**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

**ý**** QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended June 30, 2005**

 

**or**

 

**o**** TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period from               to               .**

 

**CommissionFile No.  001-32248**

 

**GRAMERCY CAPITAL CORP.**

(Exact name ofregistrant as specified in its charter)

 
| **Maryland**                                                     | ** ** | **06-1722127**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction  of incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **420  Lexington Avenue, New York, New York 10170**              |
| (Address of  principal executive offices - zip code)             |
|                                                             |       |                                  |
| **(212)  297-1000**                                              |
| (Registrant’s  telephone number, including area code)       |

 

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

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes   o   No  ý

 

The number of sharesoutstanding of the registrant’s common stock, $0.001 par value, was 18,833,060at July 27, 2005.

 

 

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**GRAMERCYCAPITAL CORP.**

 

**INDEX**

 
| **PART I.**                                                                                             | **FINANCIAL INFORMATION**                                                                       |       |
|--------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                   | ** **                                                                                      |       |
| **ITEM 1.**                                                                                                  | **FINANCIAL STATEMENTS**                                                                        |       |
|                                                                                                         |                                                                                            |
| Consolidated Balance Sheets as of June 30,  2005 (unaudited) and December 31, 2004                 |                                                                                            |
|                                                                                                         |                                                                                            |
| Consolidated Statement of Income  for the three and six months ended June 30, 2005 (unaudited)          |                                                                                            |
|                                                                                                         |                                                                                            |
| Consolidated Statement of  Stockholders’ Equity for the six months ended June 30, 2005 (unaudited) |                                                                                            |
|                                                                                                         |                                                                                            |
| Consolidated Statement of  Cash Flows for the six months ended June 30, 2005 (unaudited)                |                                                                                            |
|                                                                                                         |                                                                                            |
| Notes to Consolidated  Financial Statements (unaudited)                                                      |                                                                                            |
|                                                                                                         |                                                                                            |
| **ITEM 2.**                                                                                                  | **MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS** | ** ** |
| ** **                                                                                                   | ** **                                                                                      | ** ** |
| **ITEM  3.**                                                                                                 | **QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**                                 | ** ** |
| ** **                                                                                                   | ** **                                                                                      | ** ** |
| **ITEM 4.**                                                                                                  | **CONTROLS AND PROCEDURES**                                                                     | ** ** |
| ** **                                                                                                   | ** **                                                                                      | ** ** |
| **PART II.**                                                                                            | **OTHER INFORMATION**                                                                           | ** ** |
| ** **                                                                                                   | ** **                                                                                      | ** ** |
| **ITEM 1.**                                                                                                  | **LEGAL PROCEEDINGS**                                                                           | ** ** |
| ** **                                                                                                   | ** **                                                                                      | ** ** |
| **ITEM 2.**                                                                                                  | **CHANGES IN  SECURITIES AND USE OF PROCEEDS**                                                  | ** ** |
| ** **                                                                                                   | ** **                                                                                      | ** ** |
| **ITEM 3.**                                                                                                  | **DEFAULTS  UPON SENIOR SECURITIES**                                                            | ** ** |
| ** **                                                                                                   | ** **                                                                                      | ** ** |
| **ITEM 4.**                                                                                                  | **SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS**                                        | ** ** |
| ** **                                                                                                   | ** **                                                                                      | ** ** |
| **ITEM  5.**                                                                                                 | **OTHER  INFORMATION**                                                                          | ** ** |
| ** **                                                                                                   |                                                                                            | ** ** |
| **ITEM 6.**                                                                                                  | **EXHIBITS AND REPORTS ON FORM 8-K**                                                       | ** ** |
| ** **                                                                                                   | ** **                                                                                      | ** ** |
| **Signatures**                                                                                               |                                                                                            |
|                                                                                                              |                                                                                                 |            |  |

 

2

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**PART I.****                                                   ****FINANCIAL INFORMATION**

**ITEM 1.****                                                     FinancialStatements**

 

**GramercyCapital Corp.**

**ConsolidatedBalance Sheets**

**(Amountsin thousands, except share and per share data)**

 
| ** **                                                                                                                                                                                   | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                   | ** ** | **(Unaudited)**         | ** ** | ** **                  | ** ** |
| **Assets:**                                                                                                                                                                                  |       |                    |       |                        |       |
| Cash  and cash equivalents                                                                                                                                                                   |       | $                       | 15,598     |                        | $          | 39,094 |   |
| Restricted  cash                                                                                                                                                                             |       | 3,001                   |       | 1,901                       |       |
| Loans  and other lending investments, net                                                                                                                                                    |       | 678,141                 |       | 395,717                     |       |
| Commercial  mortgage backed securities, net                                                                                                                                                  |       | 10,948                  |       | 10,898                      |       |
| Investments  in unconsolidated joint ventures                                                                                                                                                |       | 57,190                  |       | —                      |       |
| Loans  held for sale, net                                                                                                                                                                    |       | 59,911                  |       | —                      |       |
| Stock  subscriptions receivable                                                                                                                                                              |       | —                  |       | 60,445                      |       |
| Accrued  interest                                                                                                                                                                            |       | 3,719                   |       | 2,921                       |       |
| Deferred  financing costs                                                                                                                                                                    |       | 5,041                   |       | 2,044                       |       |
| Deferred  costs                                                                                                                                                                              |       | 672                     |       | 189                         |       |
| Derivative  instruments, at fair value                                                                                                                                                       |       | —                  |       | 249                         |       |
| Other  assets                                                                                                                                                                                |       | 446                     |       | 589                         |       |
| Total  assets                                                                                                                                                                                |       | $                       | 834,667    |                        | $          | 514,047 |   |
|                                                                                                                                                                                         |       |                    |       |                        |       |
| **Liabilities and Stockholders’ Equity:**                                                                                                                                               |       |                    |       |                        |       |
| Credit  facilities                                                                                                                                                                           |       | $                       | 500,000    |                        | $          | 238,885 |   |
| Management  fees payable                                                                                                                                                                     |       | 662                     |       | 416                         |       |
| Dividends  payable                                                                                                                                                                           |       | 6,515                   |       | 1,951                       |       |
| Accounts  payable and accrued expenses                                                                                                                                                       |       | 3,919                   |       | 1,935                       |       |
| Derivative  instruments, at fair value                                                                                                                                                       |       | 487                     |       | —                      |       |
| Other  liabilities                                                                                                                                                                           |       | 3,501                   |       | 1,901                       |       |
| Junior  subordinated deferrable interest debentures held by trusts that issued trust  preferred securities                                                                                   |       | 50,000                  |       | —                      |       |
| Total  liabilities                                                                                                                                                                           |       | 565,084                 |       | 245,088                     |       |
|                                                                                                                                                                                         |       |                    |       |                        |       |
| Commitments  and contingencies                                                                                                                                                               |       | —                  |       | —                      |       |
|                                                                                                                                                                                         |       |                    |       |                        |       |
| **Stockholders’ Equity:**                                                                                                                                                               |       |                    |       |                        |       |
| Preferred  stock, par value $0.001, 25,000,000 shares authorized, no shares issued or  outstanding                                                                                           |       | —                  |       | —                      |       |
| Common  stock, par value $0.001, 100,000,000 shares authorized, 18,833,060 and 18,812,500 shares issued and outstanding  at June 30, 2005 and December 31, 2004, respectively |       | 19                      |       | 19                          |       |
| Additional  paid-in-capital                                                                                                                                                                  |       | 268,479                 |       | 268,558                     |       |
| Accumulated  other comprehensive income / (loss)                                                                                                                                             |       | (451                    | )          | 282                         |       |
| Retained  earnings                                                                                                                                                                           |       | 1,536                   |       | 100                         |       |
| Total  stockholders’ equity                                                                                                                                                             |       | 269,583                 |       | 268,959                     |       |
| Total  liabilities and stockholders’ equity                                                                                                                                             |       | $                       | 834,667    |                        | $          | 514,047 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

3

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**GramercyCapital Corp.**

**ConsolidatedStatement of Income**

**(Unaudited,amounts in thousands, except per share data)**

 
| ** **                                                                                              | ** ** | **For the Three  Months Ended  June 30, 2005** | ** ** | **For the Six  Months Ended  June 30, 2005** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **Revenues**                                                                                            |       |                                                |       |                                              |       |
| Investment  income                                                                                      |       | $                                                   | 15,689     |                                              | $          | 25,939 |   |
| Other  income                                                                                           |       | 3,069                                               |       | 3,509                                             |       |
| Total  revenues                                                                                         |       | 18,758                                              |       | 29,448                                            |       |
|                                                                                                    |       |                                                |       |                                              |       |
| **Expenses**                                                                                            |       |                                                |       |                                              |       |
| Interest  expense                                                                                       |       | 6,264                                               |       | 9,065                                             |       |
| Management  fees                                                                                        |       | 1,870                                               |       | 3,538                                             |       |
| Depreciation  and amortization                                                                          |       | 106                                                 |       | 128                                               |       |
| Marketing,  general and administrative                                                                  |       | 1,632                                               |       | 3,266                                             |       |
| Provision  for loan loss                                                                                |       | 525                                                 |       | 525                                               |       |
| Total  expenses                                                                                         |       | 10,397                                              |       | 16,522                                            |       |
| Income  from continuing operations before equity in net loss of unconsolidated joint  venture and taxes |       | 8,361                                               |       | 12,926                                            |       |
| Equity  in net loss of unconsolidated joint venture                                                     |       | (404                                                | )          | (404                                              | )          |
| Income  from continuing operations before taxes                                                         |       | 7,957                                               |       | 12,522                                            |       |
| Provision  for taxes                                                                                    |       | (500                                                | )          | (500                                              | )          |
| Net  income available to common stockholders                                                            |       | $                                                   | 7,457      |                                              | $          | 12,022 |   |
|                                                                                                    |       |                                                |       |                                              |       |
| **Basic earnings per share:**                                                                           |       |                                                |       |                                              |       |
| Net  income available to common stockholders                                                            |       | $                                                   | 0.40       |                                              | $          | 0.64 |   |
| **Diluted earnings per share:**                                                                         |       |                                                |       |                                              |       |
| Net  income available to common stockholders                                                            |       | $                                                   | 0.39       |                                              | $          | 0.63 |   |
| Dividends  per common share                                                                             |       | $                                                   | 0.35       |                                              | $          | 0.57 |   |
| Basic  weighted average common shares outstanding                                                       |       | 18,833                                              |       | 18,833                                            |       |
| Diluted  weighted average common shares and common share equivalents outstanding                        |       | 19,033                                              |       | 19,026                                            |       |

 

Theaccompanying notes are an integral part of these financial statements.

 

4

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**GramercyCapital Corp.**

**ConsolidatedStatement of Stockholders’ Equity**

**(Unaudited,amounts in thousands, except share data)**

 
| ** **                                              | ** ** | ** ** | ** ** | ** **     | ** ** | ** **        | ** ** | ** **      | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|------------|------------|----------------|------------|-------------------|------------|-----------------|------------|--------------|------------|-------------------|------------|------------|------------|
| ** **                                              | ** ** | ** ** | ** ** | ** **     | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                              | ** ** | **Common** | ** ** | **Additional** | ** ** | **Other**         | ** ** | ** **      | ** ** | ** **   | ** ** | ** **        | ** ** |
| ** **                                              | ** ** | **Stock**  | ** ** | **Paid-**      | ** ** | **Comprehensive** | ** ** | **Retained**    | ** ** | ** **   | ** ** | **Comprehensive** | ** ** |
| ** **                                              | ** ** | **Shares** | ** ** | **Par Value**  | ** ** | **In-Capital**    | ** ** | **Income**      | ** ** | **Earnings** | ** ** | **Total**         | ** ** | **Income** | ** ** |
| **Balance at December 31, 2004**                   |       | 18,813     |       | $              | 19         |              | $          | 268,558         |       | $            | 282        |              | $          | 100        |       | $ | 268,959 |   |   |   |
| Net income                                              |       |       |       |           |       |              |       |            |       | 12,022       |       | 12,022            |       | $          | 12,022     |   |
| Net  unrealized gain / (loss) on derivative instruments |       |       |       |           |       |              |       | (733            | )          |         |       | (733              | )          | (733       | )          |
| Costs  related to common stock offerings                |       |       |       |           |       | (1,536            | )          |            |       |         |       | (1,536            | )          |       |       |
| Stock-based  compensation – fair value             |       |       |       |           |       | 1,457             |       |            |       |         |       | 1,457             |       |       |       |
| Deferred  compensation plan, net                        |       | 20         |       | —         |       |              |       |            |       |         |       | —            |       |       |       |
| Cash  distributions declared                            |       |       |       |           |       |              |       |            |       | (10,586      | )          | (10,586           | )          |       |       |
| **Balance at June 30, 2005**                       |       | 18,833     |       | $              | 19         |              | $          | 268,479         |       | $            | (451       | )                 | $          | 1,536      |       | $ | 269,583 |   | $ | 11,289 |   |

 

The accompanying notesare an integral part of these financial statements

 

5

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**GramercyCapital Corp.**

**ConsolidatedStatement of Cash Flows**

**(Unaudited,amounts in thousands)**

 
| ** **                                                                                                           | ** ** | **For the Six  Months Ended  June 30, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| **Operating Activities**                                                                                             | ** ** | ** **                                        | ** ** |
| Net  income available to common stockholders                                                                         |       | $                                                 | 12,022     |   |
| Adjustments  to reconcile net income available to common stockholders to net cash provided  by operating activities: |       |                                              |       |
| Depreciation  and amortization                                                                                       |       | 953                                               |       |
| Amortization  of discount on investments                                                                             |       | (505                                              | )          |
| Equity  in net income of unconsolidated joint venture                                                                |       | 404                                               |       |
| Provision  for loan losses                                                                                           |       | 525                                               |       |
| Changes  in operating assets and liabilities:                                                                        |       |                                              |       |
| Accrued  interest                                                                                                    |       | (798                                              | )          |
| Other  assets                                                                                                        |       | 15                                                |       |
| Management  fees payable                                                                                             |       | 246                                               |       |
| Accounts  payable, accrued expenses and other liabilities                                                            |       | 2,485                                             |       |
| Net  cash provided by operating activities                                                                           |       | 15,347                                            |       |
| **Investing Activities**                                                                                             |       |                                              |       |
| New  investment originations                                                                                         |       | (404,791                                          | )          |
| Principal  collections on investments                                                                                |       | 62,424                                            |       |
| Investment  in joint venture                                                                                         |       | (57,594                                           | )          |
| Deferred  loan costs                                                                                                 |       | (483                                              | )          |
| Net  cash used in investing activities                                                                               |       | (400,444                                          | )          |
| **Financing Activities**                                                                                             |       |                                              |       |
| Proceeds  from credit facilities                                                                                     |       | 533,449                                           |       |
| Repayments  of credit facilities                                                                                     |       | (272,334                                          | )          |
| Net  proceeds from sale of common stock                                                                              |       | 60,333                                            |       |
| Issuance  of trust preferred securities                                                                              |       | 50,000                                            |       |
| Deferred  financing costs                                                                                            |       | (3,823                                            | )          |
| Dividends  paid                                                                                                      |       | (6,024                                            | )          |
| Net  cash provided by financing activities                                                                           |       | 361,601                                           |       |
| Net  increase in cash and cash equivalents                                                                           |       | (23,496                                           | )          |
| Cash  and cash equivalents at beginning of period                                                                    |       | 39,094                                            |       |
| Cash  and cash equivalents at end of period                                                                          |       | $                                                 | 15,598     |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

6

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**GramercyCapital Corp.**

**Notes ToConsolidated Financial Statements**

**(Unaudited,amounts in thousands, except share and per share data)**

**June 30,2005**

 

**1.**     Organization

 

Gramercy Capital Corp.(the Company or Gramercy), was organized in Maryland on April 12, 2004 asa commercial real estate specialty finance company focused on originating andacquiring, for our own account, fixed and floating rate mortgage loans, bridgeloans, subordinate interests in mortgage loans, distressed debt,mortgage-backed securities, mezzanine loans and preferred equity interests inentities that own commercial real estate, primarily in the United States.  We also make equity investments in commercialreal estate properties net leased to tenants, primarily for the recurringearnings, tax benefits and long-term residual benefits these transactions oftenhold.

 

Substantially all ofGramercy’s operations are conducted through and all assets are held by GKKCapital LP, a Delaware limited partnership, or the Operating Partnership.  Gramercy, as the sole general partner of, andholder of 100% of the common units of, the Operating Partnership, hasresponsibility and discretion in the management and control of the OperatingPartnership, and the limited partners of the Operating Partnership, in suchcapacity, have no authority to transact business for, or participate in themanagement activities of, the Operating Partnership.  Accordingly, we consolidate the accounts ofthe Operating Partnership.

 

We are externally managedand advised by GKK Manager LLC, or the Manager, a majority-owned subsidiary ofSL Green Realty Corp., or SL Green.  At June 30,2005, SL Green also owned approximately 25% of the outstanding shares of ourcommon stock. We qualified as a real estate investment trust, or REIT, underthe Internal Revenue Code commencing with our taxable year ending December 31,2004.  To maintain our tax status as aREIT, we plan to distribute at least 90% of our taxable income.  Unless the context requires otherwise, allreferences to “we,” “our,” and “us” means Gramercy Capital Corp.

 

As of June 30, 2005,we held loans and other lending investments of approximately $749,000 net offees, discounts, repayments, asset sales and unfunded commitments with anaverage spread to LIBOR of 522 basis points for our floating rate investmentsand an average yield of 9.36% for our fixed rate investments.  As of June 30, 2005 we also held a$57,190 investment in an unconsolidated joint venture that acquired the SouthBuilding located at One Madison Avenue in New York, New York, which SouthBuilding is occupied almost entirely by Credit Suisse First Boston (USA) Inc.,or CSFB, under a net lease with a 15 year remaining term.

 

**Basis of QuarterlyPresentation**

The accompanyingfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financial informationand with the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, it does notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States, or GAAP, for complete financialstatements.  In management’s opinion, alladjustments (consisting of normal recurring accruals) considered necessary forfair presentation have been included. The 2005 operating results for the period presented are not necessarilyindicative of the results that may be expected for the year ending December 31,2005.  These financial statements should be read in conjunction with thefinancial statements and accompanying notes included in the Company’s annualreport on Form 10-K for the year ended December 31, 2004.

 

The balance sheet at December 31,2004 has been derived from the audited financial statement at that date, butdoes not include all the information and footnotes required by GAAP forcomplete financial statements.

 

**2.**     Significant Accounting Policies

** **

**Principles of Consolidation**

Theconsolidated financial statements include our accounts and those of oursubsidiaries which are wholly-owned or controlled by us, or entities which arevariable interest entities in which we are the primary beneficiaries under FASBInterpretation No. 46, FIN 46, “Consolidation of Variable InterestEntities.”  FIN 46 requires a variableinterest entity, or VIE, to be consolidated by its primary beneficiary.  The primary beneficiary is the party thatabsorbs a majority of the VIE’s anticipated losses and/or a majority of theexpected returns.  We have evaluated ourinvestments for potential classification as variable interests by evaluatingthe sufficiency of the entities’ equity investment at risk to absorb losses,and determined that we are not the primary beneficiary for any of ourinvestments.  Entities which we do notcontrol and entities which are VIE’s, but where we are not the primarybeneficiary, are accounted for under the equity method.  All significant intercompany balances andtransactions have been eliminated.

 

**Cash andCash Equivalents**

Weconsider all highly liquid investments with maturities of three months or lesswhen purchased to be cash equivalents.

 

7

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**Restricted Cash**

**Restricted cash consists of interest reserves held on behalf ofborrowers.**

** **

**Loans and Investments and LoansHeld for Sale**

Loansheld for investment are intended to be held to maturity and, accordingly, arecarried at cost, net of unamortized loan origination costs and fees, discounts,repayments, sales of partial interests in loans, and unfunded commitmentsunless such loan or investment is deemed to be impaired. Loans held for saleare carried at the lower of cost or market value using available marketinformation obtained through consultation with dealers or other originators ofsuch investments.  We originate oracquire preferred equity interests that allow us to participate in a percentageof the underlying property’s cash flows from operations and proceeds from asale or refinancing.  At the inception ofeach such investment, we must determine whether such investment should beaccounted for as a loan, joint venture or as an interest in real estate.

 

Specific valuation allowances are established for impaired loans basedon the fair value of collateral on an individual loan basis.  The fair value of the collateral isdetermined by an evaluation of operating cash flow from the property during theprojected holding period, and the estimated sales value of the collateralcomputed by applying an expected capitalization rate to the stabilized netoperating income of the specific property, less selling costs, all of which arediscounted at market discount rates.

 

If upon completion of thevaluation, the fair value of the underlying collateral securing the impairedloan is less than the net carrying value of the loan, an allowance is createdwith a corresponding charge to the provision for loan losses.  The allowance for each loan is maintained ata level we believe is adequate to absorb probable losses.  At June 30, 2005 we maintained a reserveof $525.

 

Our Manager evaluates ourassets on a regular basis to determine if they continue to satisfy ourinvestment criteria. Subject to certain restrictions applicable to REITs, ourManager may cause us to sell our investments opportunistically and use theproceeds of any such sale for debt reduction, additional acquisitions orworking capital purposes.

 

#### **Classifications of Mortgage-BackedSecurities**

Inaccordance with applicable GAAP, mortgage-backed securities, or MBS, areclassified as available-for-sale securities. As a result, changes in fair value will be recorded as a balance sheetadjustment to accumulated other comprehensive income, which is a component ofstockholders equity, rather than through our statement of operations.  If available-for-sale securities wereclassified as trading securities, there could be substantially greatervolatility in earnings from period-to-period as these investments would bemarked to market and any reduction in the value of the securities versus theprevious carrying value would be considered an expense on our statement ofoperations. We had no investments as of June 30, 2005 that were accountedfor as trading securities.

 

#### **Valuations of Mortgage-BackedSecurities**

AllMBS will be carried on the balance sheet at fair value.  We determine the fair value of MBS based onthe types of securities in which we have invested.  For liquid, investment-grade securities, weconsult with dealers of such securities to periodically obtain updated marketpricing for the same or similar instruments. For non-investment grade securities, we actively monitor the performanceof the underlying properties and loans and update our pricing model to reflectchanges in projected cash flows.  Thevalue of the securities is derived by applying discount rates to such cashflows based on current market yields. The yields employed are obtained from our own experience in the market,advice from dealers and/or information obtained in consultation with otherinvestors in similar instruments. Because fair value estimates may vary to some degree, we must makecertain judgments and assumptions about the appropriate price to use tocalculate the fair values for financial reporting purposes.  Different judgments and assumptions couldresult in different presentations of value.

 

When the fair value of anavailable-for-sale security is less than the amortized cost, we considerwhether there is an other-than-temporary impairment in the value of thesecurity (for example, whether the security will be sold prior to the recoveryof fair value).  If, in our judgment, another-than-temporary impairment exists, the cost basis of the security iswritten down to the then-current fair value, and this loss is realized andcharged against earnings.  Thedetermination of other-than temporary impairment is a subjective process, anddifferent judgments and assumptions could affect the timing of lossrealization.

 

8

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#### **Credit Tenant Lease Investments**

Credittenant lease, or CTL, investments are recorded at cost less accumulateddepreciation.  Costs directly related tothe acquisition of such investments are capitalized.  Certain improvements are capitalized whenthey are determined to increase the useful life of the building.  Capitalized items are depreciated using thestraight-line method over the shorter of the useful lives of the capitalizeditem or 40 years for buildings or facilities, the remaining life of thefacility for facility improvements, four to seven years for personal propertyand equipment, and the shorter of the remaining lease term or the expected lifefor tenant improvements.

 

Inaccordance with FASB No. 144, or SFAS 144, “Accounting for the Impairmentof Disposal of Long-Lived Assets,” a property to be disposed of is reported atthe lower of its carrying amount or its estimated fair value, less its cost tosell.  Once an asset is held for sale,depreciation expense and straight-line rent adjustments are no longer recordedand historic results are reclassified as Discontinued Operations.

 

Inaccordance with FASB No. 141, or SFAS 141, “Business Combinations,” weallocate the purchase price of real estate to land and building and, ifdetermined to be material, intangibles, such as the value of above, below andat-market leases and origination costs associated with the in-placeleases.  We depreciate the amount allocated to building and otherintangible assets over their estimated useful lives, which generally range fromthree to 40 years.  The values of the above and below market leases areamortized and recorded as either an increase (in the case of below marketleases) or a decrease (in the case of above market leases) to rental incomeover the remaining term of the associated lease.  The value associatedwith in-place leases and tenant relationships are amortized over the expectedterm of the relationship, which includes an estimated probability of the leaserenewal, and its estimated term.  If a tenant vacates its space prior tothe contractual termination of the lease and no rental payments are being madeon the lease, any unamortized balance of the related intangible will be writtenoff.  The tenant improvements and origination costs are amortized as anexpense over the remaining life of the lease (or charged against earnings ifthe lease is terminated prior to its contractual expiration date).  Weassess fair value of the leases based on estimated cash flow projections that utilizeappropriate discount and capitalization rates and available marketinformation.  Estimates of future cash flows are based on a number offactors including the historical operating results, known trends, andmarket/economic conditions that may affect the property.  At June 30, 2005 we held one CTLinvestment of $57,190 through an investment in the joint venture that acquiredthe South Building located at One Madison Avenue in New York, New York asdescribed more fully in Note 4.

 

**Investment in Unconsolidated Joint Venture**

#### **We account for our investment in an unconsolidated jointventure under the equity method of accounting as we exercise significantinfluence, but do not unilaterally control the entity, and are not consideredto be the primary beneficiary under FIN 46.  In the joint venture, therights of the other investor are both protective as well as participating.These rights preclude us from consolidating the investment.  Theinvestment is recorded initially at cost, as an investment in an unconsolidatedjoint venture, and subsequently adjusted for equity in net income (loss) andcash contributions and distributions.  Any difference between the carryingamount of the investments on our balance sheet and the underlying equity in netassets is amortized as an adjustment to equity in net income (loss) ofunconsolidated joint ventures over the lesser of the joint venture term or 40years.  See Note 4.  None of the joint venture debt is recourse tous.**

#### ** **

#### **Revenue Recognition**

Interestincome on debt investments is recognized over the life of the investment usingthe effective interest method and recognized on the accrual basis.  Fees received in connection with loancommitments are deferred until the loan is funded and are then recognized overthe term of the loan as an adjustment to yield. Anticipated exit fees, whose collection is expected, are also recognizedover the term of the loan as an adjustment to yield.  Fees on commitments that expire unused arerecognized at expiration.  Fees receivedin exchange for the credit enhancement of another lender, either subordinate orsenior to us, in the form of a guarantee are recognized over the term of thatguarantee using the straight-line method.

 

Income recognition isgenerally suspended for debt investments at the earlier of the date at whichpayments become 90 days past due or when, in our opinion, a full recovery ofincome and principal becomes doubtful. Income recognition is resumed when the loan becomes contractuallycurrent and performance is demonstrated to be resumed.

 

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#### **In some instances we may sell all or a portion of ourinvestments to a third party.  To theextent the fair value received for an investment exceeds the amortized cost ofthat investment and FASB Statement No. 140, or SFAS 140, “Accounting forTransfers and Servicing of Financial Assets and Extinguishments of Liabilities,”criteria is met, under which control of the asset that is sold is surrenderedmaking it a “true sale,” a gain on the sale will be recorded through earningsas other income.**

 

#### **Reserve for Possible Credit Losses**

The expense for possiblecredit losses in connection with debt investments is the charge to earnings toincrease the allowance for possible credit losses to the level that managementestimates to be adequate considering delinquencies, loss experience andcollateral quality.  Other factorsconsidered relate to geographic trends and project diversification, the size ofthe portfolio and current economic conditions. Based upon these factors, we establish the provision for possible creditlosses by category of asset.  When it isprobable that we will be unable to collect all amounts contractually due, theaccount is considered impaired.

 

Where impairment isindicated, a valuation write-down or write-off is measured based upon theexcess of the recorded investment amount over the net fair value of thecollateral, as reduced by selling costs. Any deficiency between the carrying amount of an asset and the net salesprice of repossessed collateral is charged to the allowance for creditlosses.  At June 30, 2005 wemaintained a reserve for possible credit losses of $525.

 

**Deferred Costs**

Deferred costs consist offees and direct costs incurred to originate new investments and are amortizedusing the effective yield method over the related term of the investment.

 

**DeferredFinancing Costs**

Deferred financing costsrepresent commitment fees, legal and other third party costs associated withobtaining commitments for financing which result in a closing of suchfinancing.  These costs are amortizedover the terms of the respective agreements and the amortization is reflectedin interest expense.  Unamortizeddeferred financing costs are expensed when the associated debt is refinanced orrepaid before maturity.  Costs incurredin seeking financing transactions, which do not close, are expensed in theperiod in which it is determined that the financing will not close.

 

**StockBased Employee Compensation Plans**

Wehave a stock-based employee compensation plan, described more fully in Note9.  We account for this plan using thefair value recognition provisions of FASB Statement No. 123, or SFAS 123, “Accountingfor Stock-Based Compensation.”

 

TheBlack-Scholes option-pricing model was developed for use in estimating the fairvalue of traded options, which have no vesting restrictions and are fullytransferable.  In addition, optionvaluation models require the input of highly subjective assumptions includingthe expected stock price volatility. Because our plan has characteristics significantly different from thoseof traded options and because changes in the subjective input assumptions canmaterially affect the fair value estimate, in our opinion, the existing modelsdo not necessarily provide a reliable single measure of the fair value of ouremployee stock options.

 

Compensation cost forstock options, if any, is recognized ratably over the vesting period of theaward.  Our policy is to grant optionswith an exercise price equal to the quoted closing market price of our stock onthe business day preceding the grant date. Awards of stock or restricted stock are expensed as compensation on acurrent basis over the benefit period.

 

Thefair value of each stock option granted is estimated on the date of grant foroptions granted to our employees, and quarterly for options issued tonon-employees, using the Black-Scholes option pricing model with the followingweighted average assumptions for grants in 2005 and 2004.

 

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| ** **                       | ** ** | **2005**  | ** ** | **2004** | ** ** |
|----------------------------------|------------|-----------|------------|----------|------------|
| Dividend  yield                  |       | 8.5       | %          | 10.0     | %          |
| Expected  life of option         |       | 6.9 years |       | 7 years  |       |
| Risk-free  interest rate         |       | 4.12      | %          | 4.10     | %          |
| Expected  stock price volatility |       | 18.9      | %          | 18.0     | %          |

 

**Incentive Distribution (Class BLimited Partner Interest)**

The Class B limited partner interest isentitled to receive an incentive return equal to 25% of the amount by whichfunds from operations (as defined in the partnership agreement of the OperatingPartnership) plus certain accounting gains exceed the product of our weightedaverage stockholders equity (as defined in the partnership agreement of theOperating Partnership) multiplied by 9.5% (divided by 4 to adjust for quarterlycalculations).  We will record anydistributions on the Class B limited partner interests as an incentivedistribution expense in the period when earned and when payment of such amountshas become probable and reasonably estimable in accordance with the partnershipagreement.  These cash distributions willreduce the amount of cash available for distribution to our common unitholdersin our Operating Partnership and to common stockholders.  No amounts were earned or accrued withrespect to the Class B limited partner interests as of June 30, 2005.

 

#### **Derivative Instruments**

**In the normalcourse of business, we use a variety of derivative instruments to manage, orhedge, interest rate risk.  We requirethat hedging derivative instruments be effective in reducing the interest raterisk exposure that they are designated to hedge.  This effectiveness is essential forqualifying for hedge accounting.  Somederivative instruments are associated with an anticipated transaction.  In those cases, hedge effectiveness criteriaalso require that it be probable that the underlying transaction occurs.  Instruments that meet these hedging criteriaare formally designated as hedges at the inception of the derivative contract.**

** **

**Todetermine the fair value of derivative instruments, we use a variety of methodsand assumptions that are based on market conditions and risks existing at eachbalance sheet date. For the majority of financial instruments including mostderivatives, long-term investments and long-term debt, standard marketconventions and techniques such as discounted cash flow analysis, option-pricingmodels, replacement cost, and termination cost are used to determine fairvalue.  All methods of assessing fairvalue result in a general approximation of value, and such value may neveractually be realized.**

** **

In the normal course ofbusiness, we are exposed to the effect of interest rate changes and limit theserisks by following established risk management policies and proceduresincluding the use of derivatives.  Toaddress exposure to interest rates, we use derivatives primarily to hedge the mark-to-marketrisk of our liabilities with respect to certain of our assets.

 

We usea variety of commonly used derivative products that are considered plainvanilla derivatives.  These derivativestypically include interest rate swaps, caps, collars and floors.  We also use total rate of return swaps, orTROR swaps, which are tied to the Lehman Brothers CMBS index. We expresslyprohibit the use of unconventional derivative instruments and using derivativeinstruments for trading or speculative purposes.  Further, we have a policy of only enteringinto contracts with major financial institutions based upon their creditratings and other factors.

 

**FASB No. 133, or SFAS 133, “Accounting for Derivative Instrumentsand Hedging Activities,” which became effective January 1, 2001, asamended by FASB No. 149, requires us to recognize all derivatives on thebalance sheet at fair value.  Derivativesthat are not hedges must be adjusted to fair value through income.  If a derivative is a hedge, depending on thenature of the hedge, changes in the fair value of the derivative will either beoffset against the change in fair value of the hedged asset, liability, or firmcommitment through earnings, or recognized in other comprehensive income untilthe hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will beimmediately recognized in earnings.  SFAS133 may increase or decrease reported net income and stockholders’ equityprospectively, depending on future levels of LIBOR, swap spreads and othervariables affecting the fair values of derivative instruments and hedged items,but will have no effect on cash flows, provided the contract is carried throughto full term.**

 

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We may employ swaps,forwards or purchased options to hedge qualifying forecasted transactions.  Gains and losses related to thesetransactions are deferred and recognized in net income as interest expense inthe same period or periods that the underlying transaction occurs, expires oris otherwise terminated.

 

All hedges held by us aredeemed to be effective in meeting the hedging objectives established by ourcorporate policy governing interest rate risk management.  The effect of our derivative instruments onour financial statements is discussed more fully in Note 16.

 

**Income Taxes**

Weintend to elect to be taxed as a REIT, under Sections 856 through 860 of theInternal Revenue Code beginning with our taxable year ended December 31,2004.  To qualify as a REIT, we must meetcertain organizational and operational requirements, including a requirement todistribute at least 90% of our ordinary taxable income to stockholders.  As a REIT, we generally will not be subjectto federal income tax on taxable income that we distribute to ourstockholders.  If we fail to qualify as aREIT in any taxable year, we will then be subject to federal income taxes onour taxable income at regular corporate rates and we will not be permitted toqualify for treatment as a REIT for federal income tax purposes for four yearsfollowing the year during which qualification is lost unless the InternalRevenue Service grants us relief under certain statutory provisions.  Such an event could materially adverselyaffect our net income and net cash available for distributions tostockholders.  However, we believe thatwe will be organized and operate in such a manner as to qualify for treatmentas a REIT and we intend to operate in the foreseeable future in such a mannerso that we will qualify as a REIT for federal income tax purposes.  We may, however, be subject to certain stateand local taxes.

 

Our wholly ownedsubsidiary, GKK Trading Corp, a taxable REIT subsidiary, or TRS, may be subjectto federal, state and local taxes.

 

**UnderwritingCommissions and Costs**

**Underwriting commissions andcosts incurred in connection with our stock offerings are reflected as areduction of additional paid-in-capital.**

 

**Organization Costs**

Costsincurred to organize Gramercy in 2004 were expensed as incurred.

 

**EarningsPer Share**

We present both basic anddiluted earnings per share, or EPS. Basic EPS excludes dilution and is computed by dividing net incomeavailable to common stockholders by the weighted average number of commonshares outstanding during the period. Diluted EPS reflects the potential dilution that could occur ifsecurities or other contracts to issue common stock were exercised or convertedinto common stock, where such exercise or conversion would result in a lowerEPS amount.  Diluted EPS at June 30,2005 reflects the dilutive effect of stock options and the issuance of phantomshares to non-employee directors.

 

**Use ofEstimates**

Thepreparation of financial statements in conformity with GAAP requires managementto make estimates and assumptions that affect the amounts reported in thefinancial statements and accompanying notes. Actual results could differ fromthose estimates.

 

**Concentrationsof Credit Risk**

**Financial instruments that potentially subject us to concentrations ofcredit risk consist primarily of cash investments, debt investments andaccounts receivable.  Gramercy places itscash investments in excess of insured amounts with high quality financialinstitutions.  Our Manager performsongoing analysis of credit risk concentrations in our debt investment portfolioby evaluating exposure to various markets, underlying property types,investment structure, term, sponsors, tenant mix and other credit metrics.  Three investments accounted for more than 24%of the total carrying value of our debt investments as of June 30, 2005.Two investments accounted for approximately 22% of the revenue earned on ourdebt investments for the three months ended June 30, 2005 and twoinvestments accounted for more than 25% of the revenue earned on our debtinvestments for the six months ended June 30, 2005.**

 

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**Recently Issued AccountingPronouncements**

**SFAS No. 123(R), “Share-Based Payment, a revision of FASB Statement No. 123,Accounting for Stock-Based Compensation,” requires all share-based payments toemployees, including grants of employee stock options, to be recognized in theincome statement based on their fair value.  The new standard is effectivefor interim or annual reporting periods beginning after January 1,2006.  Because we currently recognize allrestricted share and option grants using the provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation,” implementation of SFAS No. 123(R) isexpected to have no impact on the our financial statements.**

** **

**3.****     Loansand Other Lending Investments**

 

**The aggregatecarrying values, allocation by product type and weighted average coupons of ourloans and other lending investments as of June 30, 2005 were as follows:**

** **

| ** **                                     | ** ** | **Carrying Value  ($ in thousands)** | ** ** | **Allocation by  Investment  Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average  Spread over  LIBOR** | ** ** |
|------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------|------------|--------------------------------|------------|-------------------------------------------------|------------|
| Whole  loans, floating rate                    |       | $                                         | 291,451    |                                | 39         | %                              |       |                                            | 308        | bps |
| Whole  loans, fixed rate                       |       | 68,866                                    |       | 9                                   | %          | 8.33                           | %          |                                            |       |
| Subordinate  mortgage interests, floating rate |       | 252,926                                   |       | 34                                  | %          |                           |       | 643                                             | bps        |
| Subordinate  mortgage interests, fixed rate    |       | 34,970                                    |       | 4                                   | %          | 9.60                           | %          |                                            |       |
| Mezzanine  loans, floating rate                |       | 74,808                                    |       | 10                                  | %          |                           |       | 889                                             | bps        |
| Mezzanine  loans, fixed rate                   |       | 3,291                                     |       | 1                                   | %          | 14.53                          | %          |                                            |       |
| Preferred  equity                              |       | 11,740                                    |       | 2                                   | %          |                           |       | 900                                             | bps        |
| Commercial  mortgage backed securities         |       | 10,948                                    |       | 1                                   | %          | 13.49                          | %          |                                            |       |
| Total  / Average                               |       | $                                         | 749,000    |                                | 100        | %                              | 9.36       | %                                               | 522        | bps |

 

Forthe three and six months ended June 30, 2005 the Company’s investmentincome from debt investments was generated by the following investment types:

 

| ** **                      | ** ** | **For the Three Months  Ended June 30, 2005** | ** ** | **For the Six Months  Ended June 30, 2005** | ** ** |
|---------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| **Investment  Type**            | ** ** | **Investment  Income**                             | ** ** | **% of Total**                                   | ** ** | **Investment  Income** | ** ** | **% of Total** | ** ** |
| Subordinate  mortgage interests |       | $                                                  | 6,517      |                                             | 42         | % | $ | 12,160 |   | 47 | % |
| Whole  loans                    |       | 5,991                                              |       | 38                                               | %          | 8,983 |   | 35 | % |
| Mezzanine  loans                |       | 2,422                                              |       | 16                                               | %          | 3,370 |   | 13 | % |
| Preferred  Equity               |       | 385                                                |       | 2                                                | %          | 691 |   | 2 | % |
| CMBS                            |       | 374                                                |       | 2                                                | %          | 735 |   | 3 | % |
|                            |       | $                                                  | 15,689     |                                             | 100        | % | $ | 25,939 |   | 100 | % |

 

AtJune 30, 2005, our loan and other lending investment portfolio had thefollowing geographic diversification:

 

| **Region** | ** ** | **Carrying Value** | ** ** | **% of Total** | ** ** |
|------------|------------|--------------------|------------|----------------|------------|
| Northeast  |       | $                  | 374,634    |           | 50         | % |
| South      |       | 132,095            |       | 17             | %          |
| West       |       | 117,368            |       | 16             | %          |
| Midwest    |       | 74,937             |       | 10             | %          |
| Various    |       | 49,966             |       | 7              | %          |
| Total      |       | $                  | 749,000    |           | 100        | % |

 

**In connectionwith our preferred equity investment we have guaranteed a portion of theoutstanding principal balance of the first mortgage loan, up to approximately$1,400, that is a financial obligation of the entity in which we have investedin the event of a borrower default under such loan.  The loan matures in 2032.  As compensation, we received a creditenhancement fee of $125 from the borrower in**

 

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**exchange forthe guarantee, which is recognized as the fair value of the guarantee and hasbeen recorded on our balance sheet as a liability. The liability will beamortized over the life of the guarantee using the straight-line method andcorresponding fee income will be recorded. Our maximum exposure under this guarantee is approximately $1,400 as of June 30,2005.  Under the terms of the guarantee,the investment sponsor is required to reimburse us for the entire amount paidunder the guarantee until the guarantee expires.**

** **

**4.**     Investment in Unconsolidated Joint Venture

 

***One Madison Office Fee LLC***

 

**On April 29,2005, we closed on a $57,503 initial investment in a joint venture with SLGreen to acquire, own and operate the South Building located at One MadisonAvenue, New York, New York, or the Property. The joint venture, which was created to acquire, own and operate theProperty, is owned 45% by our wholly-owned subsidiary and 55% by a wholly-ownedsubsidiary of SL Green.  The jointventure interests are pari passu.  Alsoon April 29, 2005, the joint venture completed the acquisition of theProperty from Metropolitan Life Insurance Company for the purchase price ofapproximately $802,800 plus closing costs, financed in part through a $690,000first mortgage loan on the Property.  Thefirst mortgage is non-recourse to us. The Property comprises approximately 1.2 million square feet and isalmost entirely net leased to CSFB pursuant to a lease with a 15-yearremaining term.  As of June 30, 2005the investment has a carrying value of $57,190. For the three and six months ended June 30, 2005, we recorded ourpro rata share of net losses of the joint venture of $404.**

 

**5.**     Junior Subordinated Debentures

 

**On May 20,2005 we completed the issuance of $50,000 in unsecured floating rate trustpreferred securities through a newly formed Delaware statutory trust, GramercyCapital Trust I, or GCTI, that is a wholly owned subsidiary of the OperatingPartnership.  The securities bearinterest at a fixed rate of 7.57% for the first ten years ending June 2015.  Thereafter the rate will float based on thethree-month LIBOR plus 300 basis points. The trust preferred securities require quarterly interest distributions,however payments may be deferred while the interest expense is accrued for aperiod of up to four consecutive quarters if the Operating Partnershipexercises its right to defer such payments. The trust preferred securities are redeemable, at the option of theOperating Partnership, in whole or in part, with no prepayment premium any timeafter June 30, 2010.**

 

**GCTI issued$1,550 aggregate liquidation amount of common securities, representing 100% ofthe voting common stock of GCTI to the Operating Partnership for a purchaseprice of $1,550.  GCTI used the proceedsfrom the sale of the trust preferred securities and the common securities topurchase the Operating Partnership’s junior subordinated notes.  The terms of the junior subordinated notesmatch the terms of the trust preferred securities.  The notes are subordinate and junior in rightof payment to all present and future senior indebtedness and certain other ofour financial obligations.  We realizednet proceeds from this offering of approximately $48,956.**

 

Ourinterest in GCTI is accounted for using the equity method and the assets andliabilities of GCTI are not consolidated into our financial statements.  Interest on the junior subordinated notes isincluded in interest expense on our consolidated income statements while thejunior subordinated notes are presented as a separate item in our consolidatedbalance sheet.

 

**6.****     CollateralizedDebt Obligation**

 

On July 14, 2005, weissued approximately $1,000,000 of collateralized debt obligations, or CDO,through two newly-formed indirect subsidiary, Gramercy Real Estate CDO 2005-1Ltd., or the Issuer, and Gramercy Real Estate CDO 2005-1 LLC, or theCo-Issuer. The CDO consists of $810,500 of investment grade notes, and $84,500of non-investment grade notes, which were co-issued by the Issuer and theCo-Issuer, and $105,000 of preferred shares, which were issued by the Issuer.  We retained all non-investment grade securitiesand the preferred shares in the Issuer. The Issuer holds assets, consisting primarily of whole loans,subordinate interests in whole loans, mezzanine loans and preferred equityinvestments, which serve as collateral for the CDO. The investment grade noteswere issued with floating rate coupons with a combined weighted average rate ofthree-month LIBOR plus 0.49%. The CDO may be replenished pursuant to certainrating agency guidelines relating to credit quality and diversification, withsubstitute collateral for loans that are repaid during the first five years ofthe CDO. Thereafter, the CDO securities will be retired in sequential orderfrom senior-most to junior-most as loans are repaid. We incurred approximately$11,342 of issuance costs which will be amortized on a level yield basis overthe average life of the CDO. For accounting purposes, the Issuer isconsolidated in our financial statements. The investment grade notes aretreated as a secured financing, and are non-recourse to us. Proceeds from thesale of the investment grade notes issued were used to repay substantially alloutstanding debt under our repurchase agreements and to fund additionalinvestments. The assets pledged as collateral were contributed from ourexisting portfolio of assets.

 

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**7.**     Debt Obligations

 

**We have threesecured credit facilities; two with Wachovia Capital Markets, LLC or one ormore of its affiliates and one with Goldman Sachs Mortgage Company.**

 

Thefirst facility with Wachovia Capital Markets, LLC and its affiliates is a$500,000 repurchase facility.  Thisfacility was increased to $350,000 from $250,000 effective January 3,2005, and subsequently increased to $500,000 effective April 22,2005.  As part of the April 2005increase to $500,000, the initial term of the facility was modified to reflectstaggered maturities in which $250,000 matures in August 2007, $150,000matures in December 2007 and the remaining $100,000 matures in June 2008.  Also in conjunction with the April 2005increase, the $50,000 credit facility we previously maintained with Wachoviawas consolidated into the $500,000 repurchase facility.  The $500,000 facility bears interest atspreads of 1.25% to 3.50% over a 30-day LIBOR and, based on our expectedinvestment activities, provides for advance rates that vary from 50% to 95%based upon the collateral provided under a borrowing base calculation.  The lender has a consent right to theinclusion of investments in this facility, determines periodically the marketvalue of the investments, and has the right to require additional collateral ifthe estimated market value of the included investments declines.  At June 30, 2005 we had borrowings of$347,789 under this facility.  On July 14,2005 we repaid substantially all of the borrowings against this facility usingproceeds from the issuance of the CDO. We can utilize the $25,000 revolving credit facility described below tofund requirements for additional collateral pursuant to the warehouse financingor to fund the acquisition of assets.

 

Thesecond facility with Wachovia Capital Markets, LLC and its affiliates is a$25,000 revolving credit facility with a term of two years.  Amounts drawn under this facility forliquidity purposes bear interest at a rate equal to a spread over LIBOR of 525basis points.  Amounts drawn under thisfacility for acquisition purposes bear interest at a spread over LIBOR of 225basis points.  Amounts drawn under thisfacility for liquidity purposes must be repaid within 105 days.  Amounts drawn under this facility generallywill be secured by assets established under a borrowing base calculation unlesscertain financial covenants are satisfied. These covenants are generally more restrictive than those set forthbelow.  At June 30, 2005 we had noborrowings under this facility.

 

Wehave an additional repurchase facility of $200,000 with Goldman Sachs MortgageCompany, an affiliate of Goldman Sachs & Co.  This facility has an initial term of threeyears expiring in January 2008 with one six-month extension option.  This facility bears interest at spreads of1.125% to 2.75% over a 30-day LIBOR and, based on our expected investmentactivities, provides for advance rates that vary from 75% to 90% based upon thecollateral provided under a borrowing base calculation.  As with the Wachovia facility, the lender hasa consent right to the inclusion of investments in this facility, determinesperiodically the market value of the investments, and has the right to requireadditional collateral if the estimated market value of the included investmentsdeclines.  At June 30, 2005 we hadborrowings of $152,211 under this facility. On July 14, 2005 we repaid the borrowings against this facility infull using proceeds from the issuance of the CDO.

 

The terms of both of ourrepurchase facilities and our credit facility include covenants that****(a) limit our maximum totalindebtedness to no more than 85% of total assets, (b) require us tomaintain minimum liquidity of at least $10,000 for the first two years and$15,000 thereafter, (c) our fixed charge coverage ratio shall at no timebe less than 1.50 to 1.00, (d) our minimum interest coverage ratio shallat no time be less than 1.75 to 1.00, (e) require us to maintain minimumtangible net worth of not less than the greater of (i) $129,750, or (i) plus(ii) 75% of the proceeds of our subsequent equity issuances and (f) restrictthe maximum amount of our total indebtedness. The covenants also restrict us from making distributions in excess of amaximum of 103% of our funds from operations (as defined by the NationalAssociation of Real Estate Investment Trusts) through July 2005 and 100%thereafter, except that we may in any case pay distributions necessary tomaintain our REIT status.  Under our facilitieswith Wachovia Capital Markets LLC, an event of default will be triggered if GKKManager LLC ceases to be the Manager.

 

The revolving creditfacility and the repurchase facilities require that we pay down borrowingsunder these facilities as principal payments on our loans and investments arereceived.

 

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At June 30, 2005borrowings under the Wachovia and Goldman repurchase facilities were secured bythe following investments:

 

| **Investment  Type**            | ** ** | **Carrying Value** | ** ** |
|---------------------------------|------------|--------------------|------------|
| Whole  loans                    |       | $                  | 182,003    |   |
| Subordinate  mortgage interests |       | 232,644            |       |
| Mezzanine  loans                |       | 10,000             |       |
| CMBS                            |       | —             |       |
|                            |       | $                  | 424,647    |   |

 

**8.**     Operating PartnershipAgreement / Manager

 

At June 30, 2005 we owned all of the Class A limited partnerinterests in our Operating Partnership. At June 30, 2005, the Class B limited partner interests were ownedby our Manager and SL Green Operating Partnership, L.P. and certain officersand employees of SL Green Realty Corp., including some of whom are ourexecutive officers.  

 

At June 30, 2005 the majority-owned interests in our Manager wereheld by SL Green Operating Partnership, L.P. and certain officers and employeesof SL Green Realty Corp., including some of whom are our executive officers.

 

**9.**     Related Party Transactions

 

Inconnection with our initial public offering, we entered into a managementagreement with GKK Manager LLC, which provides for an initial term through December 2007with automatic one-year extension options and is subject to certain terminationrights.  We pay the Manager an annualmanagement fee equal to 1.75% of our gross stockholders equity (as defined inthe Management Agreement) inclusive of the trust preferred securities issued onMay 20, 2005.  For the three and sixmonths ended June 30, 2005, we paid or had payable an aggregate ofapproximately $1,326 and $2,530 to the Manager under this agreement,respectively.

 

At June 30, 2005, the Class B limited partner interests were ownedby our Manager and SL Green Operating Partnership, L.P. and certain officersand employees of SL Green Realty Corp., including some of whom are ourexecutive officers.  To provide anincentive for the Manager to enhance the value of the common stock, the Managerand SL Green Operating Partnership, L.P. are entitled through their ownershipof Class B limited partner interests of the Operating Partnership to anincentive return equal to 25% of the amount by which funds from operations (asdefined in the partnership agreement of the Operating Partnership) plus certainaccounting gains exceed the product of our weighted average stockholders equity(as defined in the partnership agreement of the Operating Partnership)multiplied by 9.5% (divided by 4 to adjust for quarterly calculations).  We will record any distributions on the Class Blimited partner interests as an incentive distribution expense in the periodwhen earned and when payments of such amounts have become probable andreasonably estimable in accordance with the partnership agreement.  No amounts were earned or accrued withrespect to such Class B limited partner interests through June 30,2005.

 

We are obligated toreimburse the Manager for its costs incurred under an Asset Servicing Agreementbetween our Manager and an affiliate of SL Green Operating Partnership, L.P.and a separate Outsourcing Agreement between our Manager and SL Green OperatingPartnership, L.P.  The Asset ServicingAgreement provides for an annual fee payable by us of 0.15% of the carryingvalue of our investments, excluding certain defined investments for which otherservicing arrangements are executed and further reduced by fees paid directlyto outside servicers by us which have been approved by SL Green OperatingPartnership, L.P.  The Outsourcing Agreementprovides a fee payable by us of $1,250 per year, increasing 3% annually overthe prior year.  For the three monthsended June 30, 2005, we paid or had payable an aggregate of $312 and $232to our Manager under the Outsourcing and Asset Servicing Agreements,respectively.  For the six months ended June 30,2005, we paid or had payable an aggregate of $625 and $383 to our Manager underthe Outsourcing and Asset Servicing Agreements, respectively.

 

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Inconnection with the closing of our CDO, the Issuer entered into a CollateralManagement Agreement with the Manager. Pursuant to the Collateral ManagementAgreement, the Manager has agreed to provide certain advisory andadministrative services in relation to the collateral debt securities and othereligible investments securing the CDO notes. As compensation for the performance of its obligations as collateralmanager, the Manager is entitled to receive a senior collateral management fee,payable quarterly in accordance with the priority of payments as set forth inthe indenture, equal to 0.15% per annum of the net outstanding portfoliobalance, and an additional subordinate collateral management fee, payablequarterly in accordance with the priority of payments as set forth in theindenture, equal to 0.25% per annum of the net outstanding portfoliobalance.  Net outstanding portfoliobalance is the sum of the (i) aggregate principal balance of thecollateral debt securities, excluding defaulted securities, (ii) aggregateprincipal balance of all principal proceeds held as cash and eligibleinvestments in certain accounts, and (iii) with respect to the defaultedsecurities, the calculation amount of such defaulted securities. In connectionwith the closing of the CDO, our Board of Directors allocated to the Manager theportion of the subordinate collateral management fee paid on those securitiesnot held by us on account of additional management services to be performed bythe Manager, and allocated the senior collateral management fee and balance ofthe subordinate management fee to us.

 

Inconnection with the 5,500,000 shares of common stock that were sold on December 3,2004 and settled on December 31, 2004 and January 3, 2005 in aprivate placement, we agreed to pay the Manager a fee of $1,000 as compensationfor financial advisory, structuring and costs incurred on our behalf.  This fee was recorded as a reduction in theproceeds of the private placement.  Apartfrom legal fees and stock clearing charges totaling $245, no other fees werepaid by us to an investment bank, broker/dealer or other financial advisor inconnection with the private placement, resulting in total costs of 1.3% oftotal gross proceeds.

 

**On April 29, 2005, we closed on a $57,503 million initial investmentin a joint venture SL Green to acquire, own and operate the South Buildinglocated at One Madison Avenue, New York, New York, or the Property.  The joint venture, which was created toacquire, own and operate the Property, is owned 45% by a wholly-ownedsubsidiary of us and 55% by a wholly-owned subsidiary of SL Green.  The joint venture interests are paripassu.  Also on April 29, 2005, thejoint venture completed the acquisition of the Property from Metropolitan LifeInsurance Company for the purchase price of approximately $802,800 plus closingcosts, financed in part through a $690,000 first mortgage loan on theProperty.  The Property comprisesapproximately 1.2 million square feet and is almost entirely net leased toCredit Suisse First Boston (USA) Inc., or CSFB, pursuant to a lease with a 15-yearremaining term.**

** **

CommencingMay 1, 2005 we are party to a lease agreement with SLG Graybar SubleaseLLC, an affiliate of SL Green, for our corporate offices at 420 LexingtonAvenue, New York, New York.  The lease isfor approximately five thousand square feet with an option to lease anadditional approximately two thousand square feet and carries a term of tenyears with rents on the entire seven thousand square feet of approximately $249per annum for year one rising to $315 per annum in year ten.

 

**Bright Star Couriers LLC, or Bright Star, provides messenger services tous.  Bright Star is owned by Gary Green,a son of Stephen L. Green.  The aggregateamount of fees paid by us for such services for the three and six months ended June 30,2005 was less than $1.**

** **

**SL Green Operating Partnership, L.P. has invested $75,000 and $6,100 inpreferred equity interests that are subordinate to two of our investments withbook values of $61,616 and $6,436, respectively, as of June 30, 2005.**

** **

**On July 14, 2005 we closed on the purchase of a $40,000participation interest in a $224,000 mezzanine loan involving an officeproperty in New York, New York from an entity sponsored by SL Green.  On July 14, 2005 we also closed on a$32,493 subordinate participation in a loan which is senior to a $75,000preferred equity interest of SL Green Operating Partnership, L.P.**

 

**10.**  Deferred Costs

 

Deferredcosts at June 30, 2005 consisted of the following (in thousands):

 

| Deferred financing             |   | $     | 6,157  |   |
|--------------------------------|--------|-------|--------|--------|
| Deferred  acquisition          |   | 793   |   |
|                           |   | 6,950 |   |
| Less  accumulated amortization |   | 1,237 |   |
|                           |   | $     | 5,713  |   |

 

17

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Deferredfinancing costs relate to our existing repurchase and credit facilities withWachovia and Goldman Sachs and the completion of our CDO and are amortized on astraight-line basis to interest expense based on the remaining term of therelated facility or the CDO.

 

Deferredacquisition costs consist of fees and direct costs incurred to originate ourinvestments and are amortized using the effective yield method over therelated term of the investment.

 

**11.**  Fair Value of Financial Instruments

 

Thefollowing discussion of fair value was determined by our Manager, usingavailable market information and appropriate valuation methodologies.  Considerable judgment is necessary tointerpret market data and develop estimated fair value.  Accordingly, fair values are not necessarilyindicative of the amounts we could realize on disposition of the financialinstruments.  The use of different marketassumptions and/or estimation methodologies may have a material effect onestimated fair value amounts.

 

Cashequivalents, accrued interest, and accounts payable balances reasonablyapproximate their fair values due to the short maturities of these items.  The carrying value of our repurchase andcredit facilities approximate fair value because they bear interest at floatingrates, which we believe, for facilities with a similar risk profile, reasonablyapproximate market rates.  Loans and commercialmortgage backed securities are carried at amounts which reasonably approximatetheir fair value as determined by our Manager.

 

Disclosureabout fair value of financial instruments is based on pertinent informationavailable to us at June 30, 2005. Although we are not aware of any factors that would significantly affectthe reasonable fair value amounts, such amounts have not been comprehensivelyrevalued for purposes of these financial statements since that date and currentestimates of fair value may differ significantly from the amounts presentedherein.

 

**12.**  Stockholders’ Equity

 

**Common Stock**

Ourauthorized capital stock consists of 125,000,000 shares, $0.001 par value, ofwhich we have authorized the issuance of up to 100,000,000 shares of commonstock, $0.001 par value per share, and 25,000,000 shares of preferred stock,par value $0.001 per share.

 

Asof the date of our formation, April 12, 2004, we had 500,000 shares ofcommon stock outstanding valued at approximately $200,000.  On August 2, 2004 we completed ourinitial public offering of 12,500,000 shares of common stock resulting in netproceeds of approximately $177,600, which was used to fund investments andcommence our operations.  As of June 30,2005, 333,000 restricted shares had also been issued under our 2004 EquityIncentive Plan, or the Equity Incentive Plan. These shares have a vesting period of three to four years and are notentitled to receive distributions declared by us on our common stock until suchtime as the shares have vested, or the shares have been designated to receivedividends by the Compensation Committee of our Board of Directors.

 

OnDecember 3, 2004 we sold 5,500,000 shares of common stock resulting in netproceeds of approximately $93,740 under a private placement exemption from theregistration requirements of Section 5 of the Securities Act of 1933, asamended.  A total of 4,225,000 shareswere sold to various institutional investors and an additional 1,275,000 weresold to SL Green Operating Partnership, L.P. pursuant to its contractual rightto choose to maintain a 25% ownership interest in the outstanding shares of ourcommon stock.  After the privateplacement, SL Green Operating Partnership, L.P. owned 4,710,000 shares of ourcommon stock.  Of the 5,500,000 sharessold, 2,000,000 shares were settled on December 31, 2004 and the remaining3,500,000 shares were settled on January 3, 2005.  The value of the shares settled on January 3,2005 were reflected as a stock subscription receivable for financial statementpurposes as of December 31, 2004.

 

Asof June 30, 2005, 18,833,060 shares of common stock and no shares ofpreferred stock were issued and outstanding.

 

18

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**EquityIncentive Plan**

As part of our initial publicoffering we instituted our Equity Incentive Plan.  The Equity Incentive Plan, as amended,authorizes (i) the grant of stock options that qualify as incentive stockoptions under Section 422 of the Internal Revenue Code of 1986, asamended, or ISOs, (ii) the grant of stock options that do not qualify, orNQSOs, (iii) the grant of stock options in lieu of cash directors’ feesand (iv) grants of shares of restricted and unrestricted commonstock.  The exercise price of stockoptions will be determined by the compensation committee, but may not be lessthan 100% of the fair market value of the shares of common stock on the date ofgrant.  At June 30, 2005,approximately 1,883,306 shares of common stock were available for issuanceunder the Equity Incentive Plan.

 

Options granted under theEquity Incentive Plan to employees are exercisable at the fair market value onthe date of grant and, subject to termination of employment, expire ten yearsfrom the date of grant, are not transferable other than on death, and areexercisable in three to four annual installments commencing one year from thedate of grant.  In some instances,options may be granted under the Equity Incentive Plan to persons who providesignificant transaction related services, but are not considered employeesbecause compensation for their services is not covered by our ManagementAgreement or Outsourcing Agreement. Options granted to non-employees have the same terms as those issued toemployees except as it relates to any performance-based provisions within thegrant.  To the extent there areperformance provisions associated with a grant to a non-employee, an estimatedexpense related to these options is recognized over the vesting period and thefinal expense is reconciled at the point performance has been met, or themeasurement date.  If no performancebased provision exists, the fair value of the options is calculated on aquarterly basis and the related expense is recognized over the vesting period.

 

A summary of the statusof our stock options as of June 30, 2005 are presented below:

** **

| ** **                    | ** ** | **2005**                       | ** ** |
|-------------------------------|------------|--------------------------------|------------|
| ** **                    | ** ** | **Options********Outstanding** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Balance  at beginning of year |       | 640,500                        |       | $ | 15.05 |   |
| Granted                       |       | 218,000                        |       | $ | 19.40 |   |
| Exercised                     |       | —                         |       | $ | — |   |
| Lapsed  or cancelled          |       | —                         |       | $ | — |   |
| Balance  at end of period     |       | 858,500                        |       | $ | 16.15 |   |

 

Alloptions were granted within a price range of $15.00 to $20.60.  The remaining weighted average contractuallife of the options was 9.27 years.  Ofthe options granted 69% will vest equally over a three-year period and theremaining 31% will vest equally over a four-year period.  Compensation expense of $43 and $59 wasrecorded during the three and six months ended June 30, 2005,respectively, related to the issuance of stock options.

 

Asof June 30, 2005, 333,000 restricted shares had been issued under theEquity Incentive Plan.  Of the shares ofrestricted stock issued, approximately 89% will vest equally over a three-yearperiod and the remaining 11% will vest equally over a four-year period.  These shares are not entitled to receivedistributions declared by us on our common stock until such time as the shareshave vested.  Unvested shares may beentitled to receive dividends at the discretion of the Compensation Committeeof our Board of Directors.  Holders ofrestricted shares are prohibited from selling such shares until they vest butare provided the ability to vote such shares beginning on the date ofgrant.  Compensation expense of $396 and$648 was recorded during the three and six months ended June 30, 2005,respectively, related to the issuance of restricted shares.

 

**Outperformance Plan**

On June 15, 2005, the Compensation Committee ofour Board of Directors approved the 2005 Outperformance Plan, or the 2005Outperformance Plan, a long-term incentive compensation program.  On the same day, our Compensation Committeeapproved long-term performance awards under the 2005 Outperformance Plan.

 

19

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Under the 2005 Outperformance Plan, a “performancepool” will be established in June, 2008 if our total return to stockholders forthe period from June 1, 2005 through May 31, 2008 exceeds acumulative total return to stockholders of 30%. The size of the pool would be 10% of the outperformance amount in excessof the 30% benchmark, subject to a maximum limit based on such outperformanceequal to the greater of 4% of our outstanding shares, or $18,600.  In the event the potential outperformancepool reaches the maximum dilution cap before May 31, 2008 and remains atthat level or higher for 30 consecutive days, the performance period will endearly and the pool will be formed at such earlier date.

 

Each officer’s award under the 2005 OutperformancePlan is designated as a specified percentage of the aggregate performance awardpool.  Assuming that the 30% benchmark isachieved, the pool will be allocated among our senior officers in accordancewith the percentage specified in each officer’s participation agreement.  Individual awards under the 2005Outperformance Plan will be made in the form of partnership units, or LTIPUnits, under the Company’s 2004 Equity Incentive Plan (or successor plan), thatare convertible into shares of our common stock.  The 2005 Outperformance Plan provides that ifthe pool is established, each officer will also be entitled to the dividendsthat would have been paid by us had the LTIP Units been issued on the date the2005 Outperformance Plan was approved. Those dividends will be paid by the issuance of additional LTIPUnits.  Thereafter, dividends will bepaid on the outstanding LTIP Units, whether or not vested.

 

Although the amount of the awards will be determinedon the measurement date, none of the awards vest at that time.  Instead, 50% of the awards vest in May 2009and the balance vest one year later based on continued employment.

 

Inthe event of a change in control of us prior to the establishment of the pool,the performance period will be shortened to end on a date immediately prior tosuch event and the cumulative shareholder return benchmark will be adjusted ona pro rata basis.  The pool will beformed as described above if the adjusted benchmark target is achieved andfully vested awards will be issued.  Alldeterminations, interpretations and assumptions relating to the vesting andcalculation of the performance awards will be made by the CompensationCommittee.  We will record the expense ofthe restricted stock award in accordance with SFAS 123. Compensationexpense of $750 was recorded for the six months ended June 30, 2005 relatedto the 2005 Outperformance Plan.

 

**Deferred Stock Compensation Plan forDirectors**

 

Underour Independent Director’s Deferral Program, which commenced April 2005,our non-employee directors may elect to defer up to 100% of their annualretainer fee, chairman fees and meeting fees.  Unless otherwise elected bya participant, fees deferred under the program shall be credited in the form ofphantom stock units.  The phantom stock units are convertible into anequal number of shares of common stock upon such directors’ termination ofservice from the Board of Directors or a change in control by us, as defined bythe program.  Phantom stock units are credited to each non-employeedirector quarterly using the closing price of our common stock on theapplicable dividend record date for the respective quarter.  Eachparticipating non-employee director’s account is also credited for anequivalent amount of phantom stock units based on the dividend rate for eachquarter.

 

Duringthe three months ended June 30, 2005, 833 phantom stock units were earnedrepresenting all of the phantom stock units outstanding at June 30, 2005.

 

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**Earnings per Share**

 

Earningsper share for the three months ended June 30, 2005 is computed as follows:

 

| **Numerator  (Income)**                      | ** ** | **Three months  ended June  30, 2005** | ** ** | **Six months  ended June  30, 2005** | ** ** |
|----------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| Basic  Earnings:                             |       |                                   |       |                                 |       |
| Net  income available to common stockholders |       | $                                      | 7,457      |                                 | $          | 12,022 |   |
| Effect  of dilutive securities               |       | —                                 |       | —                               |       |
| Diluted  Earnings:                           |       |                                   |       |                                 |       |
| Net  income available to common stockholders |       | $                                      | 7,457      |                                 | $          | 12,022 |   |
|                                         |       |                                   |       |                                 |       |
| **Denominator (Weighted Average Shares)**    |       |                                   |       |                                 |       |
| Basic                                        |       |                                   |       |                                 |       |
| Shares  available to common stockholders     |       | 18,833                                 |       | 18,833                               |       |
| Effect  of Diluted Securities:               |       |                                   |       |                                 |       |
| Stock  options                               |       | 199                                    |       | 192                                  |       |
| Phantom  stock units                         |       | 1                                      |       | 1                                    |       |
| Diluted  Shares                              |       | 19,033                                 |       | 19,026                               |       |

 

**13.**  MinorityInterest

 

At June 30, 2005 we owned all of the Class A limited partnerinterests in our Operating Partnership. At June 30, 2005, the Class B limited partner interests were ownedby our Manager and SL Green Operating Partnership, L.P. and certain officersand employees of SL Green Realty Corp., including some of whom are ourexecutive officers.

 

At June 30, 2005 themajority-owned interests in our Manager were held by SL Green OperatingPartnership, L.P. and certain officers and employees of SL Green Realty Corp.,including some of whom are our executive officers.

 

**14.**  BenefitPlans

** **

**We do not maintain a defined benefit pension plan,post-retirement health and welfare plan, 401(K) plan or other benefits plans aswe do not have any employees.  Thesebenefits are provided to its employees by our Manager, a majority-ownedsubsidiary of SL Green.**

** **

**15.**  Commitments and Contingencies

** **

Weand our Operating Partnership are not presently involved in any materiallitigation nor, to our knowledge, is any material litigation threatened againstus or our investments, other than routine litigation arising in the ordinarycourse of business.  Management believesthe costs, if any, incurred by us and our Operating Partnership related tolitigation will not materially affect our financial position, operating resultsor liquidity.

 

Ourcorporate offices at 420 Lexington Avenue, New York, New York are subject to anoperating lease agreement with SLG Graybar Sublease LLC, an affiliate of SLGreen, effective May 1, 2005.  Thelease is for approximately five thousand square feet with an option to lease anadditional approximately two thousand square feet and carries a term of tenyears with rents on the entire seven thousand square feet of approximately $249per annum for year one rising to $315 per annum in year ten.

 

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Thefollowing is a schedule of future minimum lease payments under ouroperating lease as of June 30, 2005.

 

| ** **                    | ** ** | **Operating  Leases** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| 2005                          |       | $                     | 145        |   |
| 2006                          |       | 252                   |       |
| 2007                          |       | 256                   |       |
| 2008                          |       | 261                   |       |
| 2009                          |       | 265                   |       |
| Thereafter                    |       | 1,633                 |       |
| Total  minimum lease payments |       | $                     | 2,812      |   |

 

**16.**  Financial Instruments: Derivatives and Hedging

 

FASB No. 133, or SFAS 133, “Accounting for Derivative Instrumentsand Hedging Activities,” which became effective January 1, 2001, requiresGramercy to recognize all derivatives on the balance sheet at fair value.  Derivatives that are not hedges must beadjusted to fair value through income. If a derivative is a hedge, depending on the nature of the hedge,changes in the fair value of the derivative will either be offset against thechange in fair value of the hedged asset, liability, or firm commitment throughearnings, or recognized in other comprehensive income until the hedged item isrecognized in earnings.  The ineffectiveportion of a derivative’s change in fair value will be immediately recognizedin earnings.  SFAS 133 may increase ordecrease reported net income and stockholders’ equity prospectively, dependingon future levels of LIBOR interest rates and other variables affecting the fairvalues of derivative instruments and hedged items, but will have no effect oncash flows, provided the contract is carried through to full term.

 

The following table summarizes the notional and fair value of ourderivative financial instrument at June 30, 2005.  All derivative instruments have beendesignated as cash flow hedges.  For thethree and six months ended June 30, 2005 $4 and $7, respectively, wereattributable to the ineffective portion of our derivative’s change in fairvalue and was recognized as an increase in interest expense.  The notional value is an indication of theextent of our involvement in this instrument at that time, but does notrepresent exposure to credit, interest rate or market risks (in thousands):

 
| ** **                 | ** ** | **Notional  Value** | ** ** | **Strike  Rate** | ** ** | **Effective  Date** | ** ** | **Expiration  Date** | ** ** | **Fair  Value** | ** ** |
|----------------------------|------------|---------------------|------------|------------------|------------|---------------------|------------|----------------------|------------|-----------------|------------|
| Interest  Rate Swap        |       | $                   | 10,729     |             | 3.360      | %                   | 8/2004     |                 | 12/2007    |            | $          | 143 |   |
| Interest  Rate Swap        |       | $                   | 31,686     |             | 3.855      | %                   | 4/2005     |                 | 11/2009    |            | $          | 141 |   |
| Interest  Rate Swap        |       | $                   | 3,465      |             | 3.300      | %(1)                | 2/2005     | (1)                  | 2/2006     | (1)             | $          | 7 |   |
| Interest  Rate Swap        |       | $                   | 19,800     |             | 3.625      | %                   | 5/2005     |                 | 2/2006     |            | $          | (3 | ) |
| Interest  Rate Swap        |       | $                   | 26,235     |             | 4.188      | %                   | 6/2005     |                 | 6/2010     |            | $          | (233 | ) |
| Interest  Rate Swap        |       | $                   | 20,048     |             | 4.348      | %                   | 6/2005     |                 | 6/2015     |            | $          | (244 | ) |
| Interest  Rate Swap        |       | $                   | 40,590     |             | 4.245      | %                   | 6/2005     |                 | 6/2015     |            | $          | (131 | ) |
|                       |       |                |       |             |       |                |       |                 |       |            |       |
| Total  Rate of Return Swap |       | $                   | 36,000     |             | —     |                | 4/2005     |                 | 11/2005    |            | $          | (180 | ) |

 

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(1)   This swap has a step-up component with a strike rate of4.28%, an effective date of February 2006 and an expiration of December 2009.  The total fair value of the initial swap andthe step-up provisions are reflected in the fair value.

 

OnJune 30, 2005, the derivative instruments were reported as a liability attheir fair value of $487.  Offsettingadjustments are represented as deferred losses and are a component ofAccumulated Other Comprehensive Loss of $451. Currently, all derivative instruments are designated as effectivehedging instruments.  Over time, therealized and unrealized gains and losses held in Accumulated OtherComprehensive Income will be reclassified into earnings as interest expense inthe same periods in which the hedged interest payments affect earnings.

 

Weare hedging exposure to variability in future interest payments on our debtfacilities except in the case of our TROR swaps which are intended to hedge ourexposure to variability in the rate of return in excess of anticipated futureinterest payments on that portion of our debt facilities used to fund fixedrate mortgage loan assets held as available for sale.

 

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**17.****  IncomeTaxes**

 

Weintend to be taxed as a REIT, under Sections 856 through 860 of the InternalRevenue Code beginning with our taxable year ending December 31,2004.  To qualify as a REIT, we must meetcertain organizational and operational requirements, including a requirement todistribute at least 90% of our ordinary taxable income to stockholders.  As a REIT, we generally will not be subjectto federal income tax on taxable income that we distribute to ourstockholders.  If we fail to qualify as aREIT in any taxable year, we will then be subject to federal income taxes onour taxable income at regular corporate rates and we will not be permitted toqualify for treatment as a REIT for federal income tax purposes for four yearsfollowing the year during which qualification is lost unless the InternalRevenue Service grants us relief under certain statutory provisions.  Such an event could materially adverselyaffect our net income and net cash available for distributions tostockholders.  However, we believe thatwe will be organized and operate in such a manner as to qualify for treatmentas a REIT and we intend to operate in the foreseeable future in such a mannerso that we will qualify as a REIT for federal income tax purposes.  We may, however, be subject to certain stateand local taxes.

 

During the three and sixmonths ended June 30, 2005, we recorded $500 of income tax expense forincome attributable to GKK Trading Corp., our wholly owned taxable REITsubsidiary. We have assumed an effective tax rate for the year ended December 31,2005 of 40% taking into consideration the anticipated applicable U.S. federalstatutory tax rate at December 31, 2005 of 34% and state and local taxes,net of federal tax benefit.

 

**18.**  Environmental Matters

 

**Our management believes we are in compliance in allmaterial respects with applicable Federal, state and local ordinances andregulations regarding environmental issues. Our management is not aware of any environmental liability that itbelieves would have a materially adverse impact on our financial position,results of operations or cash flows.**

 

**19.**  Segment Reporting

 

**Statement of Financial AccountingStandard No. 131, or “SFAS No. 131,” establishes standards for theway that public entities report information about operating segments in theirannual financial statements.  We are aREIT focused on originating and acquiring loans and securities related to realestate and currently operate in only one segment.**

 

**20.**  Supplemental Disclosure ofNon-Cash Investing and Financing Activities

 

Thefollowing table represents non-cash investing and financing activities (inthousands):

 

| ** **                            | ** ** | **2005** | ** ** |
|---------------------------------------|------------|----------|------------|
| Derivative  instruments at fair value |       | $        | (487       | ) |
|                                       |            |          |            |  |

 

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**ITEM 2:  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

**Overview**

We are a nationalcommercial real estate specialty finance company formed in April of 2004focused on originating and acquiring, for our own account, fixed and floatingrate mortgage loans, bridge loans, subordinate interests in mortgage loans,distressed debt, mortgage-backed securities, mezzanine loans and preferredequity interests in entities that own commercial real estate, primarily in theUnited States.  We also make equityinvestments in commercial real estate properties net leased to tenants,primarily for the recurring earnings, tax benefits and long-term residualbenefits these transactions often hold. We conduct substantially all of our operations through our operatingpartnership, GKK Capital LP.  We areexternally managed and advised by GKK Manager LLC, or the Manager, a majority-ownedsubsidiary of SL Green Realty Corp., or SL Green.  We intend to elect to be taxed as a REITunder the Internal Revenue Code and generally will not be subject to federalincome taxes to the extent we distribute our income to our stockholders.  However, we may establish taxable REITsubsidiaries to effect various taxable transactions.  Those taxable REIT subsidiaries would incurfederal, state and local taxes on the taxable income from their activities.  Unless the context requires otherwise, all referencesto “we,” “our” and “us” mean Gramercy Capital Corp.

 

In each financingtransaction we undertake, we seek to control as much of the capital structureas possible in order to be able to identify and retain that portion thatprovides the best risk adjusted returns. This is generally achieved through the direct origination of wholeloans, the ownership of which permits a wide variety of syndication andsecuritization executions to achieve excess returns.  By providing a single source of financing fordevelopers and sponsors, we intend to streamline the lending process, providegreater certainty for borrowers and retain the high yield debt instruments thatwe manufacture.  By creating, rather thanbuying whole loans, subordinate mortgage participations, mezzanine debt andpreferred equity, we strive to deliver superior returns to our shareholders.

 

Since our inception, wehave completed transactions in a variety of markets and secured by severalproperty types.  During this period, themarket for commercial real estate debt has continued to demonstrate low ratesof default, high relative returns and tremendous inflows of capital.  Consequently, the market for debt instrumentshas evidenced moderately declining yields and more flexible credit standardsand loan structures.  In particular, “conduit”originators who package whole loans for resale to investors have driven debtyields lower while maintaining substantial liquidity because of the strongdemand for the resulting securities. Because of reduced profits in the most liquid sectors of the mortgagefinance business, several large institutions have begun originating largebridge loans for the purpose of generating interest income, rather than thetypical focus on trading profits.  Inthis environment we have focused on areas where we have comparative advantagesrather than competing for product merely on the basis of yield orstructure.  This has particularlyincluded whole loan origination in markets and transactions where we have anadvantage due to knowledge or relationships we have or our largest shareholder,SL Green, has or where we have an ability to better assess and manage risksover time.  When considering investmentopportunities in secondary market transactions in tranched debt, we generallyavoid first loss risk in larger transactions due to the high historicvaluations of most of the corresponding assets. Because of the significant increase in the value of institutionalquality assets relative to historic norms, we typically focus on positions inwhich a customary refinancing at loan maturity would provide for a return ofour investment.  Because of ourrelatively small size at this time, we can meet our growth objectives with amoderate amount of new investment activity.

 

Because of the high relativevaluation of debt instruments in the current market and a generally increasingrate environment, we have carefully managed our exposure to interest ratechanges that could affect our liquidity. We generally match our assets and liabilities in terms of base interestrate (generally 30-day LIBOR) and expected duration.  We raised $95.0 million of additional equityin December 2004 and January 2005 to reduce our outstandingindebtedness and maintain sufficient liquidity for our investment portfolio.   In May 2005 we sold $50.0 million of trust preferredsecurities through the wholly owned subsidiary of the Operating Partnership,Gramercy Capital Trust I, with a 30 year term expiring in May 2035.  They bear interest at a fixed rate of 7.57%for the first ten years ending June 2015, after which they bear interest atthree month LIBOR plus 300 basis points. The proceeds from the issuance of the trust preffered securities wereused to fund existing and future investment opportunities.  In July 2005 we closed on a $1.0 billioncollateralized debt obligation, or CDO, which will serve to extend the term ofour liabilities and lower our overall cost of funds from approximately 200basis points over LIBOR to approximately 49 basis points over LIBOR, excludingtransaction costs.  The proceeds of theCDO were used to refinance our warehouse facilities and to fund additionalinvestment activities.

 

As of June 30, 2005,we held loans and other lending investments of approximately $749.0 million netof fees, discounts, repayments, asset sales and unfunded commitments.  As of June 30, 2005 we also held a57,190 investment in an unconsolidated joint venture that acquired the SouthBuilding located at One Madison Avenue in New York, New York.

 

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The aggregate carryingvalues, allocation by product type and weighted average coupons of our loansand other lending investments as of June 30, 2005 were as follows:

 
| ** **                                     | ** ** | **Carrying Value  ($ in thousands)** | ** ** | **Allocation by  Investment  Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average  Spread over  LIBOR** | ** ** |
|------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------|------------|--------------------------------|------------|-------------------------------------------------|------------|
| Whole  loans, floating rate                    |       | $                                         | 291,451    |                                | 39         | %                              |       |                                            | 308        | bps |
| Whole  loans, fixed rate                       |       | 68,866                                    |       | 9                                   | %          | 8.33                           | %          |                                            |       |
| Subordinate  mortgage interests, floating rate |       | 252,926                                   |       | 34                                  | %          |                           |       | 643                                             | bps        |
| Subordinate  mortgage interests, fixed rate    |       | 34,970                                    |       | 4                                   | %          | 9.60                           | %          |                                            |       |
| Mezzanine  loans, floating rate                |       | 74,808                                    |       | 10                                  | %          |                           |       | 889                                             | bps        |
| Mezzanine  loans, fixed rate                   |       | 3,291                                     |       | 1                                   | %          | 14.53                          | %          |                                            |       |
| Preferred  equity                              |       | 11,740                                    |       | 2                                   | %          |                           |       | 900                                             | bps        |
| Commercial  mortgage backed securities         |       | 10,948                                    |       | 1                                   | %          | 13.49                          | %          |                                            |       |
| Total  / Average                               |       | $                                         | 749,000    |                                | 100        | %                              | 9.36       | %                                               | 522        | bps |

 

The following discussionrelating to our consolidated financial statements should be read in conjunctionwith the financial statements appearing in Item 8 of the Annual Report on Form 10-Kand Item 1 of this form 10-Q.

 

**CriticalAccounting Policies**

Our discussion andanalysis of financial condition and results of operations is based on ourfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States, known as GAAP. Theseaccounting principles require us to make some complex and subjective decisionsand assessments.  Our most criticalaccounting policies involve decisions and assessments which could significantlyaffect our reported assets, liabilities and contingencies, as well as ourreported revenues and expenses.  Webelieve that all of the decisions and assessments upon which our financialstatements are based were reasonable at the time made based upon informationavailable to us at that time.  Weevaluate these decisions and assessments on an ongoing basis.  Actual results may differ from theseestimates under different assumptions or conditions.  We have identified our most criticalaccounting policies to be the following:

 

**Loans and Investments and LoansHeld for Sale**

Loansheld for investment are intended to be held to maturity and, accordingly, arecarried at cost, net of unamortized loan origination costs and fees, discounts,repayments, sales of partial interests in loans, and unfunded commitmentsunless such loan or investment is deemed to be impaired. Loans held for saleare carried at the lower of cost or market value using available marketinformation obtained through consultation with dealers or other originators of suchinvestments.  We originate or acquirepreferred equity interests that allow us to participate in a percentage of theunderlying property’s cash flows from operations and proceeds from a sale orrefinancing.  At the inception of eachsuch investment, we must determine whether such investment should be accountedfor as a loan, joint venture or as an interest in real estate.

 

Specific valuation allowances are established for impaired loans basedon the fair value of collateral on an individual loan basis.  The fair value of the collateral isdetermined by an evaluation of operating cash flow from the property during theprojected holding period, and the estimated sales value of the collateralcomputed by applying an expected capitalization rate to the stabilized netoperating income of the specific property, less selling costs, all of which arediscounted at market discount rates.

 

If upon completion of thevaluation, the fair value of the underlying collateral securing the impairedloan is less than the net carrying value of the loan, an allowance is createdwith a corresponding charge to the provision for loan losses.  The allowance for each loan is maintained ata level we believe is adequate to absorb probable losses.  At June 30, 2005 we maintained a reserveof $525.

 

Our Manager evaluates ourassets on a regular basis to determine if they continue to satisfy ourinvestment criteria. Subject to certain restrictions applicable to REITs, ourManager may cause us to sell our investments opportunistically and use theproceeds of any such sale for debt reduction, additional acquisitions orworking capital purposes.

 

25

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#### **Classifications of Mortgage-BackedSecurities**

Inaccordance with applicable GAAP, mortgage-backed securities, or MBS, areclassified as available-for-sale securities. As a result, changes in fair value will be recorded as a balance sheetadjustment to accumulated other comprehensive income, which is a component ofstockholders equity, rather than through our statement of operations.  If available-for-sale securities wereclassified as trading securities, there could be substantially greatervolatility in earnings from period-to-period as these investments would bemarked to market and any reduction in the value of the securities versus theprevious carrying value would be considered an expense on our statement ofoperations. We had no investments as of June 30, 2005 that were accountedfor as trading securities.

 

#### **Valuations of Mortgage-BackedSecurities**

AllMBS will be carried on the balance sheet at fair value.  We determine the fair value of MBS based onthe types of securities in which we have invested.  For liquid, investment-grade securities, weconsult with dealers of such securities to periodically obtain updated marketpricing for the same or similar instruments. For non-investment grade securities, we actively monitor the performanceof the underlying properties and loans and update our pricing model to reflectchanges in projected cash flows.  Thevalue of the securities is derived by applying discount rates to such cashflows based on current market yields. The yields employed are obtained from our own experience in the market,advice from dealers and/or information obtained in consultation with otherinvestors in similar instruments. Because fair value estimates may vary to some degree, we must makecertain judgments and assumptions about the appropriate price to use tocalculate the fair values for financial reporting purposes.  Different judgments and assumptions couldresult in different presentations of value.

 

When the fair value of anavailable-for-sale security is less than the amortized cost, we considerwhether there is an other-than-temporary impairment in the value of thesecurity (for example, whether the security will be sold prior to the recoveryof fair value).  If, in our judgment, another-than-temporary impairment exists, the cost basis of the security iswritten down to the then-current fair value, and this loss is realized andcharged against earnings.  Thedetermination of other-than temporary impairment is a subjective process, anddifferent judgments and assumptions could affect the timing of lossrealization.

 

#### **Credit Tenant Lease Investments**

Credittenant lease, or CTL, investments are recorded at cost less accumulateddepreciation.  Costs directly related tothe acquisition of such investments are capitalized.  Certain improvements are capitalized whenthey are determined to increase the useful life of the building.  Capitalized items are depreciated using thestraight-line method over the shorter of the useful lives of the capitalized itemor 40 years for buildings or facilities, the remaining life of the facility forfacility improvements, four to seven years for personal property and equipment,and the shorter of the remaining lease term or the expected life for tenantimprovements.

 

Inaccordance with FASB No. 144, or SFAS 144, “Accounting for the Impairmentof Disposal of Long-Lived Assets,” a property to be disposed of is reported atthe lower of its carrying amount or its estimated fair value, less its cost tosell.  Once an asset is held for sale,depreciation expense and straight-line rent adjustments are no longer recordedand historic results are reclassified as Discontinued Operations.

 

Inaccordance with FASB No. 141, or SFAS 141, “Business Combinations,” weallocate the purchase price of real estate to land and building and, ifdetermined to be material, intangibles, such as the value of above, below andat-market leases and origination costs associated with the in-placeleases.  We depreciate the amount allocated to building and otherintangible assets over their estimated useful lives, which generally range fromthree to 40 years.  The values of the above and below market leases areamortized and recorded as either an increase (in the case of below marketleases) or a decrease (in the case of above market leases) to rental incomeover the remaining term of the associated lease.  The value associatedwith in-place leases and tenant relationships are amortized over the expectedterm of the relationship, which includes an estimated probability of the leaserenewal, and its estimated term.  If a tenant vacates its space prior tothe contractual termination of the lease and no rental payments are being madeon the lease, any unamortized balance of the related intangible will be writtenoff.  The tenant improvements and origination costs are amortized as anexpense over the remaining life of the lease (or charged against earnings ifthe lease is terminated prior to its contractual expiration date).  Weassess fair value of the leases based on estimated cash flow projections thatutilize appropriate discount and capitalization rates and available marketinformation.  Estimates of future cash flows are based on a number offactors including the historical operating results, known trends, andmarket/economic conditions that may affect the property.  At June 30, 2005 we held one CTLinvestment of $57,190 through an investment in the joint venture that acquiredthe South Building located at One Madison Avenue in New York, New York.

 

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**Investment in Unconsolidated Joint Ventures**

#### **We account for our investment in an unconsolidated jointventure under the equity method of accounting as we exercise significantinfluence, but do not unilaterally control the entity, and are not consideredto be the primary beneficiary under FIN 46.  In the joint venture, therights of the other investor are both protective as well as participating.These rights preclude us from consolidating the investment.  Theinvestment is recorded initially at cost, as an investment in an unconsolidatedjoint venture, and subsequently adjusted for equity in net income (loss) andcash contributions and distributions.  Any difference between the carryingamount of the investments on our balance sheet and the underlying equity in netassets is amortized as an adjustment to equity in net income (loss) ofunconsolidated joint ventures over the lesser of the joint venture term or 40years.  None of the joint venture debt is recourse to us.**

#### ** **

#### **Revenue Recognition**

Interestincome on debt investments is recognized over the life of the investment usingthe effective interest method and recognized on the accrual basis.  Fees received in connection with loancommitments are deferred until the loan is funded and are then recognized overthe term of the loan as an adjustment to yield. Anticipated exit fees, whose collection is expected, are also recognizedover the term of the loan as an adjustment to yield.  Fees on commitments that expire unused arerecognized at expiration.  Fees receivedin exchange for the credit enhancement of another lender, either subordinate orsenior to us, in the form of a guarantee are recognized over the term of thatguarantee using the straight-line method.

 

Income recognition isgenerally suspended for debt investments at the earlier of the date at whichpayments become 90 days past due or when, in our opinion, a full recovery ofincome and principal becomes doubtful. Income recognition is resumed when the loan becomes contractuallycurrent and performance is demonstrated to be resumed.

 

In some instances we may sell all or a portion ofour investments to a third party.  To theextent the fair value received for an investment exceeds the amortized cost ofthat investment and FASB Statement No. 140, or SFAS 140, “Accounting forTransfers and Servicing of Financial Assets and Extinguishments of Liabilities,”criteria is met, under which control of the asset that is sold is surrenderedmaking it a “true sale,” a gain on the sale will be recorded through earningsas other income.

 

#### **Reserve for Possible Credit Losses**

The expense for possiblecredit losses in connection with debt investments is the charge to earnings toincrease the allowance for possible credit losses to the level that managementestimates to be adequate considering delinquencies, loss experience andcollateral quality.  Other factorsconsidered relate to geographic trends and project diversification, the size ofthe portfolio and current economic conditions. Based upon these factors, we establish the provision for possible creditlosses by category of asset.  When it isprobable that we will be unable to collect all amounts contractually due, theaccount is considered impaired.

 

Where impairment isindicated, a valuation write-down or write-off is measured based upon theexcess of the recorded investment amount over the net fair value of thecollateral, as reduced by selling costs. Any deficiency between the carrying amount of an asset and the net salesprice of repossessed collateral is charged to the allowance for creditlosses.  At June 30, 2005 wemaintained a reserve for possible credit losses of $525.

 

**Incentive Distribution (Class BLimited Partner Interest)**

The Class B limited partner interest isentitled to receive an incentive return equal to 25% of the amount by whichfunds from operations (as defined in the partnership agreement of the OperatingPartnership) plus certain accounting gains exceed the product of our weightedaverage stockholders equity (as defined in the partnership agreement of theOperating Partnership) multiplied by 9.5% (divided by 4 to adjust for quarterlycalculations).  We will record anydistributions on the Class B limited partner interests as an incentivedistribution expense in the period when earned and when payment of such amountshas become probable and reasonably estimable in accordance with the partnershipagreement.  These cash distributions willreduce the amount of cash available for distribution to our common unitholdersin our Operating Partnership and to common stockholders.  No amounts were earned or accrued withrespect to the Class B limited partner interests as of June 30, 2005.

 

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**Derivative Instruments**

**In thenormal course of business, we use a variety of derivative instruments tomanage, or hedge, interest rate risk.  Werequire that hedging derivative instruments be effective in reducing theinterest rate risk exposure that they are designated to hedge.  This effectiveness is essential for qualifyingfor hedge accounting.  Some derivativeinstruments are associated with an anticipated transaction.  In those cases, hedge effectiveness criteriaalso require that it be probable that the underlying transaction occurs.  Instruments that meet these hedging criteriaare formally designated as hedges at the inception of the derivative contract.**

** **

**Todetermine the fair value of derivative instruments, we use a variety of methodsand assumptions that are based on market conditions and risks existing at eachbalance sheet date.  For the majority offinancial instruments including most derivatives, long-term investments andlong-term debt, standard market conventions and techniques such as discountedcash flow analysis, option-pricing models, replacement cost, and terminationcost are used to determine fair value. All methods of assessing fair value result in a general approximation ofvalue, and such value may never actually be realized.**

** **

In the normal course ofbusiness, we are exposed to the effect of interest rate changes and limit theserisks by following established risk management policies and proceduresincluding the use of derivatives.  Toaddress exposure to interest rates, we use derivatives primarily to hedge the mark-to-marketrisk of our liabilities with respect to certain of our assets.

 

We usea variety of commonly used derivative products that are considered plainvanilla derivatives.  These derivativestypically include interest rate swaps, caps, collars and floors.  We also use total rate of return swaps, orTROR swaps, which are tied to the Lehman Brothers CMBS index. We expresslyprohibit the use of unconventional derivative instruments and using derivativeinstruments for trading or speculative purposes.  Further, we have a policy of only enteringinto contracts with major financial institutions based upon their creditratings and other factors.

 

**FASB No. 133, or SFAS 133, “Accounting for Derivative Instrumentsand Hedging Activities,” which became effective January 1, 2001, requiresus to recognize all derivatives on the balance sheet at fair value.  Derivatives that are not hedges must beadjusted to fair value through income. If a derivative is a hedge, depending on the nature of the hedge,changes in the fair value of the derivative will either be offset against thechange in fair value of the hedged asset, liability, or firm commitment throughearnings, or recognized in other comprehensive income until the hedged item isrecognized in earnings.  The ineffectiveportion of a derivative’s change in fair value will be immediately recognizedin earnings.  SFAS 133 may increase ordecrease reported net income and stockholders’ equity prospectively, dependingon future levels of LIBOR, swap spreads and other variables affecting the fairvalues of derivative instruments and hedged items, but will have no effect oncash flows, provided the contract is carried through to full term.**

** **

We may employ swaps,forwards or purchased options to hedge qualifying forecasted transactions.  Gains and losses related to thesetransactions are deferred and recognized in net income as interest expense inthe same period or periods that the underlying transaction occurs, expires oris otherwise terminated.

 

All hedges held by us aredeemed to be highly effective in meeting the hedging objectives established byour corporate policy governing interest rate risk management.

 

**Income Taxes**

Weintend to elect to be taxed as a REIT, under Sections 856 through 860 of theInternal Revenue Code, beginning with our taxable year ending December 31,2004.  To qualify as a REIT, we must meetcertain organizational and operational requirements, including a requirement todistribute at least 90% of our ordinary taxable income to stockholders.  As a REIT, we generally will not be subjectto federal income tax on taxable income that we distribute to ourstockholders.  If we fail to qualify as aREIT in any taxable year, we will then be subject to federal income taxes onour taxable income at regular corporate rates and we will not be permitted toqualify for treatment as a REIT for federal income tax purposes for four yearsfollowing the year during which qualification is lost unless the InternalRevenue Service grants us relief under certain statutory provisions.  Such an event could materially adverselyaffect our net income and net cash available for distributions tostockholders.  However, we believe thatwe will be organized and operate in such a manner as to qualify for treatmentas a REIT and we intend to operate in the foreseeable future in such a mannerso that we will qualify as a REIT for federal income tax purposes.  We may, however, be subject to certain stateand local taxes.

 

**Our wholly owned subsidiary, GKK Trading Corp, a taxableREIT subsidiary, or TRS, is subject to federal, state and local taxes.**

** **

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** **

**Results of Operations**

 

***Forthe three months ended June 30, 2005 (dollars in thousands)***

 

*Revenue*

Investmentincome of $15,689 for the three months ended June 30, 2005 was generated onour whole loans, senior mortgage interests, subordinate mortgage interests,mezzanine loans, preferred equity interests and CMBS investments.  $2,058 was earned on fixed rate investmentswhile the remaining $13,631 relates to floating rate investments.

 

Otherincome of $3,069 for the three months ended June 30, 2005 is comprisedprimarily of income recorded on the sale of senior mortgage interests or wholeloans of $2,967.

 

*Expenses*

Interest expense was$6,264 for the three months ended June 30, 2005, of which $5,532represents interest on borrowings on our master repurchase facilities withWachovia Capital Markets LLC and Goldman Sachs Mortgage Company.  The remaining balance is comprised primarilyof $410 of interest expense accrued against the $50,000 issuance of trustpreferred securities and $431 of amortization of deferred financing costs,offset by an adjustment to previously paid interest on our interest rate swapagreements.

 

Management fees of $1,870for the three months ended June 30, 2005 represents fees paid or payableto the Manager of $1,326 under our management agreement and fees paid orpayable to SL Green Operating Partnership, L.P. of $312 and $232 under ouroutsourcing and servicing agreements, respectively.  These fees and the relationship between us,the Manager and SL Green Operating Partnership, L.P. are discussed further in “RelatedParty Transactions.”

 

Marketing, general andadministrative expenses were $1,632 for the three months ended June 30,2005, which represents professional fees, stock-based compensation, insuranceand general overhead costs.

 

Stock-based compensationexpense included in marketing, general and administrative expenses was $814 forthe three months ended June 30, 2005. This represents the cost of restricted stock and options granted or tobe granted to certain of our executive officers and directors.  The compensation expense recorded for thethree months ended June 30, 2005 represents a ratable portion of theexpense of the issuance of these shares over their vesting period.

 

***Forthe six months ended June 30, 2005 (dollars in thousands)***

 

*Revenue*

Investmentincome of $25,939 for the six months ended June 30, 2005 was generated onour whole loans, senior mortgage interests, subordinate mortgage interests,mezzanine loans, preferred equity interests and CMBS investments.  $3,308 was earned on fixed rate investmentswith a weighted average yield of 9.36%. The remaining $22,631 relates to floating rate investments with aweighted average interest rate of LIBOR plus 5.22%.

 

Otherincome of $3,509 for the six months ended June 30, 2005 is comprisedprimarily of income recorded on the sale of senior mortgage interests or wholeloans of $3,370.  $139 representsinterest earned on cash balances and servicing strip income.

 

*Expenses*

Interest expense was$9,065 for the six months ended June 30, 2005, of which $7,829 representsinterest on borrowings on our master repurchase facilities with WachoviaCapital Markets LLC and Goldman Sachs Mortgage Company which had a weighted averagespread to LIBOR of 190 basis points for the same period.  The remaining balance is comprised primarilyof $410 of interest expense accrued against the $50,000 issuance of trustpreferred securities and $826 of amortization of deferred financing costs,offset by an adjustment to previously paid interest on our interest rate swapagreements.

 

Management fees of $3,538for the six months ended June 30, 2005 represents fees paid or payable tothe Manager of $2,530 under our management agreement and fees paid or payableto SL Green Operating Partnership, L.P. of $625 and $383 under our outsourcingand servicing agreements, respectively.

 

Marketing, general andadministrative expenses were $3,266 for the six months ended June 30,2005, which represents professional fees, stock-based compensation, insuranceand general overhead costs.

 

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Stock-basedcompensation expense included in marketing, general and administrative expenseswas $1,457 for the three months ended June 30, 2005.  This represents the cost of restricted stockand options granted or to be granted to certain of our executive officers anddirectors.  Of the shares of restrictedstock issued, approximately 89% will vest equally over a three-year period andthe remaining 11% will vest equally over a four-year period.  Of the options granted, 69% will vest equallyover a three-year period and the remaining 31% will vest equally over afour-year period.  The compensationexpense recorded for the six months ended June 30, 2005 represents aratable portion of the expense of the issuance of these shares over theirvesting period.

 

**Liquidity and Capital Resources**

 

**Liquidity is a measurement of the ability to meet cash requirements,including ongoing commitments to repay borrowings, fund and maintain loans andinvestments, pay dividends and other general business needs.**  Webelieve that our principal sources of working capital and funds for additionalinvestments will primarily include: 1) cash flow from operations; 2) borrowingsunder our repurchase and credit facilities; 3) our CDO; 4)other forms offinancing or additional securitizations including CMBS or subsequent CDOofferings; 5) proceeds from common or preferred equity offerings and, to alesser extent, 6) the proceeds from principal payments on our investments.  We believe these sources of financing will besufficient to meet our short-term liquidity needs.

** **

Our ability to meet ourlong-term liquidity and capital resource requirements will be subject to obtainingadditional debt financing and equity capital. If we are unable to renew, replace or expand our sources of financing onsubstantially similar terms, it may have an adverse effect on our business andresults of operations.  In addition, anevent of default is triggered under our repurchase facility with WachoviaCapital Markets LLC if the management agreement with GKK Manager LLC isterminated.  Depending on marketconditions, our debt financing will be in the range of 70% to 80% of thecarrying value of our total assets.  Anyindebtedness we incur will likely be subject to continuing covenants and wewill likely be required to make continuing representations and warranties inconnection with such debt.  Our debtfinancing terms may require us to keep uninvested cash on hand, or to maintaina certain portion of our assets free of liens, each of which could serve tolimit our borrowing ability.  Moreover,our debt may be secured by our assets. If we default in the payment of interest or principal on any such debt,breach any representation or warranty in connection with any borrowing orviolate any covenant in any loan document, our lender may accelerate thematurity of such debt requiring us to immediately repay all outstandingprincipal.  If we are unable to make suchpayment, our lender could foreclose on our assets that are pledged ascollateral to such lender.  The lendercould also sue us or force us into bankruptcy. Any such event would have a material adverse effect on our liquidity andthe value of our common stock.  Inaddition, posting additional collateral to support our credit facilities willreduce our liquidity and limit our ability to leverage our assets.

 

To maintain our status asa REIT under the Internal Revenue Code, we must distribute annually at least90% of our taxable income.  Thesedistribution requirements limit our ability to retain earnings and therebyreplenish or increase capital for operations. However, we believe that our significant capital resources and access tofinancing will provide us with financial flexibility at levels sufficient tomeet current and anticipated capital requirements, including funding newlending and investment opportunities.

 

**CollateralizedDebt Obligation**

 

On July 14, 2005, weissued approximately $1,000,000 of collateralized debt obligations, or CDO,through two newly-formed indirect subsidiary, Gramercy Real Estate CDO 2005-1Ltd., or the Issuer, and Gramercy Real Estate CDO 2005-1 LLC, or theCo-Issuer. The CDO consists of $810,500 of investment grade notes, and $84,500of non-investment grade notes, which were co-issued by the Issuer and theCo-Issuer, and $105,000 of preferred shares, which were issued by the Issuer.  We retained all non-investment gradesecurities and the preferred shares in the Issuer.  The Issuer holds assets, consisting primarilyof whole loans, subordinate interests in whole loans, mezzanine loans andpreferred equity investments, which serve as collateral for the CDO. Theinvestment grade notes were issued with floating rate coupons with a combinedweighted average rate of three-month LIBOR plus 0.49%. The CDO may bereplenished pursuant to certain rating agency guidelines relating to creditquality and diversification, with substitute collateral for loans that arerepaid during the first five years of the CDO. Thereafter, the CDO securitieswill be retired in sequential order from senior-most to junior-most as loansare repaid. We incurred approximately $11,342 of issuance costs which will beamortized on a level yield basis over the average life of the CDO. Foraccounting purposes, the Issuer is consolidated in our financial statements.The investment grade notes are treated as a secured financing, and arenon-recourse to us.

 

Proceeds from the sale ofthe investment grade notes issued were used to repay substantially alloutstanding debt under our repurchase agreements and fund additionalinvestments. The assets pledged as collateral were contributed from ourexisting portfolio of assets.

 

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**Junior Subordinated Debentures**

** **

**On May 20,2005 we completed the issuance of $50,000 in unsecured floating rate trustpreferred securities through a newly formed Delaware statutory trust, GramercyCapital Trust I, or GCTI, that is a wholly owned subsidiary of the OperatingPartnership.  The securities bearinterest at a fixed rate of 7.57% for the first ten years ending June 2015.  Thereafter the rate will float based on thethree-month LIBOR plus 300 basis points. The trust preferred securities require quarterly interest distributions,however payments may be deferred while the interest expense is accrued for aperiod of up to four consecutive quarters if the Operating Partnershipexercises its right to defer such payments. The trust preferred securities are redeemable, at the option of theOperating Partnership, in whole or in part, with no prepayment premium any timeafter June 30, 2010.**

** **

**GCTI issued$1,550 aggregate liquidation amount of common securities, representing 100% ofthe voting common stock of GCTI to the Operating Partnership for a purchaseprice of $1,550.  GCTI used the proceedsfrom the sale of the trust preferred securities and the common securities topurchase the Operating Partnership’s junior subordinated notes.  The terms of the junior subordinated notesmatch the terms of the trust preferred securities.  The notes are subordinate and junior in rightof payment to all present and future senior indebtedness and certain other of ourfinancial obligations.  We realized netproceeds from this offering of approximately $48,956.**

** **

**Our interest in GCTI is accounted for using the equity method and theassets and liabilities of GCTI are not consolidated into our financialstatements.  Interest on the juniorsubordinated notes is included in interest expense on our consolidated incomestatements while the junior subordinated notes are presented as a separate itemin our consolidated balance sheet.**

** **

**Indebtedness**

** **

**The table below summarizes borrowings under our Wachovia and Goldman repurchasefacilities at June 30, 2005 (dollars in thousands).**

** **

| **Debt  Summary:**                     | ** ** | **June 30,  2005** | ** ** |
|----------------------------------------|------------|-------------------------|------------|
| **Balance**                            | ** ** | ** **              | ** ** |
| Fixed rate                             | ** ** | $                       | —     | ** ** |
| Variable rate                          | ** ** | 500,000                 | ** ** |
| Total                                  | ** ** | $                       | 500,000    | ** ** |
| ** **                             | ** ** | ** **              | ** ** |
| Effective interest rate for the period | ** ** | LIBOR + 1.90%           | ** ** |

** **

**Repurchase Facilities**

** **

Wecurrently have two repurchase facilities with an aggregate of $700 million oftotal debt capacity.  In August 2004we closed on a $250 million repurchase facility with Wachovia Capital MarketsLLC.  This facility was then increased to$350 million on January 3, 2005 and subsequently increased to $500 millionon April 22, 2005.  As partof the April 2005 increase to $500 million, the initial term of thisfacility was modified to reflect a staggered term in which $250 million maturesin August 2007, $150 million matures in December 2007 and theremaining $100 million matures in June 2008.  Also in conjunction with the April 2005upsize, the $50 million credit facility we previously maintained with Wachoviawas consolidated into the $500 million repurchase facility.  The$500 million facility bears interest at spreads of 1.25% to 3.50% over 30-dayLIBOR and, based on our investment activities, provides for advance rate thatvary from 50% to 95% based upon the collateral provided under a borrowing basecalculation.  The lender has a consentright with respect to the inclusion of investments in this facility, determinesperiodically the market value of the investments, and has the right to requireadditional collateral if the estimated market value of the included investmentsdeclines. At June 30, 2005 we had an outstanding balance of $347.8 millionon this facility at a weighted average spread to LIBOR of 2.02%. On July 14,2005 we repaid substantially all of the borrowings against this facility usingproceeds from the issuance of the CDO.

 

**On January 3, 2005 we closed an additional repurchase facility of$200 million with Goldman Sachs Mortgage Company, an affiliate of Goldman Sachs &Co.  This facility has an initial term ofthree years expiring in January 2008 with one six-month extensionoption.  This facility bears interest atspreads of 1.125% to 2.75% over a 30-day LIBOR and, based on ourinvestment activities, provides for advance rates that vary from 75% to 90%based upon the collateral provided under a borrowing base calculation.  As with the Wachovia repurchase facility, thelender has a consent right to the inclusion of investments in this facility,determines periodically the market value of the investments, and has the rightto require additional collateral if the estimated market value of the includedinvestments declines. At June 30, 2005 we had an outstanding**

** **

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** **

**balance of $152.2 million on this repurchase facility at a weightedaverage spread to LIBOR of 1.64%.**On July 14, 2005 we repaid all of the borrowingsagainst this facility using proceeds from the issuance of the CDO.

** **

The repurchase facilitiesrequire that we pay down borrowings under these facilities as principalpayments on our loans and investments are received.  Assets pledged as collateral under these facilities may includestabilized and transitional first mortgage whole loans, first mortgage B-notes,mezzanine loans, and rated CMBS or commercial real estate CDO securitiesoriginated or acquired by us.

 

**Credit Facility**

** **

Wecurrently have one $25 million credit facility with Wachovia Capital Markets LLC. with a term of two years.  Amounts drawn under this facility forliquidity purposes bear interest at a spread over LIBOR of 525 basis points.  Amounts drawn under this facility foracquisition purposes bear interest at a spread over LIBOR of 225 basispoints.  Amounts drawn under thisfacility for liquidity purposes must be repaid within 105 days.  Amounts drawn under this facility generallywill be secured by assets established under a borrowing base calculation unlesscertain financial covenants are satisfied. These covenants are generally more restrictive than those set forthbelow.  At June 30, 2005 we did nothave any borrowings under our credit facilities.

 

**The credit facility requires that we pay down borrowings under thesefacilities as principal payments on our loans and investments are received.**

** **

**Restrictive Covenants**

** **

**The terms of both of our repurchase facilities and our credit facilityinclude covenants that (a) limit our maximum total indebtedness to no morethan 85% of our total assets, (b) require us to maintain minimum liquidityof at least $10 million for the first two years and $15 million thereafter, (c) ourfixed charge coverage ratio shall at no time be less than 1.50 to 1.00, (d) ourminimum interest coverage ratio shall at no time be less than 1.75 to 1.00, (e) requireus to maintain minimum tangible net worth of not less than the greater of (i) $129.75million, or (i) plus (ii) 75% of the proceeds of our subsequentequity issuances and (f) restrict the maximum amount of our totalindebtedness.  The covenants alsorestrict us from making distributions in excess of a maximum of 103% of ourfunds from operations (as defined by the National Association of Real EstateInvestment Trusts) through July 2005 and 100% thereafter, except that wemay in any case pay distributions necessary to maintain our REIT status.  Under our facilities with Wachovia CapitalMarkets LLC, an event of default will be triggered if GKK Manager LLC ceases tobe the Manager.  As of June 30,2005, we were in compliance with all such covenants.**

** **

To maintain our status asa REIT under the Internal Revenue Code, we must distribute annually at least90% of our taxable income.  Thesedistribution requirements limit our ability to retain earnings and therebyreplenish or increase capital for operations. However, we believe that our significant capital resources and access tofinancing will provide us with financial flexibility at levels sufficient tomeet current and anticipated capital requirements, including funding newlending and investment opportunities.

 

**Capitalization**

** **

As of June 30, 2005,we had 18,833,060 shares of common stock outstanding.

 

**Market Capitalization**

 

At June 30,2005, borrowings under our repurchase facilities and our revolving creditfacilities represented 52% of our consolidated market capitalization of $961million (based on a common stock price of $24.46 per share, the closing priceof our common stock on the New York Stock Exchange on June 30, 2005).  Market capitalization includes ourconsolidated debt and common stock.

 

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** **

**ContractualObligations**

 

Combinedaggregate principal maturities of borrowings under our repurchase facilitiesand revolving credit facility and our obligations under our operating lease asof June 30, 2005 are as follows (in thousands):

 
| ** ** | ** ** | **Repurchase  Facilities** | ** ** | **Trust  Preferred  Securities** | ** ** | **Revolving  Credit  Facility** | ** ** | **Operating  Leases** | ** ** | **Total** | ** ** |
|------------|------------|----------------------------|------------|----------------------------------|------------|---------------------------------|------------|-----------------------|------------|-----------|------------|
| 2005       |       | $                          | —     |                             | $          | —                          |       | $                     | —     |      | $          | 145 |   | $ | 145 |   |
| 2006       |       | —                     |       | —                           |       | —                          |       | 252                   |       | 252       |       |
| 2007       |       | 347,789                    |       | —                           |       | —                          |       | 256                   |       | 348,045   |       |
| 2008       |       | 152,211                    |       | —                           |       | —                          |       | 261                   |       | 152,472   |       |
| 2009       |       | —                     |       | —                           |       | —                          |       | 265                   |       | 265       |       |
| Thereafter |       | —                     |       | 50,000                           |       | —                          |       | 1,633                 |       | 51,633    |       |
|       |       | $                          | 500,000    |                             | $          | 50,000                          |       | —                |       | $         | 2,812      |   | $ | 552,812 |   |
|            |            |                            |            |                                  |            |                                 |            |                       |            |           |            |  |  |  |  |  |

 

**Dividends**

 

To maintain ourqualification as a REIT, we must pay annual dividends to our stockholders of atleast 90% of our REIT taxable income, determined before taking intoconsideration the dividends paid deduction and net capital gains.  We intend to continue to pay regularquarterly dividends to our stockholders. Before we pay any dividend, whether for Federal income tax purposes orotherwise, which would only be paid out of available cash to the extentpermitted under our unsecured and secured credit facilities, and our termloans, we must first meet both our operating requirements and scheduled debtservice on our mortgages and loans payable.

 

**RelatedParty Transactions**

 

Inconnection with our initial public offering, we entered into a ManagementAgreement with GKK Manager LLC, which provides for an initial term through December 2007with automatic one-year extension options and is subject to certain terminationrights.  We pay the Manager an annualmanagement fee equal to 1.75% of our gross stockholders equity (as defined inthe Management Agreement) inclusive of the trust preferred securities issued onMay 20, 2005.  For the three and sixmonths ended June 30, 2005, we paid or had payable an aggregate ofapproximately $1,326 and $2,530 to the Manager under this agreement,respectively.

 

At June 30, 2005,the Class B limited partner interests were owned by our Manager and SLGreen Operating Partnership, L.P. and certain officers and employees of SLGreen Realty Corp., including some of whom are our executive officers.  To provide an incentive for the Managerto enhance the value of the common stock, the Manager and SL Green OperatingPartnership, L.P. are entitled through their ownership of Class B limitedpartner interests of the Operating Partnership to an incentive return equal to25% of the amount by which funds from operations (as defined in the partnershipagreement of the Operating Partnership) plus certain accounting gains exceedthe product of our weighted average stockholders equity (as defined in thepartnership agreement of the Operating Partnership) multiplied by 9.5% (dividedby 4 to adjust for quarterly calculations). We will record any distributions on the Class B limited partner interestsas an incentive distribution expense in the period when earned and whenpayments of such amounts have become probable and reasonably estimable inaccordance with the partnership agreement. No amounts were earned or accrued with respect to such Class Blimited partner interests through June 30, 2005.

 

We are obligated toreimburse the Manager for its costs incurred under an Asset Servicing Agreementbetween our Manager and an affiliate of SL Green Operating Partnership, L.P.and a separate Outsourcing Agreement between our Manager and SL Green OperatingPartnership, L.P.  The Asset ServicingAgreement provides for an annual fee payable by us of 0.15% of the carryingvalue of our investments, excluding certain defined investments for which otherservicing arrangements are executed and further reduced by fees paid directlyto outside servicers by us which have been approved by SL Green OperatingPartnership, L.P..  The OutsourcingAgreement provides a fee payable by us of $1,250 per year, increasing 3% annuallyover the prior year.  For the threemonths ended June 30, 2005, we paid or had payable an aggregate of $312and $232 to our Manager under the Outsourcing and Asset Servicing Agreements,respectively.  For the six months ended June 30,2005, we paid or had payable an aggregate of $625 and $390 to our Manager underthe Outsourcing and Asset Servicing Agreements, respectively.

 

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Inconnection with the closing of our CDO, the Issuer entered into a CollateralManagement Agreement with the Manager. Pursuant to the Collateral ManagementAgreement, the Manager has agreed to provide certain advisory andadministrative services in relation to the collateral debt securities and othereligible investments securing the CDO notes. As compensation for the performanceof its obligations as collateralmanager, the Manager is entitled to receive a senior collateral management fee,payable quarterly in accordance with the priority of payments as set forth inthe indenture, equal to 0.15% per annum of the net outstanding portfoliobalance, and an additional subordinate collateral management fee, payablequarterly in accordance with the priority of payments as set forth in theindenture, equal to 0.25% per annum of the net outstanding portfoliobalance.  Net outstanding portfoliobalance is the sum of the (i) aggregate principal balance of thecollateral debt securities, excluding defaulted securities, (ii) aggregateprincipal balance of all principal proceeds held as cash and eligibleinvestments in certain accounts, and (iii) with respect to the defaultedsecurities, the calculation amount of such defaulted securities.  In connection with the closing of the CDO,our Board of Directors allocated to the Manager the portion of the subordinatecollateral management fee paid on those securities not held by us on account ofadditional management services to be performed by the Manager, and allocatedthe senior collateral Management fee and balance of the subordinate managementfee to us.

 

Inconnection with the 5,500,000 shares of common stock that were sold on December 3,2004 and settled on December 31, 2004 and January 3, 2005 in aprivate placement, we agreed to pay the Manager a fee of $1,000 as compensationfor financial advisory, structuring and costs incurred on our behalf.  This fee was recorded as a reduction in theproceeds of the private placement.  Apartfrom legal fees and stock clearing charges totaling $245, no other fees werepaid by us to an investment bank, broker/dealer or other financial advisor inconnection with the private placement, resulting in total costs of 1.3% oftotal gross proceeds.

 

**On April 29, 2005, we closed on a $57,503 million initial investmentin a joint venture with SL Green to acquire, own and operate the South Buildinglocated at One Madison Avenue, New York, New York, or the Property.  The joint venture, which was created toacquire, own and operate the Property, is owned 45% by a wholly-owned subsidiaryof us and 55% by a wholly-owned subsidiary of SL Green.  The joint venture interests are paripassu.  Also on April 29, 2005, thejoint venture completed the acquisition of the Property from Metropolitan LifeInsurance Company for the purchase price of approximately $802,800 plus closingcosts, financed in part through a $690,000 first mortgage loan on theProperty.  The Property comprisesapproximately 1.2 million square feet and is almost entirely net leased toCredit Suisse First Boston (USA), or CSFB, pursuant to a lease with a 15-yearremaining term.**

** **

CommencingMay 1, 2005 we are party to a lease agreement with SLG Graybar SubleaseLLC, an affiliate of SL Green, for our corporate offices at 420 LexingtonAvenue, New York, New York.  The lease isfor approximately five thousand square feet with an option to lease anadditional approximately two thousand square feet and carries a term of tenyears with rents on the entire seven thousand square feet of approximately $249per annum for year one rising to $315 per annum in year ten.

 

**Bright Star Couriers LLC, or Bright Star, provides messenger services tous.  Bright Star is owned by Gary Green,a son of Stephen L. Green.  The aggregateamount of fees paid by us for such services for the three and six months ended June 30,2005 was less than $1.**

** **

**SL Green Operating Partnership, L.P. has invested $75,000 and $6,100 inpreferred equity interests that are subordinate to two of our investments withbook values of $61,616 and $6,436, respectively, as of June 30, 2005.**

** **

**On July 14, 2005 we closed on the purchase of a $40,000participation interest in a $224,000 mezzanine loan involving an officeproperty in New York, New York from an entity sponsored by SL Green.  On July 14, 2005 we also closed on a$32,493 subordinate participation in a loan which is senior to a $75,000preferred equity interest of SL Green Operating Partnership, L.P.**

 

**Fundsfrom Operations**

FFO is a widelyrecognized measure of REIT performance. We compute FFO in accordance with standards established by the NationalAssociation of Real Estate Investment Trusts, or NAREIT, which may not becomparable to FFO reported by other REITs that do not compute FFO in accordancewith the NAREIT definition, or that interpret the NAREIT definition differentlythan we do.  The revised White Paper onFFO approved by the Board of Governors of NAREIT in April 2002 defines FFOas net income (loss) (computed in accordance with GAAP), excluding gains (orlosses) from debt restructuring and sales of properties, plus real estaterelated depreciation and amortization and after adjustments for unconsolidatedpartnerships and joint ventures.  Wepresent FFO because we consider it an important supplemental measure of ouroperating performance and believe that it is frequently used by securitiesanalysts, investors and other interested parties in the evaluation ofREITS.  We also use FFO as one of severalcriteria to determine performance-based bonuses for members of our seniormanagement.  FFO is intended to excludeGAAP historical cost depreciation and amortization of real estate and relatedassets, which assumes that the value of real estate assets diminishes ratablyover time.  Historically, however, realestate values have risen or fallen with market conditions.  Because FFO excludes depreciation

 

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and amortization uniqueto real estate, gains and losses from property dispositions and extraordinaryitems, it provides a performance measure that, when compared year over year,reflects the impact to operations from trends in occupancy rates, rental rates,operating costs, interest costs, providing perspective not immediately apparentfrom net income.  FFO does not representcash generated from operating activities in accordance with GAAP and should notbe considered as an alternative to net income (determined in accordance withGAAP), as an indication of our financial performance or to cash flow fromoperating activities (determined in accordance with GAAP) as a measure of ourliquidity, nor is it indicative of funds available to fund our cash needs,including our ability to make cash distributions.

 

Funds from Operations forthe three and six months ended June 30, 2005 is as follows (in thousands):

 
| ** **                                                                                  | ** ** | **For the Three  Months  Ended  June 30, 2005** | ** ** | **For the Six  Months  Ended  June 30, 2005** | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| Net  income available to common stockholders                                                |       | $                                                    | 7,457      |                                               | $          | 12,022 |   |
| Add:                                                                                        |       |                                                 |       |                                               |       |
| Depreciation  and amortization                                                              |       | 537                                                  |       | 956                                                |       |
| FFO  adjustment for unconsolidated joint ventures                                           |       | 1,199                                                |       | 1,199                                              |       |
| Less:                                                                                       |       |                                                 |       |                                               |       |
| Amortization  of deferred financing costs and depreciation on non rental real estate assets |       | (537                                                 | )          | (956                                               | )          |
| Funds  from operations – basic                                                         |       | 8,656                                                |       | 13,221                                             |       |
| Dividends  on preferred shares                                                              |       | —                                               |       | —                                             |       |
| Funds  from operations – diluted                                                       |       | $                                                    | 8,656      |                                               | $          | 13,221 |   |
| Cash  flows provided by operating activities                                                |       | $                                                    | 8,897      |                                               | $          | 15,347 |   |
| Cash  flows used in investing activities                                                    |       | $                                                    | (200,077   | )                                                  | $          | (400,444 | ) |
| Cash  flows provided by financing activities                                                |       | $                                                    | 202,357    |                                               | $          | 361,601 |   |

 

**Forward-Looking Information**

 

This report contains “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended, or the Act, and Section 21E of the Securities ExchangeAct of 1934, as amended, or the Exchange Act. You can identify forward-looking statements by the use of the words “may,”“will,” “should,” “expect,” “anticipate,” “estimate,” “believe,” “intend,” “plan,”“project,” “continue,” or any negative or other variations on suchexpressions.  Forward-looking statementsinclude information concerning possible or assumed future results of our operations,including any forecasts, projections, plans and objectives for futureoperations.  Although we believe that ourplans, intentions and expectations as reflected in or suggested by thoseforward-looking statements are reasonable, we can give no assurance that theplans, intentions or expectations will be achieved.  We have listed below some important risks,uncertainties and contingencies which could cause our actual results,performance or achievements to be materially different from the forward-lookingstatements we make in this report.  Theserisks, uncertainties and contingencies include, but are not limited to, thefollowing:

 

•      the success orfailure of our efforts to implement our current business strategy;

•      economicconditions generally and in the commercial finance and commercial real estatemarkets specifically;

•      the performanceand financial condition of borrowers and corporate customers;

•      the actions ofour competitors and our ability to respond to those actions;

•      the cost of ourcapital, which depends in part on our asset quality, the nature of ourrelationships with our lenders and other capital providers, our businessprospects and outlook and general market conditions;

•      availability ofqualified personnel;

•      availability ofinvestment opportunities on real estate related and other securities;

•      the adequacy ofour cash reserves and working capital;

•      unanticipatedincreases in financing and other costs, including a rise in interest rates;

•      the timing ofcash flows, if any, from our investments;

•      risks ofstructured finance investments;

•      GKK Manager LLCremaining as our Manager;

•      environmentaland/or safety requirements;

 

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•      continuingthreats or terrorist attacks on the national, regional and local economies;

•      competitionwith other companies;

•      our ability tosatisfy complex rules in order for us to qualify as a REIT for federalincome tax purposes, our operating partnership’s ability to satisfy the rules inorder for it to qualify as a partnership for federal income tax purposes, theability of certain of our subsidiaries to qualify as REITs, and the ability ofcertain of our subsidiaries to qualify as taxable REIT subsidiaries for federalincome tax purposes, and our ability and the ability of our subsidiaries tooperate effectively within the limitations imposed by these rules;

•      changes ingovernmental regulations, tax rates and similar matters; and

•      legislative andregulatory changes (including changes to laws governing the taxation of REITs),and other factors, many of which are beyond our control.

 

We undertake noobligation to publicly update or revise any forward-looking statements, whetheras a result of future events, new information or otherwise.

 

Therisks included here are not exhaustive. Other sections of this report may include additional factors that couldadversely affect our business and financial performance.  Moreover, we operate in a very competitiveand rapidly changing environment.  Newrisk factors emerge from time to time and it is not possible for management topredict all such risk factors, nor can it assess the impact of all such riskfactors on our business or the extent to which any factor, or combination offactors, may cause actual results to differ materially from those contained inany forward-looking statements.  Giventhese risks and uncertainties, investors should not place undue reliance onforward-looking statements as a prediction of actual results.

 

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**ITEM 3. Quantitative and Qualitative Disclosure About Market Risk**

 

Marketrisk includes risks that arise from changes in interest rates, commodityprices, equity prices and other market changes that affect market sensitiveinstruments.  In pursuing our businessplan, we expect that the primary market risks to which we will be exposed arereal estate and interest rate risks.

 

#### **Real Estate Risk**

 

Commercial andmulti-family property values and net operating income derived from suchproperties are subject to volatility and may be affected adversely by a numberof factors, including, but not limited to, national, regional and localeconomic conditions which may be adversely affected by industry slowdowns andother factors), local real estate conditions (such as an oversupply of retail,industrial, office or other commercial or multi-family space), changes orcontinued weakness in specific industry segments, construction quality, age anddesign, demographic factors, retroactive changes to building or similar codes,and increases in operating expenses (such as energy costs).  In the event net operating income decreases,a borrower may have difficulty repaying our loans, which could result in lossesto us.  In addition, decreases inproperty values reduce the value of the collateral and the potential proceedsavailable to a borrower to repay our loans, which could also cause us to sufferlosses.  Even when a property’s netoperating income is sufficient to cover the property’s debt service, at thetime a loan is made, there can be no assurance that this will continue in thefuture.

 

###### **Interest Rate Risk**

 

Interest rate risk ishighly sensitive to many factors, including governmental monetary and taxpolicies, domestic and international economic and political considerations andother factors beyond our control.  Ahypothetical 100 basis point increase in interest rates along the entireinterest rate curve for the six months ended June 30, 2005 would haveincreased our interest cost by approximately $1,679, offset by an increase inour investment income of approximately $2,756.

 

Ouroperating results will depend in large part on differences between the incomefrom our assets and our borrowing costs. Most of our assets and borrowings are expected to be variable-rate instrumentsthat we will finance with variable rate debt. The objective of this strategy is to minimize the impact of interestrate changes on the spread between the yield on our assets and our cost offunds.  We enter into hedgingtransactions with respect to all liabilities relating to fixed rate assets inthe future.  If we were to finance fixedrate assets with variable rate debt and the benchmark for our variable ratedebt increased, our net income would decrease. Furthermore, as most of our available financing provides for an abilityof the lender to mark our assets to market and make margin calls based on achange in the value of our assets, financing fixed rate assets with this debtcreates the risk that an increase in fixed rate benchmarks (such as “swap”yields) would decrease the value of our fixed rate assets.  We have entered into certain swaptransactions in anticipation of drawing upon our mark-to-market debt to hedgeagainst this risk.  Some of our loans maybe subject to various interest rate floors. As a result, if interest rates fall below the floor rates, the spreadbetween the yield on our assets and our cost of funds will increase, which willgenerally increase our returns.  Becauseof our strategies to date, our net income will generally increase if LIBORincreases and decreases if LIBOR decreases, but this may not always be true inthe future.  Our exposure to interestrates will also be affected by our overall corporate leverage, which we anticipatewill be 70% to 80% of the carrying value of our assets; but our actual leveragedepends on our mix of assets.

 

In the event of asignificant rising interest rate environment and/or economic downturn,delinquencies and defaults could increase and result in credit losses to us,which could adversely affect our liquidity and operating results.  Further, such delinquencies or defaults couldhave an adverse effect on the spreads between interest-earning assets andinterest-bearing liabilities

 

**ITEM 4. Controls and Procedures**

 

**Evaluation of Disclosure Controls and Procedures**

 

Wemaintain disclosure controls and procedures that are designed to ensure thatinformation required to be disclosed in our Exchange Act reports is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms, and that such information is accumulated and communicatedto our management, including our Chief Executive Officer and Chief FinancialOfficer, as appropriate, to allow timely decisions regarding requireddisclosure based closely on the definition of “disclosure controls andprocedures” in Rule 13a-15(e). In designing and evaluating the disclosure controls and procedures,management recognized that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving the

 

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desiredcontrol objectives, and management necessarily was required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.  Also, we may haveinvestments in certain unconsolidated entities. As we do not control these entities, our disclosure controls andprocedures with respect to such entities are necessarily substantially morelimited than those we maintain with respect to our consolidated subsidiaries.

 

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and our Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures.  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were effective as of the end of the period covered bythis report.

 

**Changes in Internal Controls over Financial Reporting**

 

**Therewere no changes in our internal controls over financial reporting identified inconnection with the evaluation of such internal controls that occurred duringGramercy’s last fiscal quarter that have materially affected, or are reasonablylikely to materially**affect, Gramercy’s internalcontrols over financial reporting.

 

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**PART II****                 OTHERINFORMATION**

 

##### **ITEM 1.**                  LEGALPROCEEDINGS

##### ** **

See Note 15 to theConsolidated Financial Statements

 

##### **ITEM 2.**                  UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS

##### ** **

None

 

#### **ITEM 3.**                  DEFAULTS UPON SENIOR SECURITIES

#### ** **

None

 

#### **ITEM 4.**                  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

#### ** **

We held our annualmeeting of stockholders on May 18, 2005, at which the following matterswere voted upon:

 

1.     Toelect one Class I director of the Company to serve until the 2007 AnnualMeeting of Stockholders and until their successors are duly elected andqualified.

 

2.     Toratify the selection of Ernst & Young LLP as the independent auditorsof the Company for the fiscal year ended December 31, 2005.

 

The results of themeeting were as follows:

 
| ** **         | ** ** | **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|--------------------|------------|------------|------------|-------------|------------|-------------|------------|
| Proposal  1:       |       |       |       |        |       |        |       |
| Hugh  F. Hall      |       | 16,801,696 |       | 329,252     |       | —      |       |
| Jeffrey  E. Kelter |       | 17,002,014 |       | 128,934     |       | —      |       |
|               |       |       |       |        |       |        |       |
| Proposal  2:       |       | 17,098,019 |       | 30,329      |       | 2,680       |       |

 

There was no solicitationin opposition to the foregoing nominees by stockholders.  The term of office of Messrs. Green,Baum, Holliday, Konigsberg and Laven continued after the meeting.

 

Further informationregarding the proposals is contained in the Company’s Proxy Statement dated April 19,2005.

 

#### **ITEM 5.**                  OTHERINFORMATION

#### ** **

None

 

**ITEM 6.****                  EXHIBITSAND REPORTS ON FORM 8-K**

 

(a)           Exhibits:

 

**3.1**   Articles of Incorporation ofthe Company, incorporated by reference to the Company’s Registration Statementon Form S-11 (No. 333-114673), declared effective by theCommission on July 27, 2004.

** **

**3.2**   Bylaws of the Company,incorporated by reference to the Company’s Registration Statement on Form S-11(No. 333-114673), declared effective by the Commission on July 27,2004.

** **

**4.1**   Specimen Common StockCertificate, incorporated by reference to the Company’s Registration Statementon Form S-11 (No. 333-114673), declared effective by theCommission on July 27, 2004.

 

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**10.1 Form of Management Agreement by and between the Company and GKKManager LLC, incorporated by reference to the Company’s Registration Statementon Form S-11 (No. 333-114673), declared effective by theCommission on July 27, 2004.**

 

**10.2 Form of Origination Agreement by and between the Company and SLGreen Realty Corp., incorporated by reference to the Company’s RegistrationStatement on Form S-11 (No. 333-114673), declaredeffective by the Commission on July 27, 2004.**

 

**10.3 Form of Agreement of Limited Partnership of GKK Capital LP,incorporated by reference to the Company’s Registration Statement on Form S-11(No. 333-114673), declared effective by the Commission on July 27,2004.**

 

**10.4 Form of Asset Servicing Agreement by and between GKK ManagerLLC and SLG Gramercy Services LLC, incorporated by reference to the Company’sRegistration Statement on Form S-11 (No. 333-114673),declared effective by the Commission on July 27, 2004.**

 

**10.5 Form of Outsource Agreement by and between GKK Manager LLC andSLG Operating Partnership, L.P., incorporated by reference to the Company’sRegistration Statement on Form S-11 (No. 333-114673),declared effective by the Commission on July 27, 2004.**

 

**10.6 Form of 2004 Equity Incentive Plan, incorporated by referenceto the Company’s Registration Statement on Form S-11 (No. 333-114673),declared effective by the Commission on July 27, 2004.**

 

**10.7 Form of Master Repurchase Agreement, incorporated by referenceto the Company’s Registration Statement on Form S-11 (No. 333-114673),declared effective by the Commission on July 27, 2004.**

 

**10.8 Form of Acquisition Repurchase Agreement, incorporated byreference to the Company’s Registration Statement on Form S-11 (No. 333-114673),declared effective by the Commission on July 27, 2004.**

 

**10.9 Form of Credit Agreement, incorporated by reference to theCompany’s Registration Statement on Form S-11 (No. 333-114673),declared effective by the Commission on July 27, 2004.**

 

**10.10 Form of Master Repurchase Agreement dated as of January 3,2005, incorporated by reference to the Company’s Annual Report on Form 10-Kfor the fiscal year ended December 31, 2004.**

 

**10.11 Annex to the Form of Master Repurchase Agreement dated as of January 3,2005, incorporated by reference to the Company’s Annual Report on Form 10-Kfor the fiscal year ended December 31, 2004.**

 

**10.12 Form of Employment Agreement by and between Hugh Hall and GKKManager LLC, incorporated by reference to the Company’s Annual Report on Form 10-Kfor the fiscal year ended December 31, 2004.**

 

**10.13 Form of Employment Agreement by and between Robert R. Foleyand GKK Manager LLC, incorporated by reference to the Company’s Annual Reporton Form 10-K for the fiscal year ended December 31, 2004.**

 

**10.14 Form of Registration Rights Agreement, by and between variousholders of the Company’s common stock and the Company, incorporated byreference to the Company’s Form 8-K, dated December 9, 2004,filed with the Commission on December 9, 2004.**

 

**10.15 Form of Amended and Restated Registration Rights Agreement, byand between SL Green Realty Corp. and the Company, incorporated by reference tothe Company’s Annual Report on Form 10-K for the fiscal year ended December 31,2004.**

 

**10.16 Form of Purchase Agreement, by and among the Company andvarious investors in the Company’s common stock, incorporated by reference tothe Company’s Form 8-K, dated December 3, 2004 filed with theCommission on December 3, 2004.**

 

**10.17 Form of LLC Agreement, by and between GKK Madison InvestmentLLC, a wholly owned subsidiary of the Company, and SLG Madison Investment LLC,a wholly owned subsidiary of SL Green Realty Corp.**

 

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**10.18 Form of Amended and Restated Master Repurchase Agreement, byand between the Company and Wachovia Capital Markets, LLC.**

** **

**10.19 Form of Indenture by and among Gramercy Real Estate CDO 2005-1,Ltd., as issuer, Gramercy Real Estate CDO 2005-1 LLC, as co-issuer, GKKLiquidity LLC, as advancing agent and Wells Fargo Bank, National Association,as trustee, paying agent, calculation agent, transfer agent, custodialsecurities intermediary, backup advancing agent, notes registrar.**

** **

**10.20 Form of Collateral Management Agreement by andbetween**Gramercy Real Estate CDO 2005-1, Ltd., as issuer andGKK Manager LLC, as collateral manager.

** **

**10.21 Form of Amended and Restated Trust Agreement by and among GKKCapital LP, as depositor, JPMorgan Chase Bank, National Association, asproperty trustee, Chase Bank USA, National Association, as Delaware trustee,and the administrative trustees named therein.**

** **

**10.22 Form of Junior Subordinated Indenture between GKK Capital LPand JPMorgan Chase Bank, National Association, as trustee.**

** **

31.1Certification by the Chief Executive Officer pursuant to Section 302 ofthe Sarbanes-Oxley Act of 2002 filed herewith.

 

31.2Certification by the Chief Financial Officer pursuant to Section 302 ofthe Sarbanes-Oxley Act of 2002 filed herewith.

 

32.1Certification pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906of the Sarbanes-Oxley Act of 202 filed herewith.

 

32.2Certification pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906of the Sarbanes-Oxley Act of 2002 filed herewith.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|                                             | GRAMERCY CAPITAL CORP. |
|--------------------------------------------------|------------------------|
|                                             |                   |
|                                             |                   |
|                                             | By:                    | /s/  Robert R. Foley |   |
|                                             |                   | Robert R. Foley |   |
|                                             |                   | Chief Financial Officer |   |
|                                             |                   |
|                                             |                   |
| Date:    July 27,  2005 |                   |

 

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