar
amounts in thousands)
 
 December
31, 2004, 2003 and 2002
  **12.**
    **Commitments
      and Contingencies**
  As of
December 31, 2004, the Company was obligated under non-cancelable operating
lease agreements for office space and copy machines.  The future minimum
lease payments under these lease agreements at December 31, 2004
were:
 2005
    
    $
    5692006
    
    
    241$
    810
 Included
in general and administrative expense is rent expense of approximately $510,
$510, and $438, (net of sublease income of $60, $60, and $60) for the years
ended December 31, 2004, 2003 and 2002, respectively.
  The
Company is involved from time to time in litigation arising in the ordinary
course of business.  The Company is not involved in any matter, which
Management believes will have a material adverse effect on its business, results
of operations or financial conditions.  During the year ended December 31,
2004, the Company settled a routine litigation matter for $20, which was
recorded in the Company's Consolidated Income Statement under "General and
administrative expenses.”
  The
Company is obligated under a letter of credit with respect to one of its 1999
securitization transactions (BSCMS 1999-CLF1).  The maximum potential
amount of future required payments under the letter of credit is $2,850. 
The letter of credit expires on February 18, 2009.  The trustee may draw
the letter of credit if there are realized losses on the mortgage loans that
would create a shortfall in the interest or principal on any investment grade
certificate.  The letter of credit may be withdrawn when the ratings of the
investment grade certificates are no longer dependent upon the credit support
provided by the letter of credit.  As of December 31, 2004, there have been
no defaults and no losses on any of the mortgage loans in the collateral
pool.  During February 2005, one of the mortgage loans on a property net
leased to Winn-Dixie defaulted, as a result of the bankruptcy of
Winn-Dixie.  However, management does not expect any draw on the letter of
credit as a result of this mortgage default, or otherwise.  Letter of
credit fees included in interest expense were $100, $117, and $64 in 2004, 2003
and 2002, respectively.
  The
Company has outstanding commitments to fund mortgage loans of approximately
$1,979 related to certain of its development or joint-venture loans as of
December 31, 2004. As of December 31, 2004, advances of $837 had been made
against these commitments.
  **13.**
    **Stock
      Based Compensation**
  The
Company adopted an incentive stock compensation plan for its employees during
March 2004 in connection with its initial public offering.  The shares
issued under the stock plan are accounted for under Statement of Financial
Accounting Standards No. 123 ("SFAS No. 123"), " *Accounting
for Stock Based Compensation* ." 
The Company accounts for stock based compensation using the intrinsic value
method proscribed by Accounting Principles Board Opinion No. 25, “ *Accounting
for Stock Issued to Employees* ,”
(“APB25”) and related interpretations.  APB25 requires compensation cost to
be measured as the fair value of the Company’s stock less the amount, if any,
that the employee is required to pay.  During the year ended December 31,
2004, CLF, Inc. granted 383,766 shares of common stock to employees and
directors, simultaneous with the completion of its public equity offering. 
Of this total, 129,580 shares were immediately vested on the date of
grant.  During the year, 3,630 shares were granted to a new employee, and
3,630 shares were forfeited as a result of an employee termination.  The
balance of the remaining shares from the stock grants at CLF, Inc.’s initial
public offering (250,556 shares) vest over the two-year period ending March 24,
2006.  The shares granted subsequent to the public offering date (3,630)
vest over a three-year period from the date of initial grant.  For
accounting purposes, the Company measures compensation costs for these shares as
of the date of the grant and expenses such amounts against earnings, either at
the grant date (if no vesting period exists) or ratably over the respective
vesting period.  For the year ended December 31, 2004, compensation expense
of $2,378 was recorded in the Company's Consolidated Income Statement under
"General and administrative—stock based compensation expense."
  79
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 
 On
November 17, 2003, CLF, Inc. sold 139,134 shares to certain current and former
employees of the Predecessor for $0.10 per share.  The Company recorded no
compensation expense in connection with the issuance of the 139,134 shares,
since the fair value of the stock on the date of sale was equal to the $0.10 per
share purchase price.  Upon completion of CLF, Inc.’s initial public
offering on March 24, 2004, the difference between the public offering price per
share of $10.50 and the price at which these individuals purchased the shares
was recognized as a $1,447 expense (a component of General and
administrative—stock based compensation expense) in the Company's Consolidated
Income Statement.
  **14.**
    **Rental
      Income**
  CLF,
Inc., through its wholly-owned subsidiaries, is the lessor to tenants under
operating leases with expiration dates ranging from 2010 to 2019.  The
minimum rental amounts due under the leases are generally subject to scheduled
fixed increases.  The leases generally also require that the tenants pay
for or reimburse us for the occupancy and operating costs of the properties, or
in certain cases reimburse us for increases in certain operating costs and real
estate taxes above their base year costs.  Approximate future minimum rents
to be received over the next five years and thereafter for non-cancelable
operating leases in effect at December 31, 2004 for the properties are as
follows (in thousands):
 2005
    
    $
    15,4672006
    
    
    15,7432007
    
    
    16,0422008
    
    
    16,2372009
    
    
    15,771Thereafter
    
    
    101,026$
    180,286
 **15.**
    **Pro
      Forma Condensed Consolidated Income Statements****(Unaudited)**
  The
accompanying unaudited Pro Forma Condensed Consolidated Income Statements are
presented as if, at January 1, 2003, the Company acquired all of the properties
acquired during 2004.  Earnings per share are presented using the pro forma
shares outstanding during 2003, and the weighted average shares outstanding
during 2004.  In management's opinion, all adjustments necessary to reflect
the effects of the above transactions have been made.
  The
unaudited Pro Forma Condensed Consolidated Income Statements are not necessarily
indicative of what the actual results of operations would have been assuming the
acquisition transactions had occurred at the dates indicated above, nor do they
purport to represent our future results of operations.
  80
 Capital
Lease Funding, Inc. and Subsidiaries
 Notes to
Consolidated Financial Statements
 (Dollar
amounts in thousands)
 
 December
31, 2004, 2003 and 2002
 2004
    
    
    2003Total
      revenues
    
    $
    37,350
    
    $
    41,148Net
      income
    
    $
    4,301
    
    $
    11,420Net
      income per diluted common share
    
    $
    0.19
    
    $
    2.78
  **16.**
    **Concentration
      Risks**
  The
Company relies on its repurchase agreements with its lenders (including Wachovia
and Bank of America) to provide the majority of its cash for funding of
investments.  Deterioration in the financial condition of these financial
institutions could have a negative impact on the Company’s ability to continue
funding loans.  However, management is confident that alternative funding
sources could be obtained with substantially similar terms.  As of December
31, 2004, Wachovia carried an A rating and Bank of America carried an A+ rating,
each from Standard & Poor’s.
  Approximately
20% of revenue was derived from one tenant during 2004-Aon
Corporation.
  **17.**
    **401K
      Plan**
  The
Company has a 401(k) Savings/Retirement Plan (the “401(k) Plan”) in place to
cover eligible employees of the Company.  The 401(k) Plan permits eligible
employees of the Company to defer a portion of their annual compensation,
subject to certain limitations imposed by the Internal Revenue Service
Code.  The employee’s elective deferrals are immediately vested and
non-forfeitable upon contribution to the 401(k) Plan.  For the years ended
December 31, 2004, 2003, and 2002, the Company made matching contributions of
$241, $272, and $266, respectively.
  **18.**
    **Segment
      Reporting**
  SFAS No.
131, *Disclosures
about Segments of an Enterprise and Related Information* ,
establishes the manner in which public businesses report information about
operating segments in annual and interim financial reports issued to
stockholders.  SFAS No. 131 defines a segment as a component of an
enterprise about which separate financial information is available and that is
evaluated regularly to allocate resources and assess performance. The Company
conducts its business through two segments: net lease mortgage debt and
operating net lease real estate. For segment reporting purposes, we do not
allocate interest income on short-term investments or general and administrative
expenses.
  Selected
results of operations for the year ended December 31, 2004 are as
follows:
  Corporate
      /
      Unallocated
    
    
    Operating
      Net
      Lease
      Real
      Estate
    
    
    Lending
      InvestmentsTotal
      revenues
    
    $
    603
    
    $
    6,356
    
    $
    14,045Total
      expenses
    
    
    11,869
    
    
    4,206
    
    
    3,569Net
      income
    
    
    (11,266
    )
    
    2,150
    
    
    10,476Total
      assets
    
    
    31,454
    
    
    247,325
    
    
    302,923
 **19.**
    **Other
      Comprehensive Income**
  The
components of other comprehensive income for the years ended December 31, 2004,
2003 and 2002 are as follows (also see Notes 6 and 9):
  81
 Capital
Lease Funding, Inc. and Subsidiaries
 Notes to
Consolidated Financial Statements
 (Dollar
amounts in thousands)
 
 December
31, 2004, 2003 and 2002
 2004
    
    
    2003
    
    
    2002Net
      income
    
    $
    1,360
    
    $
    6,633
    
    $
    832Unrealized
      change in value on securities available for sale
    
    
    8,121
    
    
    (363
    )
    
    2,451Unrealized
      loss on derivatives
    
    
    (7,312
    )
    
    –
    
    
    –Realized
      loss on cash flow hedges
    
    
    (1,694
    )
    
    –
    
    
    –Other
      comprehensive income
    
    $
    475
    
    $
    6,270
    
    $
    3,283
 **20.**
    **Quarterly
      Financial Information (Unaudited)**
  The
following table sets forth the selected quarterly financial data for the Company
(in thousands, except per share amounts).
  Revenue
    
    
    Net
      income
      applicable
      to
      common
      shares
    
    
    Basic
      and
      diluted
      income
      per
      common share2004December
      31
    
    $
    11,223
    
    $
    3,101
    
    $
    0.11September
      30
    
    
    5,017
    
    
    2,007
    
    
    0.07June
      30
    
    
    2,799
    
    
    443
    
    
    0.02March
      31
    
    
    1,966
    
    
    (4,192
    )
    
    (0.71
    )2003December
      31
    
    
    4,535
    
    
    1,689
    
    
    0.41September
      30
    
    
    4,607
    
    
    3,678
    
    
    0.90June
      30
    
    
    6,426
    
    
    1,173
    
    
    0.29March
      31
    
    
    3,553
    
    
    93
    
    
    0.02
 The
totals for the year may differ from the sum of the quarters as a result of
weighting and rounding. Basic and diluted income per share are shown on a pro
forma basis for 2003.
 **21.**
    **Variable
      Interest Entities**
  In
January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB
Interpretation Number 46, “Consolidation of Variable Interest Entities.” FIN 46
was revised by FIN 46(R) in December 2003 (as revised, “FIN 46”).  FIN 46
defines a variable interest entity (“VIE”) as an entity with one or more of the
following characteristics:
  ·
    the
      equity investment at risk is not sufficient to permit the entity to
      finance its activities without additional subordinated financial support
      from other parties;
  ·
    equity
      holders either (a) lack direct or indirect ability to make decisions about
      the entity, (b) are not obligated to absorb expected losses of the entity
      or (c) do not have the right to receive expected residual returns of the
      entity if they occur; or
  ·
    equity
      holders have voting rights that are not proportionate to their economic
      interests, and the activities of the entity involve or are conducted on
      behalf of an investor with a disproportionately small voting
      interest.
  If an
entity is deemed to be a VIE, an enterprise that absorbs a majority of the
expected losses of the entity is considered the primary beneficiary and must
consolidate the VIE.
  82
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 
 Based on
the provisions of FIN 46, we have concluded that whenever we agree to purchase a
real estate property by agreeing to acquire the entity that owns the property
and pay the seller a deposit, a VIE is created if our deposit puts us, rather
than the equity owners, in a first loss position.  For each VIE created
with a deposit, we will compute expected losses and residual returns based on
the probability of future cash flows as outlined in FIN 46.  If we are
deemed to be the primary beneficiary of the VIE we will consolidate it on our
balance sheet.
  Management
believes FIN 46 was not clearly thought out for application in the real estate
industry for agreements to acquire a real property and the payment of a
deposit.  Under FIN 46, we can agree to purchase a property subject to
various conditions and put down a small deposit as a percentage of the purchase
price and still have to consolidate the entity.  We typically have the
right to a refund of our deposit under certain circumstances, including if we
determine not to proceed with the transaction for any reason during our due
diligence review period.  Therefore, our exposure to loss as a result of
our involvement with the VIE may only be the deposit, not its total assets
consolidated on the balance sheet.  In addition, if the VIE has creditors,
its debt will be placed on our balance sheet even though the creditors have no
recourse against our Company.  Based on these observations we believe
consolidating VIEs based on an agreement to acquire real property and payment of
a purchase price deposit does not reflect the economic realities or risks of the
transaction.
  On
December 23, 2004, we entered into a purchase and sale agreement to acquire an
office and technology center in Hanover Township, New Jersey for $48
million.  We paid the seller a deposit of $2.0 million.  The
acquisition subsequently closed on January 6, 2005.  We were required under
FIN 46 to consolidate this acquisition at December 31, 2004.  Our deposit
represents our maximum exposure to loss.  The fair value of the property,
representing the purchase price we agreed to pay, was reported on our balance
sheet as “Real estate investments consolidated under FIN 46.”  Liabilities
of the entity owning the property, which were retired in full at closing, were
$4.8 million at December 31, 2004, and were reported on our balance sheet as
“Mortgage on real estate investments consolidated under FIN 46.”  The net
balance of the assets and liabilities consolidated under FIN 46 for this VIE is
reported on our balance sheet as “Minority interest in real estate investments
consolidated under FIN 46.”  Creditors of the VIE have no recourse against
our Company.
  As part
of our developer loan program, we fund loans to an entity that owns an
undeveloped property.  These loans are used to finance pre-construction
costs related to the property, such as due diligence costs and land acquisition
contract deposits, rather than costs to build on the property.  We have
funded five such loans as of December 31, 2004, with an aggregate unpaid
principal amount of approximately $0.8 million as of that date.  We have
determined that our borrowers are VIEs under FIN 46.  However, because part
of our collateral for these loans is a personal guarantee from each entity’s
equity owner, we are not considered the primary beneficiary of these entities
and, therefore, we are not required to consolidate them under FIN
46.
  During
2004, we also funded a long-term credit tenant loan to an entity owning a
property leased to Home Depot USA, Inc. in Westminster, Colorado.  Our
carry value on this loan was approximately $8.6 million as of December 31,
2004.  In connection with funding the loan, we acquired the right to
participate in any gain upon sale of the underlying property.  The borrower
entity similarly meets the criteria for a VIE under FIN 46, because the equity
owners of the entity are required to share 25% of their expected residual
returns with us.  However, because we are not the primary beneficiary, we
are not required to consolidate it.
  **22.**
    **Subsequent
      Events**
  During
January 2005, CLF, Inc. paid a dividend of $0.15 per common share outstanding,
or approximately $4.1 million in aggregate, to its stockholders of record as of
December 31, 2004.
  83
 Capital
Lease Funding, Inc. and Subsidiaries
Notes to
Consolidated Financial Statements
(Dollar
amounts in thousands)

December
31, 2004, 2003 and 2002
 
 During
January 2005, the Company acquired a commercial property located in Whippany, NJ
for $48 million in cash.  The Company had previously consolidated the
assets, liabilities, revenues and expenses of the property in 2004 under
FIN46.  During February 2005, the Company obtained a $36.0 million mortgage
financing on the property, at an effective interest rate of 5.26%.  The
loan matures in March 2015.  The proceeds from this financing will be used
by the Company to fund future asset investments.
  The
Company’s repurchase agreement with Bank of America expired during March
2005.  The Company chose not to renew the existing facility.  All
obligations related to the repurchase agreement were satisfied.
  During
March 2005, the Company completed a long-term secured debt financing on a
portfolio certain of its real estate, securities and mortgage loan
investments.  In connection with this financing, the Company issued $252
million of 4.926 % notes, and $16.5 million of 5.036% notes.  The stated
maturity of the notes is in January 2040, but the notes are expected to mature
in January 2015.  Inclusive of debt issuance and hedge costs, the effective
blended financing rate on the notes was approximately 5.63%.
  During
March 2005, the Company declared a dividend of $0.18 per common share
outstanding, or approximately $5.0 million in aggregate, payable on April 15,
2005 to its stockholders of record as of March 31, 2005.
  
 84
 
 **Capital
Lease Funding, Inc. and Subsidiaries**
 **Real
Estate and Accumulated Depreciation**
 **December
31, 2004**
 **(amounts
in thousands)**
 ****
 **Schedule
III**
 **Column
      A**
    
    **Column
      B**
    
    **Column
      C**
    
    **Column
      D**
    
    **Column
      E**
    
    **Column
      F**
    
    **Column
      G**
    
    **Column
      H**
    
    **Column
      I****Initial
      Cost**
    
    **Cost
      Capitalized**
      **Subsequent
      to Acquisition**
    
    **Gross
      Amount at Which Carried****at Close of
      Period****Description**
    
    **Encumbrances**
    
    **Land**
    
    **Building
      and Improvements**
    
    **Land**
    
    **Building
      and Improvements**
    
    **Land**
    
    **Building
      and Improvements**
    
    **Total**
    
    **Accumulated
      Depreciation**
    
    **Date
      of Construction**
    
    **Date**
      **Acquired**
    
    **Life
      on Which**
      **Depreciation**
      **is
      Computed**Abbott
      Labs, Columbus, OH
    
    $
    –
    
    $
    1,025
    
    $
    11,040
    
    $
    –
    
    $
    –
    
    $
    1,025
    
    $
    11,040
    
    $
    12,065
    
    $
    52
    
    
    
    
    
    11/5/2004
    
    
    40
      yrsAON
      Corporation, Glenview, IL
    
    
    64,800
    
    
    11,000
    
    
    75,774
    
    
    –
    
    
    –
    
    
    11,000
    
    
    75,774
    
    
    86,774
    
    
    840
    
    
    
    
    
    8/19/2004
    
    
    40
      yrsBaxter
      International Inc., Bloomington, IN
    
    
    –
    
    
    1,200
    
    
    9,579
    
    
    –
    
    
    –
    
    
    1,200
    
    
    9,579
    
    
    10,779
    
    
    57
    
    
    
    
    
    10/13/2004
    
    
    40
      yrsBobs
      Store, Randolph, MA
    
    
    –
    
    
    6,300
    
    
    7,801
    
    
    –
    
    
    –
    
    
    6,300
    
    
    7,801
    
    
    14,101
    
    
    50
    
    
    
    
    
    9/29/2004
    
    
    40
      yrsChoice
      Hotels International,
      Silver
      Spring, MD
    
    
    32,625
    
    
    5,500
    
    
    40,113
    
    
    –
    
    
    –
    
    
    5,500
    
    
    40,113
    
    
    45,613
    
    
    138
    
    
    
    
    
    11/23/2004
    
    
    40
      yrsCrozer-Keystone
      Health System, Ridley, PA
    
    
    –
    
    
    –
    
    
    5,015
    
    
    –
    
    
    174
    
    
    –
    
    
    5,188
    
    
    5,188
    
    
    50
    
    
    
    
    
    8/9/2004
    
    
    40
      yrsGeneral
      Services Administration, Ponce, Puerto Rico
    
    
    8,117
    
    
    2,120
    
    
    11,563
    
    
    –
    
    
    –
    
    
    2,120
    
    
    11,563
    
    
    13,683
    
    
    64
    
    
    
    
    
    11/1/2004
    
    
    40
      yrsWalgreen,
      Pennsauken, NJ
    
    
    2,347
    
    
    463
    
    
    2,789
    
    
    –
    
    
    –
    
    
    463
    
    
    2,789
    
    
    3,252
    
    
    13
    
    
    
    
    
    11/1/2004
    
    
    40
      yrsWalgreen,
      Portsmouth, VA
    
    
    3,650
    
    
    618
    
    
    3,750
    
    
    –
    
    
    –
    
    
    618
    
    
    3,750
    
    
    4,367
    
    
    17
    
    
    
    
    
    11/1/2004
    
    
    40
      yrs$
    111,539
    
    $
    28,226
    
    $
    167,424
    
    $
    –
    
    $
    174
    
    $
    28,226
    
    $
    167,597
    
    $
    195,822
    
    $
    1,281




85




**Capital
Lease Funding, Inc. and Subsidiaries**
 **Real
Estate and Accumulated Depreciation**
 **December
31, 2004**
 **(amounts
in thousands)**
 **Schedule
III—(Continued)**
 **Real
      Estate**Balance-January
      1, 2004
    
    
    
    
    $
    -Additions
      during the year:Property
      Acquisitions
    
    
    195,648Cost
      Capitalized Subsequent to Acquisition
    
    
    174Balance-December
      31, 2004
    
    
    
    
    $
    195,822**Accumulated
      Depreciation**Balance-January
      1, 2004
    
    
    
    
    $
    -Additions
      during the year:Depreciation
      on property
    
    
    1,281Balance-December
      31, 2004
    
    
    
    
    $
    (1,281
    )


86
 ****
 ****Capital
Lease Funding, Inc. and Subsidiaries**Schedule of Mortgage
Loans on Real Estate**
 **December
31, 2004**
 **(amounts
in thousands)**
 ****
 **Schedule
IV**
 **Description**
    
    **Location**
    
    **InterestRate**
    
    **Final**
      **Maturity**
      **Date**
    
    **Periodic
      Payment Terms**
    
    **Prior
      Liens**
    
    **Face
      Amount of Mortgages**
    
    **Carrying
      Amount of Mortgages(2)**
    
    **Principal
      Amount of Loans Subject to Delinquent Principal or
      Interest*****Long-Term
      Credit Tenant Loans***Autozone
    
    Douglas
      and Valdosta, GA
    
    
    6.500
    %
    
    Nov
      2022
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    $
    2,103
    
    $
    2,103
    
    $
    –Best
      Buy
    
    Chicago,
      IL
    
    
    6.430
    %
    
    Mar
      2025
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    17,609
    
    
    17,609
    
    
    –City
      of Jasper
    
    Jasper,
      TX
    
    
    7.000
    %
    
    Nov
      2024
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    1,736
    
    
    1,681
    
    
    –CVS
    
    Asheville,
      NC
    
    
    6.530
    %
    
    Jan
      2026
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    2,336
    
    
    2,405
    
    
    –CVS
    
    Athol,
      MA
    
    
    6.460
    %
    
    Jan
      2025
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    1,501
    
    
    1,501
    
    
    –CVS
    
    Bangor,
      PA
    
    
    6.280
    %
    
    Jan
      2026
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    2,472
    
    
    2,426
    
    
    –CVS
    
    Bluefield,
      WV
    
    
    8.000
    %
    
    Jan
      2021
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    1,354
    
    
    1,493
    
    
    –CVS
    
    Oak
      Ridge, NC
    
    
    6.990
    %
    
    Aug
      2024
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    3,224
    
    
    3,224
    
    
    –CVS
    
    Sunbury,
      PA
    
    
    7.500
    %
    
    Jan
      2021
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    1,699
    
    
    1,654
    
    
    –CVS
    
    Washington,
      DC
    
    
    8.100
    %
    
    Jan
      2023
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    2,569
    
    
    2,760
    
    
    –Home
      Depot
    
    Tullytown,
      PA
    
    
    6.620
    %
    
    Jan
      2033
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    8,444
    
    
    8,444
    
    
    –Home
      Depot
    
    Westminster,
      CO
    
    
    7.500
    %
    
    May
      2009
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    8,581
    
    
    8,581
    
    
    –Kohl’s
      Department Stores
    
    Chicago,
      IL
    
    
    6.690
    %
    
    Sep
      2030
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    48,270
    
    
    48,270
    
    
    –Koninklijke
      Ahold n.v.
    
    N.
      Kingstown, RI
    
    
    7.500
    %
    
    Nov
      2025
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    6,693
    
    
    6,671
    
    
    –Koninklijke
      Ahold n.v.
    
    Tewksbury,
      MA
    
    
    7.500
    %
    
    Jan
      2027
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    6,572
    
    
    6,567
    
    
    –Koninklijke
      Ahold n.v.
    
    Upper
      Darby Township, PA
    
    
    7.290
    %
    
    Apr
      2024
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    6,799
    
    
    6,475
    
    
    –Lowe’s
    
    Matamoras,
      PA
    
    
    6.610
    %
    
    May
      2030
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    7,196
    
    
    7,196
    
    
    –National
      City Bakn
    
    Chicago,
      IL
    
    
    5.890
    %
    
    Dec
      2024
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    3,114
    
    
    3,202
    
    
    –Neiman
      Marcus
    
    Las
      Vegas, NV
    
    
    6.060
    %
    
    Nov
      2021
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    7,900
    
    
    8,602
    
    
    –United
      States Postal Service
    
    Scammon
      Bay, AK
    
    7.050
    %
    
    Oct
      2021
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    986
    
    
    1,008
    
    
    –University
      of Connecticut
    
    Farmington,
      CT
    
    
    6.340
    %
    
    Nov
      2024
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    22,752
    
    
    23,667
    
    
    –Walgreen
    
    Dallas,
      TX
    
    
    6.460
    %
    
    Dec
      2029
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    2,718
    
    
    2,718
    
    
    –***Corporate
      Credit Notes***Albertson's
    
    Los
      Angeles, CA
    
    
    6.500
    %
    
    Sep
      2013
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    398
    
    
    354
    
    
    –Albertson's
    
    Norwalk,
      CA
    
    
    6.330
    %
    
    Dec
      2013
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    436
    
    
    430
    
    
    –Best
      Buy
    
    Olathe,
      KS
    
    
    5.400
    %
    
    Jun
      2013
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    1,595
    
    
    1,512
    
    
    –Best
      Buy
    
    Wichita
      Falls, TX
    
    
    6.150
    %
    
    Nov
      2012
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    631
    
    
    593
    
    
    –CVS
    
    Clemmons,
      NC
    
    
    5.540
    %
    
    Jan
      2015
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    285
    
    
    271
    
    
    –CVS
    
    Commerce,
      MI
    
    
    5.850
    %
    
    May
      2013
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    448
    
    
    429
    
    
    –CVS
    
    Garwood,
      NJ
    
    
    6.120
    %
    
    Aug
      2013
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    791
    
    
    764
    
    
    –CVS
    
    Kennett
      Square, PA
    
    
    6.400
    %
    
    Oct
      2012
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    716
    
    
    685
    
    
    –CVS
    
    Knox,
      IN
    
    
    7.600
    %
    
    Dec
      2011
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    250
    
    
    249
    
    
    –CVS
    
    Rockingham,
      NC
    
    
    6.120
    %
    
    Oct
      2013
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    397
    
    
    386
    
    
    –CVS
    
    Rutherford
      College, NC
    
    
    6.120
    %
    
    Oct
      2013
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    N/A
    
    
    321
    
    
    312
    
    
    –Federal
      Express
    
    McCook,
      IL
    
    
    5.890
    %
    
    Feb
      2015
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    N/A
    
    
    2,737
    
    
    2,699
    
    
    –Federal
      Express
    
    Reno,
      NV
    
    
    5.900
    %
    
    Oct
      2014
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    N/A
    
    
    1,357
    
    
    1,341
    
    
    –PerkinElmer
    
    Beltsville,
      MD
    
    
    7.350
    %
    
    Dec
      2011
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    547
    
    
    542
    
    
    –PerkinElmer
    
    Daytona
      Beach, FL
    
    7.350
    %
    
    Dec
      2011
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    248
    
    
    246
    
    
    –PerkinElmer
    
    Phelps,
      NY
    
    
    7.350
    %
    
    Dec
      2011
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    231
    
    
    225
    
    
    –PerkinElmer
    
    Warwick,
      RI
    
    
    7.680
    %
    
    Jan
      2012
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    735
    
    
    716
    
    
    –Staples
    
    Odessa,
      TX
    
    
    6.410
    %
    
    Sep
      2012
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    342
    
    
    321
    
    
    –Walgreen
    
    Delray
      Beach, FL
    
    6.200
    %
    
    Jan
      2013
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    508
    
    
    505
    
    
    –Walgreen
    
    Riverside,
      CA
    
    
    6.100
    %
    
    Dec
      2013
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    529
    
    
    515
    
    
    –Walgreen
    
    Waterford,
      MI
    
    
    5.500
    %
    
    Jun
      2013
    
    Principal
      and Interest are payable monthly at a level amount, over the life to
      maturity
    
    
    N/A
    
    
    842
    
    
    780
    
    
    –***Recapitalized
      Loans***Natural
      Gas Pipeline Company of America
    
    Lombard,
      IL
    
    
    5.970
    %
    
    Jun
      2007
    
    Principal
      and Interest are payable semi-annually at a varying amount, over the life
      to maturity
    
    
    N/A
    
    
    11,724
    
    
    11,724
    
    
    –Xerox
    
    El
      Segundo, CA
    
    
    4.712
    %
    
    Nov
      2007
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    13,202
    
    
    13,202
    
    
    –***Development
      Loans***
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    –Walgreen
    
    Bristol,
      CT
    
    
    10.000
    %
    
    Dec
      2006
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    20
    
    
    20
    
    
    –Walgreen
    
    Jackson,
      NJ
    
    
    10.000
    %
    
    Dec
      2006
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    128
    
    
    128
    
    
    –Walgreen
    
    Mansfield,
      NJ
    
    
    10.000
    %
    
    Dec
      2006
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    130
    
    
    130
    
    
    –Walgreen
    
    Staten
      Island, NY
    
    
    10.000
    %
    
    Dec
      2006
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    214
    
    
    214
    
    
    –Walgreen
    
    Tinley
      Park, IL
    
    
    10.000
    %
    
    Dec
      2006
    
    Principal
      and Interest are payable monthly at a varying amount, over the life to
      maturity
    
    
    N/A
    
    
    345
    
    
    345
    
    
    –Totals
    
    $
    206,735
    
    $
    207,893
    
    $
    –
  (1) This
loan carries interest at a variable rate, adjusted monthly, equal to 1 month
LIBOR+3.25%.
 (2) The
aggregate cost for Federal income tax purposes is $207,893.
 87
  ****Capital
Lease Funding, Inc. and Subsidiaries**Schedule of Mortgage
Loans on Real Estate**
 **December
31, 2004**
 **(amounts
in thousands)**
 **Schedule
IV—(Continued)**
 Balance-January
      1, 2002
    
    
    
    
    $
    84,513Additions
      during the year:New
      mortgage loans
    
    
    141,476Reduction
      in valuation provision
    
    
    83Mark
      to fair value
    
    
    100Deductions
      during the year:Principal
      received
    
    
    (3,904
    )Loans
      sold
    
    
    (144,276
    )Balance-December
      31, 2002
    
    
    
    
    $
    77,992Additions
      during the year:New
      mortgage loans
    
    
    143,566Reduction
      in valuation provision
    
    
    1,917Mark
      to fair value
    
    
    (857
    )Deductions
      during the year:Principal
      received
    
    
    (2,381
    )Loans
      sold
    
    
    (148,264
    )Balance-December
      31, 2003
    
    
    
    
    $
    71,973Additions
      during the year:New
      mortgage loans
    
    
    167,009Mark
      to fair value
    
    
    (343
    )Fair
      value hedges allocated to unearned origination discounts and
      premiums
    
    
    2,403Deductions
      during the year:Principal
      received
    
    
    (8,521
    )Loans
      sold
    
    
    (24,628
    )Balance-December
      31, 2004
    
    
    
    
    $
    207,893
   88


**Item
9.** **Changes
in and Disagreements With Accountants on Accounting and Financial
Disclosure.**




None.





**Item
9A.** **Controls
and Procedures.**




We
maintain disclosure controls and procedures (as defined under Rule 13a-15(e)
under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that
are designed to ensure that information required to be disclosed in our Exchange
Act reports is recorded, processed, summarized and reported within the time
periods specified in the SEC’s rules and forms, and that such information is
accumulated and communicated to our management, including our Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow timely decisions
regarding required disclosure.




Pursuant
to Rule 13a-15(b) under the Exchange Act, we carried out an evaluation, with the
participation of management, including our Chief Executive Officer and Chief
Financial Officer, of the effectiveness of our disclosure controls and
procedures as of the end of the period covered by this report. Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that our disclosure controls and procedures were effective.




There has
been no change in our internal control over financial reporting during the
quarter ended December 31, 2004, that has materially affected, or is reasonably
likely to materially affect, our internal control over financial
reporting.




**Item
9B.** **Other
Information.**




None.




89




**PART
III.**




**Item
10.** **Directors
and Executive Officers of the Registrant.** *****




The
information required by Item 10 is incorporated by reference herein to the
information contained in our definitive proxy statement related to our 2005
annual meeting of stockholders.




Because
our common stock is listed on the NYSE, Paul H. McDowell, our chief executive
officer, certified to the NYSE on October 25, 2004, pursuant to Section 303A.12
of the NYSE’s listing standards, that he was not aware of any violation by us of
the NYSE’s corporate governance listing standards as of that date. We also have
filed as exhibits to this Annual Report on Form 10-K the certifications of our
chief executive officer and our chief financial officer required by Sections 302
and 906 of the Sarbanes-Oxley Act of 2002.




**Item
11.** **Executive
Compensation.** *****


The
information required by Item 11 is incorporated by reference herein to the
information contained in our definitive proxy statement related to our 2005
annual meeting of stockholders.




**Item
12.** **Security
Ownership of Certain Beneficial Owners and Management.** *****




The
information required by Item 12 is incorporated by reference herein to the
information contained in our definitive proxy statement related to our 2005
annual meeting of stockholders.




**Item
13.** **Certain
Relationships and Related Transactions.** *****




The
information required by Item 13 is incorporated by reference herein to the
information contained in our definitive proxy statement related to our 2005
annual meeting of stockholders.




**Item
14.** **Principal
Accounting Fees and Services.** *****




The
information required by Item 14 is incorporated by reference herein to the
information contained in our definitive proxy statement related to our 2005
annual meeting of stockholders.




90


**PART
IV.**




**Item
15.** **Exhibits
and Financial Statement Schedules** **.**




**(a)
and (d)**




The
consolidated financial statements and supplementary data (including financial
statement schedules) are included in this report under Item 8 of Part II
hereof.




See the
exhibit index included herein for a list of exhibits to this report.







91





**(c)
Exhibits**




The
following is a list of exhibits filed as part of this annual report on Form
10-K. Where so indicated, exhibits that were previously filed are incorporated
by reference.




**Exhibit****No.**
    **Description**3.1(1)
    Articles
      of Amendment and Restatement of the registrant3.2(1)
    Amended
      and Restated Bylaws of the registrant4.1(1)
    Form
      of Certificate evidencing the Common Stock, par value $0.01 per share, of
      the registrant10.1(2)
    Purchase
      and Sale Agreement, dated January 31, 2000 between Capital Lease Funding,
      L.P., CLFC HPII Inc., CLF Holdings, Inc. and Bank of America, N.A.
      (Capital Lease Funding, L.P.’s interest was assigned to Capital Lease
      Funding, LLC on November 15, 2001)10.2(2)
    Call
      Option Agreement, dated January 31, 2000 between Bank of America, N.A.,
      Capital Leasing Funding, L.P. and CLFC HPII Inc. (Capital Lease Funding,
      L.P.’s interest was assigned to Capital Lease Funding, LLC on November 15,
      2001)10.3(2)
    Security
      Agreement, dated January 31, 2000 between Capital Lease Funding, L.P. and
      Bank of America, N.A. (Capital Lease Funding, L.P.’s interest was assigned
      to Capital Lease Funding, LLC on November 15, 2001)10.4(2)
    Loan
      Contribution Agreement, dated January 31, 2000 between Bank of America,
      N.A. and Capital Lease Funding, L.P. (Capital Lease Funding, L.P.’s
      interest was assigned to Capital Lease Funding, LLC on November 15,
      2001)10.5(2)
    Amendment
      to Purchase and Sale Agreement, Call Option Agreement, Loan Contribution
      Agreement and Security Agreement, dated April 30, 2002 between Capital
      Lease Funding, LLC, CLFC HPII Inc. and Bank of America, N.A.10.6(2)
    Second
      Amendment to Purchase and Sale Agreement, Call Option Agreement, Loan
      Contribution Agreement and Security Agreement, dated February 28, 2003
      between Capital Lease Funding, LLC, CLFC HPII Inc. and Bank of America,
      N.A.10.7(3)
    Third
      Amendment to Purchase and Sale Agreement, Call Option Agreement, Loan
      Contribution Agreement and Security Agreement, dated December 31, 2003
      between Capital Lease Funding, LLC, CLFC HPII Inc. and Bank of America,
      N.A.10.8(2)
    Contribution
      Agreement, dated as of November 20, 2003 between the registrant, Hyperion
      CLF LLC, LSR Capital CLF LLC, Wachovia Affordable Housing Community
      Development Corporation, Wachovia Investors, Inc. and CLF Management I,
      LLC10.9(2)
    Registration
      Rights Agreement, dated as of November 20, 2003 between the registrant and
      Hyperion CLF LLC, LSR Capital CLF LLC and Wachovia Investors,
      Inc.10.10(4)
    Agreement
      of Purchase and Sale, dated July 14, 2004, between Caplease, LP and NEDA
      Puerto Rico, Inc.10.11(4)
    First
      amendment of Purchase and Sale, dated August 13, 2004, between Caplease,
      LP and NEDA Puerto Rico, Inc.10.12(4)
    Second
      amendment of Purchase and Sale, dated September 15, 2004, between
      Caplease, LP and NEDA Puerto Rico, Inc.10.13(4)
    Third
      amendment of Purchase and Sale, dated September 29, 2004, between CLF VA
      Ponce LLC and NEDA Puerto Rico, Inc.10.14(4)
    Fourth
      amendment of Purchase and Sale, dated October 6, 2004, between CLF VA
      Ponce LLC and NEDA Puerto Rico, Inc.10.15(4)
    Fifth
      amendment of Purchase and Sale, dated October 28, 2004, between CLF VA
      Ponce LLC and NEDA Puerto Rico, Inc.10.16(5)
    Agreement
      of Purchase and Sale, dated July 15, 2004, between Caplease, LP and 1000
      Milwaukee Avenue Owner Corp.10.17(6)
    Master
      Repurchase Agreement, dated September 22, 2004 between the registrant,
      Wachovia Bank, National Association, Caplease, LP and Certain
      Special-Purpose Entity Subsidiaries thereof10.18(7)
    Promissory
      Note (Note A), dated October 28, 2004, of CLF 1000 Milwaukee Avenue LLC in
      favor of Wachovia Bank, National Association
  92
  **Exhibit****No.**
    **Description**
 10.19(7)
    Promissory
      Note (Note B), dated October 28, 2004, of CLF 1000 Milwaukee Avenue LLC in
      favor of Caplease, LP10.20(8)
    Promissory
      Note, dated December 9, 2004, of the registrant in favor of Wachovia Bank,
      National Association10.21(9)
    Agreement
      of Purchase and Sale, dated December 23, 2004, between Caplease, LP and
      WXV/Whippany, LLC*10.22
    Form
      of Employment Agreement between each of Paul H. McDowell, William R.
      Pollert, Shawn P. Seale, Robert C. Blanz and Michael J. Heneghan, and the
      registrant*10.23(10)
    Capital
      Lease Funding, Inc. 2004 Stock Incentive Plan*10.24(10)
    Form
      of Non-Employee Director Restricted Stock Award Agreement*10.25(10)
    Form
      of Executive Officer Restricted Stock Agreement10.26
    Purchase
      and Sale Agreement dated as of October 22, 2004 between Caplease, LP and
      10720-10750-10770 Columbia Pike Investors LLC10.27
    Contract
      of Sale dated as of November 1, 2004 between Caplease, LP and Hyperion
      Partners II L.P. (Portsmouth, VA)10.28
    Contract
      of Sale dated as of November 1, 2004 between Caplease, LP and Hyperion
      Partners II L.P. (Pennsauken, NJ)10.29(11)
    Promissory
      Note, dated February 25, 2005, of CLF Parsippany LLC in favor of Wachovia
      Bank, National Association10.30(11)
    Promissory
      Note, dated February 25, 2005, of CLF Parsippany LLC in favor of Caplease,
      LP*10.31(11)
    Summary
      of Compensation for the Chief Executive Officer and each of the Named
      Executive Officers for Fiscal 2005*10.32(12)
    Summary
      of Independent Director Compensation for Fiscal 200521.1
    List
      of Subsidiaries23.1
    Consent
      of Ernst & Young LLP31.1
    Certification
      of Chief Executive Officer required by Rule 13a-14(a)/15d-14(a) of the
      Securities Exchange Act of 1934, as amended as adopted pursuant to Section
      302 of the Sarbanes-Oxley Act of 200231.2
    Certification
      of the Chief Financial Officer required by Rule 13a-14(a)/15d-14(a) of the
      Securities Exchange Act of 1934, as amended as adopted pursuant to Section
      302 of the Sarbanes-Oxley Act of 200232.1
    Certification
      of the registrant’s Chief Executive Officer pursuant to 18 U.S.C. 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      200232.2
    Certification
      of the registrant’s Chief Financial Officer pursuant to 18 U.S.C. 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002
  *
    Denotes
      compensatory plans or arrangement or management contracts required to be
      filed as exhibits to this Annual Report on Form 10-K.(1)
    Incorporated
      by reference from the registrant’s Amendment No. 4 to Registration
      Statement on Form S-11 filed with the Securities and Exchange Commission
      on March 8, 2004 (File No. 333-110644).(2)
    Incorporated
      by reference from the registrant’s Amendment No. 1 to Registration
      Statement on Form S-11 filed with the Securities and Exchange Commission
      on January 12, 2004 (File No. 333-110644).(3)
    Incorporated
      by reference from the registrant’s Amendment No. 2 to Registration
      Statement on Form S-11 filed with the Securities and Exchange Commission
      on February 13, 2004 (File No. 333-110644).(4)
    Incorporated
      by reference from the registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on November 5,
  2004.(5)
    Incorporated
      by reference from the registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on September 3,
    2004.(6)
    Incorporated
      by reference from the registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on September 24,
    2004.
  93
  (7)
    Incorporated
      by reference from the registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on November 3,
  2004.(8)
    Incorporated
      by reference from the registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on December 15,
    2004.(9)
    Incorporated
      by reference from the registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on January 11,
  2005.(10)
    Incorporated
      by reference from the registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on February 17,
    2005.(11)
    Incorporated
      by reference from the registrant’s Current Report on Form 8-K/A filed with
      the Securities and Exchange Commission on March 3,
2005.(12)
    Incorporated
      by reference from the registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on March 25,
  2005.
  94
 **PART
V.**


**SIGNATURES**




Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.




****CAPITAL
      LEASE FUNDING, INC.*****Registrant*Date: March 30,
2005
    By:
    /s/ Paul H.
  McDowellPaul H. McDowellChief
      Executive Officer






Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated:




Signature
    Title
    Date/s/Lewis
      S. Ranieri
    Chairman
      of the Board
    March
      30, 2005Lewis
      S. Ranieri/s/Paul
      H. McDowell
    Chief
      Executive Officer and Director
      (Principal
      Executive Officer)
    March
      30, 2005Paul
      H. McDowell/s/William
      R. Pollert
    President
      and Director
    March
      30, 2005William
      R. Pollert/s/Shawn
      P. Seale
    Senior
      Vice President, Chief FinancialOfficer and Treasurer
      (Principal
      Financial and Accounting Officer)
    March
      30, 2005Shawn
      P. Seale/s/Michael
      E. Gagliardi
    Director
    March
      30, 2005Michael
      E. Gagliardi/s/Stanley
      Kreitman
    Director
    March
      30, 2005Stanley
      Kreitman/s/Jeff
      F. Rogatz
    Director
    March
      30, 2005Jeff
      F. Rogatz/s/Howard
      A. Silver
    Director
    March
      30, 2005Howard
      A. Silver


95