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

**Washington,D.C. 20549**

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**FORM 10-Q**

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

**For thequarterly period ended September 30, 2006**

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

**For thetransition period from               to               .**

**CommissionFile Number: 001-32248**

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**GRAMERCY CAPITAL CORP.**

(Exact name ofregistrant as specified in its charter)

| **Maryland**                     |   | **06-1722127**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

 

**420 Lexington Avenue, New York,New York 10170**

(Address ofprincipal executive offices) (Zip Code)

**(212) 297-1000**

(Registrant’stelephone number, including area code)

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Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  YES x     NO o

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of “accelerated filer” and “non-accelerated filer” in Rule 12b-2 ofthe Exchange Act.
| Large accelerated filer o |   | Accelerated filer x |   | Non-accelerated filer o |
|---------------------------|--------|---------------------|--------|-------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). YES o    NOx

The number of sharesoutstanding of the registrant’s common stock, $0.001 par value, was 25,878,391as of November 9, 2006.

 

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**GRAMERCYCAPITAL CORP.**

**INDEX**
|                                                                                                                | ** **                                                                                      | **PAGE**   |
|----------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------|------------|
| **PART I.**                                                                                                    | **FINANCIAL INFORMATION**                                                                       | ** ** | ** ** |
|                                                                                                           |                                                                                            |       |   |
| **ITEM 1.**                                                                                                    | **FINANCIAL STATEMENTS**                                                                        |       |   |
|                                                                                                           |                                                                                            |       |
| Consolidated  Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005                        |                                                                                            | 1          |
|                                                                                                           |                                                                                            |       |
| Consolidated Statements of Income for the three and  nine months ended September 30, 2006 and 2005 (unaudited) |                                                                                            | 2          |
|                                                                                                           |                                                                                            |       |
| Consolidated Statement of Stockholders’ Equity for the  nine months ended September 30, 2006 (unaudited)  |                                                                                            | 3          |
|                                                                                                           |                                                                                            |       |
| Consolidated Statements of Cash Flows for the nine  months ended September 30, 2006 and 2005 (unaudited)       |                                                                                            | 4          |
|                                                                                                           |                                                                                            |       |
| Notes  to Consolidated Financial Statements (unaudited)                                                        |                                                                                            | 5          |
|                                                                                                           |                                                                                            |       |
| **ITEM 2.**                                                                                                    | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS** | ** ** | 26 |
| ** **                                                                                                     | ** **                                                                                      |       |   |
| **ITEM 3.**                                                                                                    | **QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**                                 |       | 46 |
| ** **                                                                                                     | ** **                                                                                      |       |   |
| **ITEM 4.**                                                                                                    | **CONTROLS AND  PROCEDURES**                                                                    |       | 49 |
| ** **                                                                                                     | ** **                                                                                      |       |   |
| **PART II.**                                                                                                   | **OTHER INFORMATION**                                                                           |       | 50 |
| ** **                                                                                                     | ** **                                                                                      |       |   |
| **ITEM 1.**                                                                                                    | **LEGAL PROCEEDINGS**                                                                           |       | 50 |
| ** **                                                                                                     | ** **                                                                                      |       |   |
| **ITEM 1A.**                                                                                                   | **RISK FACTORS**                                                                                |       | 50 |
| ** **                                                                                                     | ** **                                                                                      |       |   |
| **ITEM 2.**                                                                                                    | **UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**                                |       | 50 |
| ** **                                                                                                     | ** **                                                                                      |       |   |
| **ITEM 3.**                                                                                                    | **DEFAULTS  UPON SENIOR SECURITIES**                                                            |       | 50 |
| ** **                                                                                                     | ** **                                                                                      |       |   |
| **ITEM 4.**                                                                                                    | **SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS**                                        |       | 50 |
| ** **                                                                                                     | ** **                                                                                      |       |   |
| **ITEM 5.**                                                                                                    | **OTHER INFORMATION**                                                                           |       | 50 |
| ** **                                                                                                     | ** **                                                                                      |       |   |
| **ITEM  6.**                                                                                                   | **EXHIBITS**                                                                                    |       | 52 |
| ** **                                                                                                     | ** **                                                                                      |       |   |
| **Signatures**                                                                                                 |                                                                                            | 53         |
|                                                                                                                |                                                                                                 |            |  |  |

 

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**PART I.****                                                    FINANCIALINFORMATION**

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

**GramercyCapital Corp.**

**Consolidated Balance Sheets**

**(Amountsin thousands, except share and per share data)**
| ** **                                                                                                                                                                          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                          | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                          | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| **Assets:**                                                                                                                                                                         |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                          |       | $                      | 39,842     |                  | $          | 70,576 |   |
| Restricted cash                                                                                                                                                                     |       | 238,450                |       | 53,833                |       |
| Loans and other lending  investments, net                                                                                                                                           |       | 2,064,058              |       | 1,163,745             |       |
| Investment in  unconsolidated joint ventures                                                                                                                                        |       | 58,512                 |       | 58,040                |       |
| Loans held for sale,  net                                                                                                                                                           |       | —                 |       | 42,000                |       |
| Commercial real estate,  net                                                                                                                                                        |       | 94,298                 |       | 51,173                |       |
| Accrued interest                                                                                                                                                                    |       | 11,477                 |       | 7,187                 |       |
| Deferred financing  costs                                                                                                                                                           |       | 27,582                 |       | 17,488                |       |
| Deferred costs                                                                                                                                                                      |       | 1,236                  |       | 1,894                 |       |
| Derivative instruments,  at fair value                                                                                                                                              |       | 613                    |       | 2,271                 |       |
| Other assets                                                                                                                                                                        |       | 3,886                  |       | 1,603                 |       |
| Total assets                                                                                                                                                                        |       | $                      | 2,539,954  |                  | $          | 1,469,810 |   |
| ** **                                                                                                                                                                          |       |                   |       |                  |       |
| **Liabilities and Stockholders’  Equity:**                                                                                                                                     |       |                   |       |                  |       |
| Repurchase agreements                                                                                                                                                               |       | $                      | 58,739     |                  | $          | 117,366 |   |
| Collateralized debt  obligations                                                                                                                                                    |       | 1,714,250              |       | 810,500               |       |
| Mortgage note payable                                                                                                                                                               |       | 94,525                 |       | 41,000                |       |
| Management fees payable                                                                                                                                                             |       | 3,031                  |       | 1,329                 |       |
| Incentive fee payable                                                                                                                                                               |       | 1,822                  |       | 1,237                 |       |
| Dividends payable                                                                                                                                                                   |       | 13,109                 |       | 10,726                |       |
| Accounts payable and  accrued expenses                                                                                                                                              |       | 18,398                 |       | 11,561                |       |
| Other liabilities                                                                                                                                                                   |       | 32,289                 |       | 3,687                 |       |
| Junior subordinated  deferrable interest debentures held by trusts that issued trust preferred  securities                                                                          |       | 150,000                |       | 100,000               |       |
| Total liabilities                                                                                                                                                                   |       | 2,086,163              |       | 1,097,406             |       |
|                                                                                                                                                                                |       |                   |       |                  |       |
| 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, 25,834,642 and 22,802,642 shares  issued and outstanding at September 30, 2006 and December 31, 2005,  respectively |       | 25                     |       | 22                    |       |
| Additional  paid-in-capital                                                                                                                                                         |       | 451,923                |       | 369,529               |       |
| Accumulated other  comprehensive income                                                                                                                                             |       | 1,439                  |       | 2,851                 |       |
| Retained earnings                                                                                                                                                                   |       | 404                    |       | 2                     |       |
| Total  stockholders’ equity                                                                                                                                                    |       | 453,791                |       | 372,404               |       |
| Total liabilities and stockholders’ equity                                                                                                                                     |       | $                      | 2,539,954  |                  | $          | 1,469,810 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

1

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**Gramercy Capital Corp.**

**Consolidated Statements of Income**

**(Unaudited,amounts in thousands, except per share data)**
| ** **                                                                                                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Revenues**                                                                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Investment income                                                                                                      |       | $                                                    | 45,299     |                                                | $          | 21,060 |   | $ | 116,313 |   | $ | 46,999 |   |
| Rental revenue, net                                                                                                    |       | —                                               |       | 314                                                 |       | 914 |   | 314 |   |
| Gain on sales and other income                                                                                         |       | 5,156                                                |       | 5,218                                               |       | 13,724 |   | 8,727 |   |
| Total revenues                                                                                                         |       | 50,455                                               |       | 26,592                                              |       | 130,951 |   | 56,040 |   |
| ** **                                                                                                             |       |                                                 |       |                                                |       |   |   |   |   |
| **Expenses**                                                                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Interest expense                                                                                                       |       | 25,782                                               |       | 11,250                                              |       | 64,280 |   | 20,316 |   |
| Management fees                                                                                                        |       | 4,409                                                |       | 2,726                                               |       | 11,793 |   | 6,264 |   |
| Incentive fee                                                                                                          |       | 1,822                                                |       | 1,038                                               |       | 4,592 |   | 1,038 |   |
| Depreciation and  amortization                                                                                         |       | 278                                                  |       | 105                                                 |       | 962 |   | 232 |   |
| Marketing,  general and administrative                                                                                 |       | 2,169                                                |       | 1,456                                               |       | 7,719 |   | 4,722 |   |
| Provision for  loan loss/(recovery)                                                                                    |       | (70                                                  | )          | 430                                                 |       | 430 |   | 955 |   |
| Total expenses                                                                                                         |       | 34,390                                               |       | 17,005                                              |       | 89,776 |   | 33,527 |   |
| Income from  continuing operations before equity in net loss of unconsolidated joint  ventures and provision for taxes |       | 16,065                                               |       | 9,587                                               |       | 41,175 |   | 22,513 |   |
| Equity in net  loss of unconsolidated joint ventures                                                                   |       | (734                                                 | )          | (510                                                | )          | (2,090 | ) | (914 | ) |
| Income from  continuing operations before provision for taxes                                                          |       | 15,331                                               |       | 9,077                                               |       | 39,085 |   | 21,599 |   |
| Provision for  taxes                                                                                                   |       | (795                                                 | )          | (500                                                | )          | (1,178 | ) | (1,000 | ) |
| Net income  available to common stockholders                                                                           |       | $                                                    | 14,536     |                                                | $          | 8,577 |   | $ | 37,907 |   | $ | 20,599 |   |
|                                                                                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| **Basic earnings per share:**                                                                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Net income  available to common stockholders                                                                           |       | $                                                    | 0.56       |                                                | $          | 0.44 |   | $ | 1.56 |   | $ | 1.08 |   |
| **Diluted earnings per share:**                                                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Net income  available to common stockholders                                                                           |       | $                                                    | 0.54       |                                                | $          | 0.41 |   | $ | 1.48 |   | $ | 1.05 |   |
| Dividends per  common share                                                                                            |       | $                                                    | 0.51       |                                                | $          | 0.45 |   | $ | 1.52 |   | $ | 1.02 |   |
| Basic weighted  average common shares outstanding                                                                      |       | 25,832                                               |       | 19,603                                              |       | 24,336 |   | 19,093 |   |
| Diluted weighted  average common shares and common share equivalents outstanding                                       |       | 27,034                                               |       | 20,788                                              |       | 25,533 |   | 19,618 |   |

 

Theaccompanying notes are an integral part of these financial statements.

2

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**Gramercy Capital Corp.**

**Consolidated Statement ofStockholders’ Equity(Unaudited, amounts in thousands, except share data)**
| ** **                                           | ** ** | **Common  Stock** | ** ** | **Additional   Paid-** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained** | ** ** | ** **   | ** ** | **Comprehensive** | ** ** |
|------------------------------------------------------|------------|-------------------|------------|-----------------------------|------------|---------------------------------------|------------|--------------|------------|--------------|------------|-------------------|------------|
| ** **                                           | ** ** | **Shares**        | ** ** | **Par Value**          | ** ** | **In-Capital**                        | ** ** | **Income**   | ** ** | **Earnings** | ** ** | **Total**         | ** ** | **Income** | ** ** |
| **Balance at December 31, 2005**                     |       | 22,803            |       | $                           | 22         |                                  | $          | 369,529      |       | $            | 2,851      |              | $          | 2 |   | $ | 372,404 |   |   |   |
| Net income                                           |       |              |       |                        |       |                                  |       |         |       | 37,907       |       | 37,907            |       | $ | 37,907 |   |
| Net unrealized loss on derivative instruments        |       |              |       |                        |       |                                  |       | (1,412       | )          |         |       | (1,412            | )          | (1,412 | ) |
| Proceeds from common stock offerings                 |       | 3,000             |       | 3                           |       | 79,787                                |       |         |       |         |       | 79,790            |       |   |   |
| Stock-based compensation – fair value           |       |              |       |                        |       | 1,426                                 |       |         |       |         |       | 1,426             |       |   |   |
| Proceeds from stock option exercises                 |       | 20                |       | —                      |       | 300                                   |       |         |       |         |       | 300               |       |   |   |
| Deferred compensation plan, net                      |       | 12                |       | —                      |       | 881                                   |       |         |       |         |       | 881               |       |   |   |
| Cash distributions declared ($1.52 per common share) |       |              |       |                        |       |                                  |       |         |       | (37,505      | )          | (37,505           | )          |   |   |
| **Balance  at September 30, 2006**                   |       | 25,835            |       | $                           | 25         |                                  | $          | 451,923      |       | $            | 1,439      |              | $          | 404 |   | $ | 453,791 |   | $ | 36,495 |   |

 

Theaccompanying notes are an integral part of these financial statements

3

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**GramercyCapital Corp.Consolidated Statements of Cash Flows****(Unaudited, amounts in thousands)**

 
| ** **                                                                                                                  | ** ** | **Nine Months ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                                  | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| **Operating Activities**                                                                                                    | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net income  available to common stockholders                                                                                |       | $                                                   | 37,907     |   | $ | 20,599 |   |
| Adjustments to  reconcile net income available to common stockholders to net cash used /  provided by operating activities: |       |                                                |       |   |   |
| Depreciation and amortization                                                                                               |       | 4,064                                               |       | 1,966 |   |
| Amortization of discount, premium and other fees on  investments                                                            |       | (7,984                                              | )          | (772 | ) |
| Equity in net loss of unconsolidated joint ventures                                                                         |       | 2,091                                               |       | 914 |   |
| Gain on sale of securities                                                                                                  |       | (6,362                                              | )          | — |   |
| Amortization of stock compensation                                                                                          |       | 2,307                                               |       | 2,775 |   |
| Provision for loan loss                                                                                                     |       | 430                                                 |       | 955 |   |
| Net realized gain on loan held for sale                                                                                     |       | (1,173                                              | )          | — |   |
| Changes in  operating assets and liabilities:                                                                               |       |                                                |       |   |   |
| New investments in loans held for sale                                                                                      |       | (62,213                                             | )          | — |   |
| Proceeds from sale of loans held for sale                                                                                   |       | 102,392                                             |       | — |   |
| Accrued interest                                                                                                            |       | (4,290                                              | )          | (3,426 | ) |
| Other assets                                                                                                                |       | 12,634                                              |       | (924 | ) |
| Management fees payable                                                                                                     |       | 1,702                                               |       | 873 |   |
| Incentive fee payable                                                                                                       |       | 585                                                 |       | 1,038 |   |
| Settlement of derivative instruments                                                                                        |       | 2,723                                               |       | — |   |
| Accounts payable, accrued expenses and other  liabilities                                                                   |       | 30,674                                              |       | 11,303 |   |
| Net cash used /  provided by operating activities                                                                           |       | 115,487                                             |       | 35,301 |   |
| **Investing Activities**                                                                                                    |       |                                                |       |   |   |
| New investment  originations                                                                                                |       | (1,326,623                                          | )          | (733,902 | ) |
| Principal  collections on investments                                                                                       |       | 432,424                                             |       | 203,701 |   |
| Investment in  commercial real estate and securities                                                                        |       | (109,235                                            | )          | (50,496 | ) |
| Net proceeds  from the sale of securities                                                                                   |       | 14,812                                              |       | — |   |
| Investment in  joint venture                                                                                                |       | —                                              |       | (57,844 | ) |
| Change in  restricted cash from investing activities                                                                        |       | (19,014                                             | )          | — |   |
| Deferred  investment costs                                                                                                  |       | (1,320                                              | )          | (759 | ) |
| Net cash used in  investing activities                                                                                      |       | (1,008,956                                          | )          | (639,300 | ) |
| **Financing Activities**                                                                                                    |       |                                                |       |   |   |
| Proceeds from  repurchase facilities                                                                                        |       | 1,002,844                                           |       | 676,290 |   |
| Repayments of  repurchase facilities                                                                                        |       | (1,061,472                                          | )          | (915,175 | ) |
| Proceeds from  issuance of collateralized debt obligation                                                                   |       | 903,750                                             |       | 810,500 |   |
| Proceeds from  mortgage note payable                                                                                        |       | 94,525                                              |       | 41,000 |   |
| Change in  restricted cash from financing activities                                                                        |       | (165,822                                            | )          | (250,663 | ) |
| Settlement of  derivative instruments                                                                                       |       | 730                                                 |       | 320 |   |
| Proceeds from  stock options exercised                                                                                      |       | 300                                                 |       | 1,920 |   |
| Net proceeds  from sale of common stock                                                                                     |       | 79,790                                              |       | 156,137 |   |
| Issuance of  trust preferred securities                                                                                     |       | 50,000                                              |       | 100,000 |   |
| Deferred  financing costs and other liabilities                                                                             |       | (6,781                                              | )          | (17,575 | ) |
| Dividends paid                                                                                                              |       | (35,129                                             | )          | (12,538 | ) |
| Net cash  provided by financing activities                                                                                  |       | 862,735                                             |       | 590,216 |   |
| Net decrease in  cash and cash equivalents                                                                                  |       | (30,734                                             | )          | (13,783 | ) |
| Cash and cash  equivalents at beginning of period                                                                           |       | 70,576                                              |       | 39,094 |   |
| Cash and cash  equivalents at end of period                                                                                 |       | $                                                   | 39,842     |   | $ | 25,311 |   |
| ** **                                                                                                                  |       |                                                |       |   |   |
| **Non-cash activity**                                                                                                       |       |                                                |       |   |   |
| Change in investment in unconsolidated joint  ventures                                                                      |       | 1,814                                               |       | 57,190 |   |
| Deferred gains on derivative instruments                                                                                    |       | 390                                                 |       | 2,224 |   |
|                                                                                                                        |       |                                                |       |   |   |
| **Supplemental cash flow disclosures**                                                                                      |       |                                                |       |   |   |
| Interest paid                                                                                                               |       | 53,880                                              |       | 9,518 |   |
| Income taxes  paid                                                                                                          |       | 1,223                                               |       | 323 |   |

 

The accompanying notesare an integral part of these financial statements.

4

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**1.   Organization**

Gramercy CapitalCorp. (the “Company” or “Gramercy”) is a national commercial real estatespecialty finance company that focuses on the direct origination andacquisition of whole loans, subordinate interests in whole loans, mezzanineloans, preferred equity, and net lease investments involving commercialproperties throughout the United States. When evaluating transactions, we assess our risk-adjusted return andtarget transactions with yields that ensure an equitable balance between risksand return.

Substantially allof our operations are conducted through GKK Capital LP, a Delaware limitedpartnership, or the Operating Partnership. We, as the sole general partner of, and holder of 100% of the commonunits of, the Operating Partnership, have responsibility and discretion in themanagement and control of the Operating Partnership, and the limited partnersof the Operating Partnership, in such capacity, have no authority to transactbusiness for, or participate in the management activities of, the OperatingPartnership.  Accordingly, we consolidatethe accounts of the Operating Partnership.

We are externallymanaged and advised by GKK Manager LLC, or the Manager, a majority-ownedsubsidiary of SL Green Realty Corp., or SL Green.  At September 30, 2006, SL Green ownedapproximately 25% of the outstanding shares of our common stock. We qualifiedas a real estate investment trust, or REIT, under the Internal Revenue Codecommencing with our taxable year ending December 31, 2004 and expect to qualifyfor the current fiscal year.  To maintainour tax status as a REIT, we plan to distribute at least 90% of our taxableincome.  Unless the context requiresotherwise, all references to “we,” “our,” and “us” means Gramercy Capital Corp.

As of September 30, 2006, we held loans andother lending investments of $2,064,058 net of fees, discounts, and unfundedcommitments with an average spread to LIBOR of 357 basis points for ourfloating rate investments, and an average yield of 10.27% for our fixed rate investments.  As of September 30, 2006, we also heldinterests in four credit tenant lease, or CTL, investments comprised of a49.75% tenancy-in-common, or TIC, interest in 55 Corporate Drive inBridgewater, New Jersey,and three joint ventureinvestments.

**Basis of Quarterly Presentation**

The accompanying financial statements have been preparedin accordance with accounting principles generally accepted in the UnitedStates for interim financial information and with the instructions to Form 10-Qand Article 10 of Regulation S-X. Accordingly, it does not include all of the information and footnotesrequired by accounting principles generally accepted in the United States, orGAAP, for complete financial statements. In management’s opinion, all adjustments (consisting of normal recurringaccruals) considered necessary for fair presentation have been included.  The 2006 operating results for theperiod presented are not necessarily indicative of the results that may beexpected for the year ending December 31, 2006.  These financialstatements should be read in conjunction with the financial statements andaccompanying notes included in the Company’s annual report on Form 10-K for theyear ended December 31, 2005.

The balance sheet at December 31, 2005 has been derivedfrom the audited financial statement at that date, but does not include all theinformation and footnotes required by GAAP for complete financial statements.

**2.   Significant Accounting Policies**

**Principles of Consolidation**

The consolidated financial statementsinclude our accounts and those of our subsidiaries which are wholly-owned orcontrolled by us, or entities which are variable interest entities in which weare the primary beneficiaries under FASB Interpretation No. 46, FIN 46, “Consolidationof Variable Interest Entities.”  FIN 46requires a variable interest entity, or VIE, to be consolidated by its primarybeneficiary.  The primary beneficiary isthe party that absorbs a majority of the VIE’s anticipated losses and/or amajority of the expected returns.  Wehave evaluated our investments for potential classification as variableinterests by evaluating the sufficiency of the entities’ equity investment atrisk to absorb losses, and determined that we are not the primary beneficiaryfor any of our investments.  Entitieswhich we do not control and entities which are VIE’s, but where we are not theprimary beneficiary, are accounted for under the equity method.  When investments are made through a TICstructure, we report our pro rata share of the assets, liabilities, revenues,and expenses of the investment in our financial statements. All significantintercompany balances and transactions have been eliminated.

**Cashand Cash Equivalents**

We consider all highly liquid investments with maturities of threemonths or less when purchased to be cash equivalents.

5

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**Restricted Cash**

**Restricted cash at September 30,2006 consists primarily of $182,967**on deposit with the trustee of ourcollateralized debt obligations, or CDOs, representing proceeds from our secondCDO issuance that will be used to fund future investments that will be acquiredby the CDO trust.  Also included are theproceeds of repayments from loans serving as collateral in our CDOs, which willbe used to fund investments to replace those trust assets which are repaid orsold by the trust, interest payments received by the trustee on investmentsthat serve as collateral for our CDOs, which are remitted to us on a quarterlybasis in the month following the end of our fiscal quarter, and future fundingobligations on certain investments.  Theremaining balance consists of interest reserves held on behalf of borrowers and$23,601 representing our share of the reserves of 55 Corporate Drive.

### **Loansand Investments and Loans Held for Sale**

Loans held for investmentare intended to be held to maturity and, accordingly, are carried at cost, netof unamortized loan origination fees, discounts, repayments, sales of partialinterests in loans, and unfunded commitments unless such loan or investment isdeemed to be impaired.  Loans held forsale are carried at the lower of cost or market value using available marketinformation obtained through consultation with dealers or other originators ofsuch investments.  We may 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.  Should we make sucha preferred equity investment, we must determine whether that investment shouldbe accounted for as a loan, joint venture or as an interest in real estate.

Specific valuation allowances are established forimpaired loans based on the fair value of collateral on an individual loanbasis.  The fair value of the collateralis determined by selecting the most appropriate valuation methodology, ormethodologies, among several generally available and accepted  in the commercial real estate industry.  The determination of the most appropriatevaluation methodology is based on the key characteristics of the collateraltype.  These methodologies include theevaluation of operating cash flow from the property during the projectedholding period, and the estimated sales value of the collateral computed byapplying an expected capitalization rate to the stabilized net operating incomeof the specific property, less selling costs, all of which are discounted atmarket discount rates.

If upon completionof the valuation, the fair value of the underlying collateral securing theimpaired loan is less than the net carrying value of the loan, an allowance iscreated with 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.  We maintained a reserve of $1,460 and $1,030at September 30, 2006 and December 31, 2005, respectively.

Our Managerevaluates our assets on a regular basis to determine if they continue tosatisfy our investment criteria. Subject to certain restrictions, our Managermay cause us to sell our investments opportunistically and use the proceeds ofany such sale for debt reduction, additional acquisitions or working capitalpurposes.

#### **Classificationsof Mortgage-Backed Securities**

Mortgage-backedsecurities, or MBS, are classified as available-for-sale securities.  As a result, changes in fair value will berecorded as a balance sheet adjustment to accumulated other comprehensiveincome, which is a component of stockholders equity, rather than through ourstatement of operations.  Ifavailable-for-sale securities were classified as trading securities, therecould be substantially greater volatility in earnings from period-to-period asthese investments would be marked to market and any reduction in the value ofthe securities versus the previous carrying value would be considered anexpense on our statement of operations. We had no investments as of September30, 2006 that were accounted for as trading securities.

#### **Valuationsof Mortgage-Backed Securities**

All MBS arecarried on the balance sheet at fair value. We determine the fair value of MBS based on the types of securities inwhich we have invested.  For liquid,investment-grade securities, we consult with dealers of such securities toperiodically obtain updated market pricing for the same or similarinstruments.  For non-investment gradesecurities, we actively monitor the performance of the underlying propertiesand loans and update our pricing model to reflect changes in projected cashflows.  The value of the securities isderived by applying discount rates to such cash flows based on current marketyields.  The yields employed are obtainedfrom our own experience in the market, advice from dealers and/or informationobtained in consultation with other investors in similar instruments.  Because fair value estimates may vary to somedegree, we must make certain judgments and assumptions about the appropriateprice to use to calculate the fair values for financial reportingpurposes.  Different judgments and assumptionscould result in different presentations of value.

When the fairvalue of an available-for-sale security is less than the amortized cost, weconsider whether there is an other-than-

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temporaryimpairment in the value of the security (for example, whether the security willbe sold prior to the recovery of fair value). If, in our judgment, an other-than-temporary impairment exists, the costbasis of the security is written down to the then-current fair value, and thisloss is realized and charged against earnings. The determination of other-than-temporary impairment is a subjectiveprocess, and different judgments and assumptions could affect the timing ofloss realization.

#### **CreditTenant Lease Investments**

Consolidated CTL investments are recorded at cost lessaccumulated depreciation.  Costs directlyrelated to the 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.

Results of operations of properties acquired are included inthe Statement of Income from the date of acquisition.

In accordance with FASB No. 144, or SFAS 144, “Accountingfor the Impairment of Disposal of Long-Lived Assets,” a property to be disposedof is reported at the lower of its carrying amount or its estimated fair value,less its cost to sell.  Once an asset isheld for sale, depreciation expense and straight-line rent adjustments are nolonger recorded and historic results are reclassified as DiscontinuedOperations.

In accordance with FASB No. 141, or SFAS 141, “BusinessCombinations,” we allocate the purchase price of real estate to land andbuilding and, if determined to be material, intangibles, such as the value ofabove, below and at-market leases and origination costs associated with thein-place leases.  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.

As of September 30, 2006, we had oneproportionately consolidated CTL investment representing a 49.75% TICinterest in 55 Corporate Drive in Bridgewater, New Jersey.  All income and expenses at this property arebeing capitalized and are not recognized in our results from operations as ofand for the period ended September 30, 2006, as the property is currently beingredeveloped.

**Investments in Unconsolidated Joint Ventures**

#### We account forour investments in unconsolidated joint ventures under the equity method ofaccounting since we exercise significant influence, but do not unilaterallycontrol, the entities and are not considered to be the primary beneficiaryunder FIN 46.  In the joint ventures, the rights of the other investor areprotective and participating. Unless we are determined to be the primarybeneficiary, these rights preclude us from consolidating the investments. The investments are recorded initially at cost as an investment inunconsolidated joint ventures, and subsequently are adjusted for equity in netincome (loss) and cash contributions and distributions.  Any differencebetween the carrying amount of the investments on our balance sheet and theunderlying equity in net assets is amortized as an adjustment to equity in netincome (loss) of unconsolidated joint ventures over the lesser of the jointventure term or 40 years.  None of the joint venture debt is recourse tous.  As of September 30, 2006 we hadinvestments of $58,512in three unconsolidated joint ventures.

#### **RevenueRecognition**

Interest income ondebt investments is recognized over the life of the investment using theeffective 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 using the effective interest method.  Anticipated exit fees, whose collection isexpected, are also recognized over the term of the loan as an adjustment toyield.  Fees on commitments that expireunused are recognized at expiration. Fees received in exchange for the credit enhancement of another lender,either subordinate or senior to us, in the form of a guarantee are recognizedover the term of that guarantee using the straight-line method.

Income recognition is generally suspended for debt investments at theearlier of the date at which payments become 90 days past due

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or when, in our opinion, a full recovery of income and principal becomesdoubtful.  Income recognition is resumedwhen the loan becomes contractually current and performance is demonstrated tobe resumed.

In some instances we may sell all or a portion of our investments to athird party.  To the extent the fairvalue received for an investment exceeds the amortized cost of that investmentand FASB Statement No. 140, or SFAS 140, “Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities,” criteria ismet, under which control of the asset that is sold is surrendered making it a “truesale,” a gain on the sale will be recorded through earnings as otherincome.  To the extent an investment thatis sold has a discount or fees, which were deferred at the time the investmentwas made and were being recognized over the term of the investment, theunamortized portion of the discount or fees are recognized at the time of saleand recorded as a gain on the sale of the investment through other income.  We recognized $400 in gains from thesyndication of one fixed rate debt investment during the three months endedSeptember 30, 2006.  For the nine monthsended September 30, 2006 we recognized $1,828 in net gains from the sale ofthree fixed rate debt investments, one fixed rate debt commitment and thesyndication of portions of two floating rate debt investments.

Rental revenue is recognized on astraight-line basis over the term of the lease. The excess of rents recognizedover amounts contractually due pursuant to the underlying leases is included inother assets on the accompanying balance sheets. We may establish, on a currentbasis, an allowance against this account for future potential tenant creditlosses, which may occur. The balance reflected on the balance sheet will be netof such allowance.

In addition to base rent, thetenants in our CTL investments also pay all operating costs of owned propertyincluding real estate taxes.

#### **Reservefor Possible Loan Losses**

The expense for possible loan losses in connection with debt investmentsis the charge to earnings to increase the allowance for possible loan losses tothe level that management estimates to be adequate considering delinquencies,loss experience and collateral quality. Other factors considered relate to geographic trends and projectdiversification, the size of the portfolio and current economic conditions.  Based upon these factors, we may establishthe provision for possible loan losses by individual asset or category ofasset. When it is probable that we will be unable to collect all amountscontractually due, the account is considered impaired.

Where impairment is indicated, a valuation write-down or write-off ismeasured based upon the excess of the recorded investment amount over the netfair value of the collateral, as reduced by selling costs.  Any deficiency between the carrying amount ofan asset and the net sales price of foreclosed collateral is charged tothe allowance for loan losses.  Wemaintained a reserve for possible loan losses of $1,460 against investmentswith a carrying value of $82,336 as of September 30, 2006, and a reserve forpossible loan losses of $1,030 against investments with a carrying value of$68,293 as of December 31, 2005, respectively.

**DeferredCosts**

Deferred costsconsist of fees and direct costs incurred to originate new investments and areamortized using the effective yield method over the related term of theinvestment.

In March 2006, werecorded a nonrecurring charge of $525 for third-party professional expenses inconnection with a possible business combination involving the acquisition of apublicly-traded commercial real estate finance company with business linesconsidered by management to be highly complementary to ours.  The decision to expense these costs was madeonce management concluded the proposed transaction was unlikely to occur onterms advantageous to us.

**DeferredFinancing Costs**

Deferredfinancing costs represent commitment fees, legal and other third party costsassociated with obtaining commitments for financing which result in a closingof such financing.  These costs areamortized over the terms of the respective agreements and the amortization isreflected in interest expense. Unamortized deferred financing costs are expensed when the associateddebt is refinanced or repaid before maturity. Costs incurred in seeking financing transactions, which do not close,are expensed in the period in which it is determined that the financing willnot close.

**StockBased Compensation Plans**

We have a stock-based compensation plan, described more fully in Note14.  We account for this plan using thefair value recognition provisions of FASB Statement 123(R), “Share-BasedPayment, a revision of FASB Statement No. 123, Accounting for Stock-BasedCompensation.”

The Black-Scholes option-pricing model was developed for use inestimating the fair value of traded options, which have no vesting

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restrictions and are fully transferable.  In addition, option valuation models requirethe input of highly subjective assumptions including the expected stock pricevolatility.  Because our plan hascharacteristics significantly different from those of traded options andbecause changes in the subjective input assumptions can materially affect thefair value estimate, in our opinion, the existing models do not necessarilyprovide a reliable single measure of the fair value of our stock options.

Compensation cost for stock options, if any, is recognized ratably overthe vesting period of the award.  Ourpolicy is to grant options with an exercise price equal to the quoted closingmarket price of our stock on the business day preceding the grant date.  Awards of stock or restricted stock areexpensed as compensation on a current basis over the benefit period.

The fair value of each stockoption granted is estimated on the date of grant for awards to co-leasedemployees, and quarterly for options issued to non-employees, using theBlack-Scholes option pricing model with the following weighted averageassumptions for grants in 2006 and 2005.

|                                  | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|----------------------------------|------------|-----------|------------|-----------|------------|
| Dividend yield                   |       | 8.1       | %          | 8.4       | %          |
| Expected life of  option         |       | 6.7 years |       | 6.9 years |       |
| Risk-free interest  rate         |       | 4.12      | %          | 4.16      | %          |
| Expected stock price  volatility |       | 21.0      | %          | 19.1      | %          |

 

**IncentiveDistribution (Class B Limited Partner Interest)**

The Class Blimited partner interests are entitled to receive an incentive return equal to25% of the amount by which funds from operations, or FFO, (as defined in thepartnership agreement of the Operating Partnership which was amended andrestated in April 2006) plus certain accounting gains exceed the product of ourweighted average stockholders equity (as defined in the amended and restatedpartnership 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 partnerinterests as an incentive distribution expense in the period when earned andwhen payment of such amounts has become probable and reasonably estimable inaccordance with the partnership agreement. These cash distributions will reduce the amount of cash available fordistribution to our common unitholders in our Operating Partnership and tocommon stockholders.  We incurredapproximately $1,822 and $4,592 with respect to such Class B limited partnerinterests for the three and nine months ended September 30, 2006, respectively,and $1,038 for the three and nine months ended September 30, 2005.

#### **DerivativeInstruments**

**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 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 market conventionsand techniques such as discounted cash flow analysis, option-pricing models,replacement cost, and termination cost are used to determine fair value.  All methods of assessing fair value result ina general approximation of value, and such value may never actually berealized.**

In the normalcourse of business, we are exposed to the effect of interest rate changes andlimit these risks by following established risk management policies andprocedures including the use of derivatives. To address exposure to interest rates, we use derivatives primarily tohedge the mark-to-market risk of our liabilities with respect to certain of ourassets.  We may also use derivatives tohedge variability in sales proceeds to be received upon the sale of loans held forsale.

We use a varietyof commonly used derivative products that are considered plain vanilladerivatives.  These derivatives typicallyinclude 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, “Accountingfor Derivative Instruments and Hedging Activities,” as amended by FASB No. 149,requires us**

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**to recognize all derivatives onthe balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value throughincome.  If a derivative is a hedge,depending on the nature of the hedge, changes in the fair value of thederivative will either be offset against the change in fair value of the hedgedasset, liability, or firm commitment through earnings, or recognized in othercomprehensive income until the hedged item is recognized in earnings.  The ineffective portion of a derivative’schange in fair value will be immediately recognized in earnings.  SFAS 133 may increase or decrease reportednet income and stockholders’ equity prospectively, depending on future levelsof LIBOR, swap spreads and other variables affecting the fair values ofderivative instruments and hedged items, but will have no effect on cash flows,provided the contract is carried through to full term.**

We may employswaps, forwards or purchased options to hedge qualifying forecastedtransactions.  Gains and losses relatedto these transactions are deferred and recognized in net income as interestexpense or other income in the same period or periods that the underlyingtransaction occurs, expires or is otherwise terminated.

All hedges held byus are deemed to be effective in meeting the hedging objectives established byour corporate policy governing interest rate risk management.  The effect of our derivative instruments onour financial statements is discussed more fully in Note 17.

# **Income Taxes**

We elected to betaxed as a REIT, under Sections 856 through 860 of the Internal Revenue Code,beginning with our taxable year ended December 31, 2004.  To qualify as a REIT, we must meet certainorganizational 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 taxable REITsubsidiaries, individually referred to as a TRS, are subject to federal, stateand local taxes.

**UnderwritingCommissions and Costs**

**Underwriting commissions and costs incurred inconnection with our stock offerings are reflected as a reduction of additionalpaid-in-capital.**

**EarningsPer Share**

Wepresent both basic and diluted earnings per share, or EPS.  Basic EPS excludes dilution and is computedby dividing net income available to common stockholders by the weighted averagenumber of common shares outstanding during the period.  Diluted EPS reflects the potential dilutionthat could occur if securities or other contracts to issue common stock wereexercised or converted into common stock, where such exercise or conversionwould result in a lower EPS amount.

**Useof Estimates**

The preparation of financialstatements in conformity with GAAP requires management to make estimates andassumptions that affect the amounts reported in the financial statements andaccompanying notes. Actual results could differ from those estimates.

**Concentrationsof Credit Risk**

**Financialinstruments that potentially subject us to concentrations of credit riskconsist primarily of cash investments, debt investments and accountsreceivable.  Gramercy places its cashinvestments 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, tenants and other credit metrics.  Four**investments accounted formore than 20% of the total carrying value of our debt investments as ofSeptember 30, 2006 and December 31, 2005. Sixinvestments accounted for approximately 26%and 21% of the revenue earned on our debt investments for the three and ninemonths ended September 30, 2006, compared to threeinvestments whichaccounted for approximately 25% and 29% of the revenue earned on our debtinvestments for the three and nine months ended September 30, 2005.

**RecentlyIssued Accounting Pronouncements**

**Statement of Financial AccountingStandard No. 123(R), or SFAS No. 123(R) “Share-Based Payment, a revision ofFASB Statement No. 123, Accounting for Stock-Based Compensation,” requires allshare-based payments to employees, including grants of employee stock**

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**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.  The implementation of SFAS No. 123(R) did nothave a material effect on our financial position or results of operations forthe three and nine months ended September 30, 2006.**

**In June 2005, the FASB ratifiedthe consensus in EITF Issue No. 04-5, or Issue 04-5, Determining Whether aGeneral Partner, or the General Partners as a Group, Controls a LimitedPartnership or Similar Entity When the Limited Partners Have Certain Rights,which provides guidance in determining whether a general partner controls alimited partnership.  Issue 04-5 states that the general partner in alimited partnership is presumed to control that limited partnership.  Thepresumption may be overcome if the limited partners have either (1) thesubstantive ability to dissolve the limited partnership or otherwise remove thegeneral partner without cause or (2) substantive participating rights, whichprovide the limited partners with the ability to effectively participate insignificant decisions that would be expected to be made in the ordinary courseof the limited partnership’s business and thereby preclude the general partnerfrom exercising unilateral control over the partnership.  If the criteriain Issue 04-5 are met, a company could be required to consolidate certain ofits existing unconsolidated joint ventures.  Our adoption of Issue 04-5for new or modified limited partnership arrangements effective June 30, 2005and existing limited partnership arrangements effective January 1, 2006 did nothave a material effect on our financial position or results of operations forthe three and nine months ended September 30, 2006.**

**In February 2006, the FASB issuedStatement of Financial Accounting Standard No. 155, or SFAS No. 155, “Accountingfor Certain Hybrid Financial Instruments — an amendment of FASB Statements No.133 and 140”. SFAS No. 155 (1) permits fair value re-measurement for any hybridfinancial instrument that contains an embedded derivative that would otherwiserequire bifurcation, (2) clarifies which interest-only strips andprincipal-only strips are not subject to the requirements of FASB Statement No.133, (3) establishes a requirement to evaluate interests in securitizedfinancial assets to identify interests that are freestanding derivatives orthat are hybrid financial instruments that contain an imbedded derivativerequiring bifurcation, (4) clarifies that concentrations of credit risk in theform of subordination are not embedded derivatives, and (5) amends FASBStatement No. 140 to eliminate the prohibition on a qualifying special-purposeentity from holding a derivative financial instrument that pertains to abeneficial interest in other than another derivative financial instrument. SFASNo. 155 is effective January 1, 2007 and we are currently evaluating theeffect, if any, that this pronouncement will have on our future financialresults.**

**InJuly 2006, the FASB issued Interpretation No. 48, or FIN 48, “**Accounting for Uncertaintyin Income Taxes”. This interpretation,among other things, creates a two-step approach for evaluating uncertain taxpositions. Recognition (step one) occurs when an enterprise concludes that atax position, based solely on its technical merits, is more-likely-than-not tobe sustained upon examination. Measurement (step two) determines the amount ofbenefit that more-likely-than-not will be realized upon settlement.Derecognition of a tax position that was previously recognized would occur whena company subsequently determines that a tax position no longer meets themore-likely-than-not threshold of being sustained. FIN 48 specificallyprohibits the use of a valuation allowance as a substitute for derecognition oftax positions, and it has expanded disclosure requirements.  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006, in which the impact of adoption should be accountedfor as a cumulative-effect adjustment to the beginning balance of retainedearnings. We are currently evaluating the effect, if any, that thispronouncement will have on our future financial results.

**In September 2006, the FASBissued Statement No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No.157 provides guidance for using fair value to measure assets and liabilities.This statement clarifies the principle that fair value should be based on theassumptions that market participants would use when pricing the asset orliability. SFAS No. 157 establishes a fair value hierarchy, giving the highestpriority to quoted prices in active markets and the lowest priority tounobservable data. SFAS No. 157 applies whenever other standards require assetsor liabilities to be measured at fair value. This statement is effective infiscal years beginning after November 15, 2007. We believe that the adoption ofthis standard on January 1, 2008 will not have a material effect on ourconsolidated financial statements.**

**In September 2006, the Securitiesand Exchange Commission issued Staff Accounting Bulletin No. 108 (“SAB 108”),which becomes effective beginning on January 1, 2007. SAB 108 provides guidanceon the consideration of the effects of prior period misstatements inquantifying current year misstatements for the purpose of a materialityassessment. SAB 108 provides for the quantification of the impact of correctingall misstatements, including both the carryover and reversing effects of prioryear misstatements, on the current year financial statements. If a misstatementis material to the current year financial statements, the prior year financialstatements should also be corrected, even though such revision was, andcontinues to be, immaterial to the prior year financial statements. Correctingprior year financial statements for immaterial errors would not requirepreviously filed reports to be amended. Such correction should be made in thecurrent period filings. We arecurrently evaluating the effect, if any, that this pronouncement will have onour future financial results.**

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**3.             Loansand Other Lending Investments**

 

**The aggregate carrying values, allocated by producttype and weighted average coupons of our loans and other lending investments asof September 30, 2006 and December 31, 2005 were as follows:**
|                                                      | ** ** | **Carrying Value (1)  ($ in thousands)** | ** ** | **Allocation by  Investment Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average Spread over  LIBOR (2)** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                                     | ** ** | **2005**                                     | ** ** | **2006**                                 | ** ** | **2005**                                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Whole loans,  floating rate                          |       | $                                                            | 1,284,562  |                                         | $          | 561,388                                  |       | 62                                                                     | %          | 46 | % | — |   | — |   | 314 bps |   | 325 bps |   |
| Whole loans,  fixed rate                             |       | 80,700                                                       |       | 94,448                                       |       | 4                                        | %          | 8                                                                      | %          | 11.94 | % | 10.67 | % | — |   | — |   |
| Subordinate  interests in whole loans, floating rate |       | 337,813                                                      |       | 362,983                                      |       | 17                                       | %          | 30                                                                     | %          | — |   | — |   | 397 bps |   | 443 bps |   |
| Subordinate  interests in whole loans, fixed rate    |       | 48,513                                                       |       | 37,104                                       |       | 2                                        | %          | 3                                                                      | %          | 8.72 | % | 8.80 | % | — |   | — |   |
| Mezzanine loans,  floating rate                      |       | 187,727                                                      |       | 82,793                                       |       | 9                                        | %          | 7                                                                      | %          | — |   | — |   | 548 bps |   | 858 bps |   |
| Mezzanine loans,  fixed rate                         |       | 68,590                                                       |       | 43,352                                       |       | 3                                        | %          | 4                                                                      | %          | 9.08 | % | 8.51 | % | — |   | — |   |
| Preferred  equity, floating rate                     |       | 11,879                                                       |       | 11,795                                       |       | 1                                        | %          | 1                                                                      | %          | — |   | — |   | 900 bps |   | 900 bps |   |
| Preferred  equity, fixed rate                        |       | 44,274                                                       |       | 11,882                                       |       | 2                                        | %          | 1                                                                      | %          | 10.79 | % | 10.27 | % | — |   | — |   |
| Total / Average                                      |       | $                                                            | 2,064,058  |                                         | $          | 1,205,745                                |       | 100                                                                    | %          | 100 | % | 10.27 | % | 9.78 | % | 357 bps |   | 417 bps |   |

 

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**(1)  Debt investments are presented afterscheduled amortization payments and prepayments, and are net of unamortizedfees, discounts, asset sales and unfunded commitments.**

**(2)**          Spreads over an indexother than LIBOR have been adjusted to a LIBOR based equivalent.

As of September30, 2006, our investment portfolio had the following maturity characteristics:

| Year of Maturity     | ** ** | **Number of  Investments  Maturing** | ** ** | **Current  Carrying Value** | ** ** | **% of Total** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|----------------------------------|------------|--------------------------|------------|
| ** **                     | ** ** | ** **                                | ** ** | **(In thousands)**          | ** ** | ** **               | ** ** |
| 2006                           |       | 4                                         |       | $                                | 51,397     |                     | 2          | % |
| 2007                           |       | 28                                        |       | 715,942                          |       | 35                       | %          |
| 2008                           |       | 20                                        |       | 842,458                          |       | 41                       | %          |
| 2009                           |       | 14                                        |       | 283,309                          |       | 14                       | %          |
| 2010                           |       | 2                                         |       | 6,625                            |       | —                   |       |
| 2011                           |       | 2                                         |       | 56,910                           |       | 3                        | %          |
| Thereafter                     |       | 7                                         |       | 107,417                          |       | 5                        | %          |
| Total                          |       | 77                                        |       | $                                | 2,064,058  |                     | 100        | % |
|                           |       |                                      |       |                             |       |                     |       |
| Weighted average  maturity (1) |       |                                      |       | 1.9 years                        |       |                     |       |

 

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(1)          The calculation ofweighted average maturity is based upon the initial term of the investment anddoes not include option or extension periods or the ability to prepay theinvestment after a negotiated lock-out period, which may be available to theborrower.

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For the three and nine months ended September 30, 2006 and 2005 theCompany’s investment income from debt investments was generated by thefollowing investment types:

 
|                                       | ** ** | **Three months ended  September 30, 2006** | ** ** | **Three months ended  September 30, 2005** | ** ** |
|---------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| **Investment Type**              | ** ** | **Investment  Income**                                         | ** ** | **% of  Total**                                           | ** ** | **Investment  Income** | ** ** | **% of  Total** | ** ** |
| Whole loans                           |       | $                                                              | 28,236     |                                                           | 62         | % | $ | 9,410 |   | 44 | % |
| Subordinate  interests in whole loans |       | 10,479                                                         |       | 23                                                             | %          | 7,529 |   | 36 | % |
| Mezzanine loans                       |       | 5,195                                                          |       | 12                                                             | %          | 3,313 |   | 16 | % |
| Preferred equity                      |       | 1,389                                                          |       | 3                                                              | %          | 421 |   | 2 | % |
| CMBS                                  |       | —                                                         |       | —                                                         |       | 387 |   | 2 | % |
| Total                                 |       | $                                                              | 45,299     |                                                           | 100        | % | $ | 21,060 |   | 100 | % |

 
|                                       | ** ** | **Nine months ended  September 30, 2006** | ** ** | **Nine months ended  September 30, 2005** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| **Investment Type**              | ** ** | **Investment  Income**                                        | ** ** | **% of  Total**                                          | ** ** | **Investment  Income** | ** ** | **% of  Total** | ** ** |
| Whole loans                           |       | $                                                             | 67,913     |                                                          | 58         | % | $ | 18,394 |   | 39 | % |
| Subordinate  interests in whole loans |       | 32,570                                                        |       | 28                                                            | %          | 19,689 |   | 42 | % |
| Mezzanine loans                       |       | 12,932                                                        |       | 11                                                            | %          | 6,682 |   | 14 | % |
| Preferred equity                      |       | 2,898                                                         |       | 3                                                             | %          | 1,112 |   | 2 | % |
| CMBS                                  |       | —                                                        |       | —                                                        |       | 1,122 |   | 3 | % |
| Total                                 |       | $                                                             | 116,313    |                                                          | 100        | % | $ | 46,999 |   | 100 | % |

 

AtSeptember 30, 2006 and December 31, 2005, our debt investment portfolio had thefollowing geographic diversification:

 
|            | ** ** | **2006**            | ** ** | **2005**             | ** ** |
|------------|------------|---------------------|------------|----------------------|------------|
| **Region** | ** ** | **Carrying  Value** | ** ** | **% of  Total** | ** ** | **Carrying  Value** | ** ** | **% of  Total** | ** ** |
| Northeast  |       | $                   | 939,384    |                 | 46         | % | $ | 429,012 |   | 46 | % |
| West       |       | 825,723             |       | 40                   | %          | 251,853 |   | 27 | % |
| South      |       | 205,084             |       | 10                   | %          | 127,973 |   | 14 | % |
| Midwest    |       | 93,867              |       | 4                    | %          | 107,563 |   | 11 | % |
| Various    |       | —              |       | —               |       | 20,000 |   | 2 | % |
| Total      |       | $                   | 2,064,058  |                 | 100        | % | $ | 936,401 |   | 100 | % |

 

In connection witha preferred equity investment we held at September 30, 2006, which wassubsequently repaid in October 2006, we have guaranteed a portion of theoutstanding principal balance of the first mortgage loan that is a financialobligation of the entity in which we have invested in the event of a borrowerdefault under such loan.  The loanmatures in 2032.  This guarantee isconsidered to be an off-balance-sheet arrangement and will survive until therepayment of the first mortgage loan.  Ascompensation, we received a credit enhancement fee of $125 from the borrower,which is recognized as the fair value of the guarantee and has been recorded onour balance sheet as a liability. The liability will be amortized over the lifeof the guarantee using the straight-line method and corresponding fee incomewill be recorded.  Our maximum exposureunder this guarantee is approximately $1,443 as of September 30, 2006.  Under the terms of the guarantee, theinvestment sponsor is required to reimburse us for the entire amount paid underthe guarantee until the guarantee expires.

**4.  Property Acquisitions**

***55 CorporateDrive***

**On June 7, 2006 we closed on theacquisition of a 49.75% TIC interest in 55 Corporate Drive, located inBridgewater, New Jersey, with a 0.25% interest to be acquired in thefuture.  The property is comprised ofthree buildings totaling 670,000 square feet which is 100% net leased to anentity whose obligations are guaranteed by Sanofi-Aventis Group through April2023. The transaction was valued at $236,000 and was financed with a $190,000,10-year, fixed-rate first mortgage loan. The remaining 50% of the property is owned as a TIC interest by SLGreen.   Upon closing the acquisition ofthe property, the $90,000 whole loan previously held by us was repaid in fullusing**

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**proceeds from the new mortgagefinancing.  All income and expenses atthis property are being capitalized and are not recognized in our results fromoperations as of and for the period ended September 30, 2006, as the propertyis currently being redeveloped.**

**5.Disposition of Security Interests in Property**

***200 FranklinSquare Drive***

OnSeptember 6, 2005, we closed on the acquisition of a 100% fee interest in200 Franklin Square Drive, located in Somerset, New Jersey. The property is a200,000 square foot building which is 100% net leased to Philips Holding USAInc., a wholly-owned subsidiary of Royal Philips Electronics, through December2021.  The property was acquired for apurchase price of $50,250, excluding closing costs, and financed with a$41,000, 10-year, fixed-rate first mortgage loan.

On March 31, 2006,following the conversion of the entity that owns 200 Franklin Square Drive intoa Delaware statutory trust, or DST, we sold approximately 29.3% of our securityinterests in the DST to a third party. Subsequently, we sold an additional 45.7% of our security interests inthe DST to the same party, reducing our final ownership interest to 25.0%.  We received total cash consideration of$12,800 for these interests and the buyer assumed 75% of the DST’s underlyingmortgage debt.  The disposition resultedin a net gain of $4,530, after transaction costs.  As a result of the disposition, thisinvestment is now classified as an investment in joint venture and accountedfor using the equity method.  As of September30, 2006 the investment has a carrying value of $2,572.  We recorded our pro rata share of net incomeof the joint venture of $25 and $81 for the three and nine months endedSeptember 30, 2006, respectively.

**6. Investments inUnconsolidated Joint Ventures**

***South Buildingat One Madison Avenue, New York, New York***

**On April 29, 2005, we closed on a$57,503 initial investment in a joint venture with SL Green to acquire, own andoperate the South Building located at One Madison Avenue, New York, New York,or the South Building.  The joint ventureis owned 45% by a wholly-owned subsidiary and 55% by a wholly-owned subsidiaryof SL Green.  The joint venture interestsare *pari passu*.  Also on April 29, 2005, the joint venturecompleted the acquisition of the South Building 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 the SouthBuilding.  The first mortgage isnon-recourse to us.  The South Buildingcomprises approximately 1.2 million square feet and is almost entirely netleased to Credit Suisse Securities (USA) LLC, or CS, pursuant to a lease with a15-year remaining term.  As of September30, 2006 the investment has a carrying value of $55,723.  We recorded our pro rata share of net lossesof the joint venture of $415 and $1,168 for the three and nine months endedSeptember 30, 2006, respectively, and $510 and $914 for the three and ninemonths ended September 30, 2005.**

***101 S. MarengoAvenue, Pasadena, California***

**On November 29, 2005, we closedon the purchase of a 50% interest in an office building in Pasadena, CA.  We also acquired an interest in certainrelated assets as part of the transaction. The 345,000 square foot officeproperty, which is net leased to Bank of America through September 2015,assuming the exercise of options, and related collateral were acquired for$52,000 plus closing costs, using a non-recourse, $50,000, 10-year fixed-ratefirst mortgage loan.  As of September 30,2006 the investment has a carrying value of $217.  For the three and nine months ended September30, 2006, we recorded our pro rata share of net losses of the joint ventures of$344 and $1,005, respectively.**

**7.  Junior Subordinated Debentures**

**On January 27, 2006, we completeda third issuance of $50,000 in unsecured trust preferred securities through aseparate newly formed DST, Gramercy Capital Trust III, or GCTIII, that is awholly-owned subsidiary of the Operating Partnership.  The securities bear interest at a fixed rateof 7.65% for the first ten years ending January 2016, with an effective rate of7.43% when giving effect to the swap arrangement previously entered into incontemplation of this financing.  Thereafterthe rate will float based on the three-month LIBOR plus 270 basis points.**

**In May and August 2005, wecompleted issuances of $50,000 each in unsecured trust preferred securitiesthrough two DST’s, Gramercy Capital Trust I, or GCTI, and Gramercy CapitalTrust II, or GCTII, that are also wholly-owned subsidiaries of the OperatingPartnership.  The securities issued inMay 2005 bear interest at a fixed rate of 7.57% for the first ten years endingJune 2015 and the securities issued in August 2005 bear interest at a fixedrate of 7.75% for the first ten years ending October 2015.  Thereafter the rates will float based on thethree-month LIBOR plus 300 basis points.**

**All issuances of trust preferredsecurities require quarterly interest distributions; however, payments may bedeferred while the interest**

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**expense is accrued for a periodof up to four consecutive quarters if the Operating Partnership exercises itsright to defer such payments.  The trustpreferred securities are redeemable, at the option of the OperatingPartnership, in whole or in part, with no prepayment premium any time afterJune 30, 2010, October 30, 2010 or January 30, 2011 for the securities issuedby GCTI, GCTII and GCTIII, respectively.**

**GCTI, GCTII and GCTIII eachissued $1,550 aggregate liquidation amount of common securities, representing100% of the voting common stock of those entities to the Operating Partnershipfor a total purchase price of $4,650. GCTI, GCTII and GCTIII used the proceeds from the sale of the trustpreferred securities and the common securities to purchase the OperatingPartnership’s junior subordinated notes. The terms of the junior subordinated notes match the terms of the trustpreferred securities.  The notes aresubordinate and junior in right of payment to all present and future seniorindebtedness and certain other of our financial obligations.  We realized net proceeds from each offeringof approximately $48,956.**

Our interests in GCTI, GCTII and GCTIII areaccounted for using the equity method and the assets and liabilities of thoseentities are not consolidated into our financial statements.  Interest on the junior subordinated notes isincluded in interest expense on our consolidated income statements while thevalue of the junior subordinated notes, net of our investment in the truststhat issued the securities, are presented as a separate item in ourconsolidated balance sheet.

**8.  Collateralized DebtObligations**

During 2005 we issuedapproximately $1,000,000 of CDOs through two indirect subsidiaries, GramercyReal Estate CDO 2005-1 Ltd., or the 2005 Issuer, and Gramercy Real EstateCDO 2005-1 LLC, or the 2005 Co-Issuer. The CDO consists of $810,500 ofinvestment grade notes, $84,500 of non-investment grade notes, which wereco-issued by the 2005 Issuer and the 2005 Co-Issuer, and $105,000 of preferredshares, which were issued by the 2005 Issuer. The investment grade notes were issued with floating rate coupons with acombined weighted average rate of three-month LIBOR plus 0.49%.  We incurred approximately $11,957 of costsrelated to Gramercy Real Estate CDO 2005-1, which are amortized on a level-yieldbasis over the average life of the CDO.

On August 24, 2006 weissued an additional approximately $1,000,000 of CDOs through two newly-formedindirect subsidiaries, Gramercy Real Estate CDO 2006-1 Ltd., or the 2006Issuer, and Gramercy Real Estate CDO 2006-1 LLC, or the 2006 Co-Issuer. The CDOconsists of $903,750 of investment grade notes, $38,750 of non-investment gradenotes, which were co-issued by the 2006 Issuer and the 2006 Co-Issuer, and$57,500 of preferred shares, which were issued by the 2006 Issuer.  The investment grade notes were issued withfloating rate coupons with a combined weighted average rate of three-monthLIBOR plus 0.37%. We incurred approximately $11,356 of costs related toGramercy Real Estate CDO 2006-1, which are amortized on a level-yield basisover the average life of the CDO.

We retained allnon-investment grade securities, the preferred shares and the common shares inthe Issuer of each CDO.  The Issuer ineach CDO holds assets, consisting primarily of whole loans, subordinateinterests in whole loans, mezzanine loans and preferred equity investments,which serve as collateral for the CDO. Each CDO may be replenished, pursuant to certain rating agencyguidelines relating to credit quality and diversification, with substitutecollateral for loans that are repaid during the first five years of the CDO.Thereafter, the CDO securities will be retired in sequential order fromsenior-most to junior-most as loans are repaid. The financial statements of the Issuer of each CDO are consolidated inour financial statements. The investment grade notes are treated as a securedfinancing, and are non-recourse to us. Proceeds from the sale of the investmentgrade notes issued in each CDO were used to repay substantially all outstandingdebt under our repurchase agreements and to fund additional investments.

**9.   Debt Obligations**

#### **RepurchaseFacilities**

**We have two repurchasefacilities, one with Wachovia Capital Markets, LLC or one or more of itsaffiliates, or Wachovia, and one with Goldman Sachs Mortgage Company, orGoldman.**

The repurchasefacility with Wachovia is a $500,000 facility. This facility was initially established as a $250,000 facility, wasincreased to $350,000 from $250,000 effective January 3, 2005, and wassubsequently increased to $500,000 effective April 22, 2005. On March 21, 2006we further modified the facility by reducing the interest spreads.  As a result of the modifications, the$500,000 facility bears interest at spreads of 1.00% to 2.50% over three monthLIBOR and, based on our expected investment activities, provides for advancerates that vary from 60% to 100% based upon the collateral provided under aborrowing base calculation.  On October13, 2006 we extended the facility’s maturity date until October 2009.  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.  We had no accrued interest and borrowings of$58,739 at a weighted average spread to LIBOR of 1.35%, and $67,717 at aweighted average spread to LIBOR of 1.50%, under this facility at September 30,2006 and December 31, 2005, respectively.

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Borrowings under the Wachovia facility at September 30, 2006 and December31, 2005 were secured by the following investments:
|                                       | ** ** | **Carrying Value (1)** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| **Investment Type**              | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Whole loans                           |       | $                                | 69,852     |   | $ | 33,223 |   |
| Subordinate  interests in whole loans |       | —                           |       | 74,689 |   |
| CDO securities  (2)                   |       | —                           |       | 49,500 |   |
| Total                                 |       | $                                | 69,852     |   | $ | 157,412 |   |

 

|  |   |
|--|--------|

**(1)**          Approximates fair value.

**(2)**          Represents the BB ratedsecurities in our CDO that were retained by us.

We also have arepurchase facility with Goldman.  OnOctober 13, 2006 we increased this facility from $200,000 to $400,000 andextended its maturity date until September 2009.  On March 21, 2006, we modified the pricing onthis facility by reducing the interest spreads. As a result of the modifications, the facility bears interest at spreadsof 1.00% to 2.25% over three month LIBOR and, based on our expected investmentactivities, provides for advance rates that vary from 40% to 85% 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.  We had no accrued interest andno outstanding borrowings as of September 30, 2006, and accrued interest of$163 and borrowings of $49,649 at a weighted average spread to LIBOR of 1.71%under this facility at December 31, 2005.

Borrowings under the Goldman facility at December 31, 2005 were securedby the following investments:
|                          | ** ** | **Carrying  Value** | ** ** |
|--------------------------|------------|---------------------|------------|
| **Investment Type** | ** ** | **2005**            | ** ** |
| Whole loans              |       | $                   | 59,457     |   |
| Total                    |       | $                   | 59,457     |   |

 

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**(1)   Approximates fair value.**

The terms of ourrepurchase facilities (together with any related guarantees) include covenantsthat****(a) limit our maximum totalindebtedness to no more than 85% of total assets under the Wachovia facility ora debt to equity ratio less than or equal to 5:1 under the Goldman facility,(b) require us to maintain minimum liquidity of at least $10,000 for the firsttwo years and $15,000 thereafter under the Goldman facility, and at least$15,000 under the Wachovia facility, (c) require our fixed charge coverageratio to be at no time less than 1.50 to 1.00, (d) require our minimum interestcoverage ratio to be at no time less than 1.75 to 1.00 under the Wachoviafacility, (e) require us to maintain minimum tangible net worth of not lessthan (i) $129,750, plus (ii) 75% of the proceeds of our subsequent equityissuances following our initial public offering under the Goldman facility andnot less than (i) $400,000, plus (ii) 75% of the net proceeds of our subsequentequity issuances following the date of the October 2006 amendment under theWachovia facility and (f) restrict the maximum amount of our totalindebtedness.  The covenants alsorestrict us from making distributions in excess of a maximum of 100% of our FFO(as defined therein) under the Wachovia facility, except that we may in anycase pay distributions necessary to maintain our REIT status.  Anevent of default can be triggered if, among other things, GKK Manager LLC isterminated as our Manager.  As ofSeptember 30, 2006 and December 31, 2005, we were in compliance with all suchcovenants.

The repurchasefacilities require that we pay down borrowings under these facilities asprincipal payments on the loans and investments pledged to these facilities arereceived.  Assets pledged as collateral under thesefacilities may include stabilized and transitional whole loans, subordinateinterests in whole loans, mezzanine loans, and rated CMBS or commercial realestate CDO securities originated or acquired by us.

In certaincircumstances, we have purchased debt investments from a counterparty andsubsequently financed the acquisition of those debt investments throughrepurchase agreements with the same counterparty.  We currently record the acquisition of thedebt investments as assets and the related repurchase agreements as financingliabilities gross on the consolidated balance sheets. Interest income earned onthe debt investments and interest expense incurred on the repurchaseobligations are reported gross on the consolidated income statements.  However, under a certain technicalinterpretation of FAS 140, such transactions may not qualify as a

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purchase byus.  We believe, and it is industrypractice, that we are accounting for these transactions in an appropriatemanner.  However, the result of thistechnical interpretation would prevent us from presenting the debt investmentsand repurchase agreements and the related interest income and interest expenseon a gross basis on our financial statements. Instead, we would present the net investment in these transactions withthe counterparty and a derivative with the corresponding change in fair valueof the derivative being recorded through earnings.  The value of the derivative would reflectchanges in the value of the underlying debt investments and changes in thevalue of the underlying credit provided by the counterparty.

#### **UnsecuredRevolving Credit Facility**

In May 2006, weclosed on a $100,000 senior unsecured revolving credit facility with KeyBankwith an initial term of three years and a one-year extension option.  The facility is supported by a negativepledge of an identified asset base with advance rates that vary from 30% to 90%of the asset value provided under a borrowing base calculation.  The lender also has consent rights to theinclusion of assets in the borrowing base calculation.  The facility bears interest at 1.90% overthree month LIBOR to the extent our leverage ratio, defined as totalliabilities to total assets, including our proportionate share of theliabilities and assets of our unconsolidated subsidiaries, is less than 80% and2.10% over three month LIBOR to the extent out leverage ratio is equal to orgreater than 80%.  We had no outstandingborrowings against this facility as of September 30, 2006.

The terms of theunsecured revolving credit facility include covenants that****(a) limit our maximum total indebtednessto no more than 85% of total assets, (b) require our fixed charge coverageratio to be at no time less than 1.50, (c) require our minimum interestcoverage ratio to be at no time less than 1.70, (d) require us to maintainminimum tangible net worth of not less than $370,000 plus 75% of the netproceeds from equity offerings completed after the closing of the facility and(e) restrict the maximum amount of our total indebtedness.  The covenants also restrict us from makingdistributions in excess of a maximum of 100% of our FFO (as defined by theNational Association of Real Estate Investment Trusts, or NAREIT), except thatwe may in any case pay distributions necessary to maintain our REITstatus.  An event of default can betriggered on our unsecured revolving credit facility if, among other things, GKKManager LLC is terminated as our Manager. As of September 30, 2006, we were in compliance with all such covenants.

In conjunctionwith the closing of the unsecured revolving credit facility with KeyBank, our$25,000 revolving credit facility with Wachovia was terminated.

#### **MortgageLoan**

We have oneconsolidated interest-only mortgage loan in an amount equal to our ownershippercentage in the entity multiplied by the outstanding principal balance of themortgage loan, which loan financed the acquisition of 55 Corporate Drive inJune 2006.  The mortgage has anoutstanding principal balance of $190,000, of which we have consolidated 49.75%or $94,525, with an effective interest rate of 5.75% and a term of tenyears.  Interest on this mortgage isbeing capitalized as of September 30, 3006 as the property is beingredeveloped.  Capitalized interest was$1,766 for the three and nine months ended September 30, 2006.

Combined aggregateprincipal maturities of our consolidated CDOs, repurchase facilities, trustpreferred securities, mortgage note payable and unsecured revolving creditfacility as of September 30, 2006 are as follows:

|            | ** ** | **Collateralized  Debt  Obligations** | ** ** | **Repurchase  Facilities** | ** ** | **Trust  Preferred  Securities** | ** ** | **Mortgage  Note  Payable** | ** ** | **Unsecured  Revolving  Credit  Facility** | ** ** | **Total** | ** ** |
|------------|------------|---------------------------------------|------------|----------------------------|------------|----------------------------------|------------|-----------------------------|------------|--------------------------------------------|------------|-----------|------------|
| 2006       |       | $                                     | —     |                       | $          | —                           |       | $                           | —     |                                       | $          | —    |       | $ | — |   | $ | — |   |
| 2007       |       | —                                |       | —                     |       | —                           |       | —                      |       | —                                     |       | —    |       |
| 2008       |       | —                                |       | —                     |       | —                           |       | —                      |       | —                                     |       | —    |       |
| 2009       |       | —                                |       | 58,739                     |       | —                           |       | —                      |       | —                                     |       | 58,739    |       |
| 2010       |       | —                                |       | —                     |       | —                           |       | —                      |       | —                                     |       | —    |       |
| 2011       |       | —                                |       | —                     |       | —                           |       | —                      |       | —                                     |       | —    |       |
| Thereafter |       | 1,714,250                             |       | —                     |       | 150,000                          |       | 94,525                      | (1)        | —                                     |       | 1,958,775 |       |
| Total      |       | $                                     | 1,714,250  |                       | $          | 58,739                           |       | $                           | 150,000    |                                       | $          | 94,525    |       | — |   | $ | 2,017,514 |   |
|            |            |                                       |            |                            |            |                                  |            |                             |            |                                            |            |           |            |  |  |  |  |  |  |

 

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(1) Wehave a 49.75% interest in the entity that is the obligor under the mortgagenote.

**10. **Operating Partnership Agreement / Manager

At September 30,2006, we owned all of the Class A limited partnership interests in ourOperating Partnership.  At September 30,2006, the majority of the Class B limited partnership interests were owned byour Manager and SL Green Operating Partnership, L.P.

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Interests werealso held by certain officers and employees of SL Green Realty Corp., includingsome of whom are among our executive officers, certain of which interests aresubject to performance thresholds.

At September 30, 2006,the majority of the interests in our Manager were held by SL Green OperatingPartnership, L.P. Interests were also held by certain officers and employees ofSL Green Realty Corp., including some of whom are among our executive officers,certain of which interests are subject to performance thresholds.

**11.  Related Party Transactions**

In connection with our initial public offering, we entered into amanagement agreement with our Manager, which was subsequently amended andrestated in April 2006.  The amended andrestated agreement provides for a term through December 2009 with automaticone-year extension options and is subject to certain termination rights.  We pay our Manager an annual management feeequal to 1.75% of our gross stockholders equity (as defined in the amended andrestated management agreement) inclusive of our trust preferredsecurities.  We incurred expense to ourManager under this agreement of an aggregate of approximately $2,704 and $7,443for the three and nine months ended September 30, 2006, respectively, andapproximately $1,678 and $4,208 for the three and nine months ended September30, 2005, respectively.

To provide an incentivefor our Manager to enhance the value of our common stock, the holders of theClass B limited partner interests of the Operating Partnership are entitled toan incentive return equal to 25% of the amount by which FFO plus certain accountinggains and losses (as defined in the partnership agreement of the OperatingPartnership which was amended and restated in April 2006) exceed the product ofour weighted average stockholders equity (as defined in the amended andrestated 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 ClassB limited 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.  We incurred approximately $1,822 and $4,592with respect to such Class B limited partner interests for the three and ninemonths ended September 30, 2006, respectively and $1,038 for the three and ninemonths ended September 30, 2005.

We are obligatedto reimburse our Manager for its costs incurred under an asset servicingagreement between our Manager and an affiliate of SL Green OperatingPartnership, L.P. and a separate outsourcing agreement between our Manager andSL Green Operating Partnership, L.P.  Theasset servicing agreement, which was amended and restated in April 2006,provides for an annual fee payable to SL Green Operating Partnership, L.P. byus of 0.05% of the book value of all credit tenant lease assets andnon-investment grade bonds and 0.15% of the book value of all otherassets.  The asset servicing fee may bereduced by SL Green Operating Partnership, L.P. for fees paid directly tooutside servicers by us.  The outsourcingagreement currently provides for a fee payable by us of $1,326 per year,increasing 3% annually over the prior year on the anniversary date of theoutsourcing agreement in August of each year. For the three months ended September 30, 2006 and 2005, we realizedexpense of $328 and $319, respectively, and for the nine months ended September30, 2006 and 2005, we realized expense of $973 and $944, respectively, to ourManager under the outsourcing agreement. For the three months ended September 30, 2006 and 2005, we realizedexpense of $621 and $291, respectively, and for the nine months ended September30, 2006 and 2005, we realized expense of $1,621 and $674, respectively, to ourManager under the asset servicing agreement.

In connection withthe closing of our first CDO in July 2005, the Issuer, Gramercy Real Estate CDO2005-1 Ltd., entered into a collateral management agreement with our Manager.Pursuant to the collateral management agreement, our Manager has agreed toprovide certain advisory and administrative services in relation to thecollateral debt securities and other eligible investments securing the CDOnotes.  The collateral managementagreement provides for a senior collateral management fee, payable quarterly inaccordance with the priority of payments as set forth in the indenture, equalto 0.15% per annum of the net outstanding portfolio balance, and an additionalsubordinate collateral management fee, payable quarterly in accordance with thepriority of payments as set forth in the indenture, equal to 0.25% per annum ofthe net outstanding portfolio balance. Net outstanding portfolio balance is the sum of the (i) aggregateprincipal balance of the collateral debt securities, excluding defaultedsecurities, (ii) aggregate principal balance of all principal proceeds held ascash and eligible investments in certain accounts, and (iii) with respect tothe defaulted securities, the calculation amount of such defaulted securities.As compensation for the performance of its obligations as collateral managerunder the first CDO, our Board of Directors has allocated to our Manager thesubordinate collateral management fee paid on securities not held by us.  The senior collateral management fee and balance of the subordinatecollateral management fee is allocated to us. For the three and nine months ended September 30, 2006 we realizedexpense of $518 and $1,518, respectively, to our Manager under such collateralmanagement agreement.

The amended andrestated management agreement provides that in connection with formations offuture collateralized debt obligations

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or othersecuritization vehicles, if a collateral manager is retained, our Manager or anaffiliate will be the collateral manager and will receive the followingfees:  (i) 0.25% per annum of the book value of the assets owned fortransitional “managed” CDOs, (ii) 0.15% per annum of the book value of theassets owned for non-transitional “managed” CDOs, (iii) 0.10% per annum of thebook value of the assets owned for static CDOs that own primarilynon-investment grade bonds, and (iv) 0.05% per annum of the book value of theassets owned for static CDOs that own primarily investment grade bonds; limitedin each instance by the fees that are paid to the collateral manager. Thebalance of the fees paid by the CDOs for collateral management services arepaid to us.  Collateral manager fees paidon our CDO that closed in August 2006 are governed by the amended and restatedmanagement agreement as a transitional managed CDO. For the three and nine months ended September30, 2006 we realized expense of $238 to our Manager under this agreement.

In connection withthe 5,500,000 shares of common stock that were sold on December 3, 2004 andsettled on December 31, 2004 and January 3, 2005 in a private placement, weagreed to pay our Manager a fee of $1,000 as compensation for financialadvisory, 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% of totalgross proceeds.

**On April 29, 2005, we closed on a$57,503 initial investment in a joint venture with SL Green to acquire, own andoperate the South Building located at One Madison Avenue, New York, New York,or the South Building.  The jointventure, which was created to acquire, own and operate the South Building, isowned 45% by a wholly-owned subsidiary of us and 55% by a wholly-ownedsubsidiary of SL Green.  The jointventure interests are *pari passu*.  Also on April 29, 2005, the joint venturecompleted the acquisition of the South Building 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 the SouthBuilding.  The South Building comprisesapproximately 1.2 million square feet and is almost entirely net leased to CSpursuant to a lease with a 15-year remaining term.**

**On June 7, 2006 we closed on theacquisition of a 49.75% TIC interest in 55 Corporate Drive, located inBridgewater, New Jersey with a 0.25% interest to be acquired in thefuture.  The remaining 50% of theproperty is owned as a TIC interest by an affiliate of SL Green OperatingPartnership, L.P..  The property iscomprised of three buildings totaling approximately six hundred and seventythousand square feet which is 100% net leased to an entity whose obligationsare guaranteed by Sanofi-Aventis Group through April 2023. The transaction wasvalued at $236,000 and was financed with a $190,000, 10-year, fixed-rate firstmortgage loan.**

Commencing May 1, 2005 we are party to a lease agreementwith SLG Graybar Sublease LLC, an affiliate of SL Green, for our corporateoffices at 420 Lexington Avenue, New York, New York.  The lease is for approximately five thousandsquare feet with an option to lease an additional approximately two thousandsquare feet and carries a term of ten years with rents on the entire seventhousand square feet of approximately $249 per annum for year one rising to$315 per annum in year ten.  For thethree and nine months ended September 30, 2006, we paid $63 and $188 under thislease.

**BrightStar Couriers LLC, or Bright Star, provides messenger services to us.  Bright Star is owned by Gary Green, a son ofStephen L. Green, our Chairman.  Theaggregate amount of fees paid by us for such services for the three and ninemonths ended September 30, 2006 was $3 and $6, respectively, and less than $1for the three and nine months ended September 30, 2005.**

**SL GreenOperating Partnership, L.P. is an equity holder in the joint venture that isthe borrower on an investment with a book value of $29,026 as of December 31,2005.**

**On July14, 2005, we closed on the purchase from an SL Green affiliate of a $40,000mezzanine loan which bears interest at 11.20%. As part of that sale, the seller retained an interest-onlyparticipation.  We have determined thatthe yield on our mezzanine loan after giving effect to the interest-onlyparticipation retained by the seller is at market.  The mezzanine loan is secured by the equityinterests in an office property in New York, New York.**

**OnFebruary 27, 2006, we closed on the purchase of a $90,000 whole loan, whichbears interest at three month LIBOR plus 2.15%, to a joint venture in which SLGreen is an equity holder.  The loan issecured by 55 Corporate Drive in Bridgewater, New Jersey.  The loan was repaid in full in June 2006 withthe proceeds from new mortgage financing obtained in connection with the saleof the property, 49.75% of which is now owned by us through a TIC structure.**

**On March17, 2006, we closed on the purchase of a $25,000 mezzanine loan, which bearsinterest at three month LIBOR plus 8.00%, to a joint venture in which SL Greenis an equity holder.  The loan is securedby office and industrial properties in northern New Jersey.  The loan was repaid in full in May 2006.**

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**On May 9,2006 we originated a $90,287 whole loan, which bears interest at three monthLIBOR plus 2.75%, to a joint venture in which SL Green is an equityholder.  The loan is secured by officeand industrial properties in northern New Jersey and has a book value of$89,966 as of September 30, 2006.**

**On August1, 2006 we acquired from a financial institution a 50% pari passu interest in a$65,000 preferred equity investment secured by an office property in New York,New York.  An affiliate of SL Greensimultaneously acquired and owns the other 50% pari passu interest. Theinvestment bears interest at a blended fixed rate of 10.52%.**

**Duringthe nine months ended September 30, 2006, we earned fees of $162,500 from SLGreen representing SL Green’s proportionate share of fees for financing andstructural advisory services related to a specific potential transaction.**

**12.  DeferredCosts**

Deferred costs at September 30, 2006 and December 31, 2005consisted of the following:
|                                | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Deferred  financing            |       | $                            | 33,862     |                        | $          | 20,553 |   |
| Deferred  acquisition          |       | 2,377                        |       | 2,210                       |       |
|                           |       | 36,239                       |       | 22,763                      |       |
| Less accumulated  amortization |       | (7,421                       | )          | (3,381                      | )          |
|                           |       | $                            | 28,818     |                        | $          | 19,382 |   |

Deferred financing costs relate to our existing repurchase facilitieswith Wachovia and Goldman, our unsecured revolving credit facility withKeyBank, our CDOs and the trust preferred securities.  These costs are amortized on a straight-linebasis to interest expense based on the remaining term of the related financing.

Deferred acquisition costs consist of fees and direct costs incurred tooriginate our investments and are amortized using the effective yieldmethod over the related term of the investment.

**13.  Fair Valueof Financial Instruments**

The following discussion of fairvalue was determined by our Manager, using available market information andappropriate valuation methodologies. Considerable judgment is necessary to interpret market data and developestimated fair value.  Accordingly, fairvalues are not necessarily indicative of the amounts we could realize ondisposition of the financial instruments. The use of different market assumptions and/or estimation methodologiesmay have a material effect on estimated fair value amounts.

Cash equivalents, accruedinterest, and accounts payable balances reasonably approximate their fairvalues due to the short maturities of these items.  The carrying value of our CDOs, repurchaseand revolving  credit facilities approximatefair value because they bear interest at floating rates, which we believe, forfacilities with a similar risk profile, reasonably approximate marketrates.  Our junior subordinateddebentures reasonably approximate fair value based upon the amount at whichsimilarly issued instruments would be issued in the current market.  Our fixed rate mortgage payable is carried atits unpaid principal balance, which approximates fair value due to the shortperiod of time the note has been outstanding. Loans and commercial mortgage backed securities are carried at amounts,which reasonably approximate their fair value as determined by our Manager.

The fair value of our fixed-ratedebt investments as determined by our Manager in consultation with marketdealers of such instruments as of September 30, 2006 are as follows:
|                              | ** ** | **Carrying  Value** | ** ** | **Fair Value** | ** ** |
|------------------------------|------------|---------------------|------------|---------------------|------------|
| Fixed-rate debt  investments |       | $                   | 242,077    |                | $          | 242,077 |   |
|                              |            |                     |            |                     |            |  |  |

 

Disclosure about fair value offinancial instruments is based on pertinent information available to us atSeptember 30, 2006.  Although we are notaware of any factors that would significantly affect the reasonable fair valueamounts, such amounts have not been comprehensively revalued for purposes of thesefinancial statements since that date and current estimates of fair value maydiffer significantly from the amounts presented herein.

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**14. Stockholders’ Equity**

**CommonStock**

Our authorized capital stockconsists of 125,000,000 shares, $0.001 par value, of which we have authorizedthe issuance of up to 100,000,000 shares of common stock, $0.001 par value pershare, and 25,000,000 shares of preferred stock, par value $0.001 per share.

As of the date of our formation,April 12, 2004, we had 500,000 shares of common stock outstanding valued at approximately$200.  On August 2, 2004 we completed ourinitial public offering of 12,500,000 shares of common stock resulting in netproceeds of approximately $172,900, which was used to fund investments andcommence our operations.  As of September30, 2006, 350,000 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.

On December 3, 2004, we sold5,500,000 shares of common stock, at a price of $17.27 per share, resulting innet proceeds of approximately $93,740 under a private placement exemption fromthe registration 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 shareswere sold to SL Green Operating Partnership, L.P. pursuant to its contractualright to choose to maintain a 25% ownership interest in the outstanding sharesof our common stock.  Of the 5,500,000shares sold, 2,000,000 shares were settled on December 31, 2004 and theremaining 3,500,000 shares were settled on January 3, 2005.

On September 14, 2005, we sold3,833,333 shares of common stock, at a price of $25.80 per share, resulting innet proceeds of approximately $97,830.  Atotal of 2,875,000 shares were sold through public offering and an additional958,333 shares were sold to SL Green Operating Partnership, L.P. pursuant toits contractual right to choose to maintain a 25% ownership interest in ouroutstanding shares of common stock.  Netproceeds were used for loan acquisitions and originations, repayment ofoutstanding principal under one of our repurchase facilities and generalcorporate purposes.

On May 16, 2006, we sold3,000,000 shares of common stock, at a price of $26.75 per share, resulting innet proceeds of approximately $79,787.  Atotal of 2,250,000 shares were sold through a public offering and an additional750,000 shares were sold to SL Green Operating Partnership, L.P. pursuant toits contractual right to choose to maintain a 25% ownership interest in ouroutstanding shares of common stock. After this offering, SL Green Operating Partnership, L.P. owned6,418,333 shares of our common stock. Net proceeds were used for loan acquisitions and originations, repaymentof outstanding principal under our repurchase facilities and general corporatepurposes.

In August 2005 our $350,000shelf registration statement was declared effective by the Securities andExchange Commission, or SEC.  This registration statement provides us withthe ability to issue common and preferred stock, depository shares andwarrants.  We currently have $170,850 available under the shelf.

As of September 30, 2006,25,834,642 shares of common stock and no shares of preferred stock were issuedand outstanding.

**Equity Incentive Plan**

As part of our initial public offering, we institutedour Equity Incentive Plan.  The EquityIncentive Plan, as amended, authorizes (i) the grant of stock options thatqualify as incentive stock options under Section 422 of the Internal RevenueCode of 1986, as amended, or ISOs, (ii) the grant of stock options that do notqualify, or NQSOs, (iii) the grant of stock options in lieu of cash directors’fees and (iv) grants of shares of restricted and unrestricted common stock.  The exercise price of stock options will bedetermined by the compensation committee, but may not be less than 100% of thefair market value of the shares of common stock on the date of grant.  At September 30, 2006, approximately1,206,799 shares of common stock were available for issuance under the EquityIncentive Plan.

Managementand outsourcing fees paid to our Manager and SL Green Operating Partnership,L.P. are sufficient to reimburse our Manager and SL Green OperatingPartnership, L.P. for the applicable compensation, including payroll taxes, ofthe employees who provide services to Gramercy pursuant to the confirmatoryaddendum to the Management Agreement between Gramercy, our Manager and theOperating Partnership.  These awardeesare considered co-leased employees. Options granted under the Equity Incentive Plan to recipients who areco-leased employees of Gramercy are exercisable at the fair market value on thedate of grant and, subject to termination of employment, expire ten years fromthe date of grant, are not transferable other than on death, and areexercisable in

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threeto four annual installments commencing one year from the date of grant.  In some instances, options may be grantedunder the Equity Incentive Plan to persons who provide significant services tous or our affiliates, but are not considered co-leased employees becausecompensation for their services is not covered by our management agreement oroutsourcing agreement.  Options grantedto recipients that are not co-leased employees have the same terms as thoseissued to co-leased employees except as it relates to any performance-basedprovisions within the grant.  To theextent there are performance provisions associated with a grant to a recipientwho is not a co-leased employee, an estimated expense related to these optionsis recognized over the vesting period and the final expense is reconciled atthe point performance has been met, or the measurement date.  If no performance based provision exists, thefair value of the options is calculated on a quarterly basis and the relatedexpense is recognized over the vesting period.

Asummary of the status of our stock options as of September 30, 2006 andDecember 31, 2005 are presented below:
|                               | ** ** | **September 30, 2006** | ** ** | **December 31, 2005**        | ** ** |
|-------------------------------|------------|----------------------------------|------------|----------------------------------------|------------|
| ** **                    | ** ** | **Options  Outstanding**         | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Balance at  beginning of year |       | 733,584                          |       | $                                      | 16.47      |   | 640,500 |   | $ | 15.05 |   |
| Granted                       |       | 197,500                          |       | $                                      | 23.49      |   | 236,000 |   | $ | 19.62 |   |
| Exercised                     |       | (20,000                          | )          | $                                      | 15.00      |   | (131,249 | ) | $ | 15.01 |   |
| Lapsed or  cancelled          |       | (35,668                          | )          | $                                      | 20.25      |   | (11,667 | ) | $ | 18.20 |   |
| Balance at end of  period     |       | 875,416                          |       | $                                      | 17.94      |   | 733,584 |   | $ | 16.47 |   |

 

All options were granted withina price range of $15.00 to $26.79.  Theremaining weighted average contractual life of the options was 8.3 years.  Compensation expense of $406 will be recordedover the course of the next 18 months, representing the remaining weightedaverage vesting period of the option awards as of September 30, 2006.  Compensation expense of $63 and $210 wasrecorded for the three and nine months ended September 30, 2006, respectively,related to the issuance of stock options, compared to $46 and $105 for thethree and nine months ended September 30, 2005, respectively.

Through September 30, 2006,350,000 restricted shares had been issued under the Equity Incentive Plan, ofwhich 62% have vested.   The unvestedshares are not currently entitled to receive distributions declared by us onour common stock until such time as the shares have vested.  Unvested shares may be entitled to receivedividends at the discretion of the Compensation Committee of our Board ofDirectors.  Holders of restricted sharesare prohibited from selling such shares until they vest but are provided theability to vote such shares beginning on the date of grant.  Compensation expense of $755 will be recordedover the course of the next 12 months, representing the remaining weightedaverage vesting period of the restricted stock awards as of September 30,2006.  Compensation expense of $299 and$951 was recorded for the three and nine months ended September 30, 2006,respectively, related to the issuance of restricted shares, compared to $274and $926 for the three and nine months ended September 30, 2005, respectively.

**Outperformance Plan**

In June 2005, the compensation committee of our board of directorsapproved a long-term incentive compensation program, the 2005 OutperformancePlan.  Participants in the 2005Outperformance Plan, all of whom are co-leased employees, will share in a “performancepool” if our total return to stockholders for the period from June 1, 2005through May 31, 2008 exceeds a cumulative total return to stockholders of 30%during the measurement period over a base share price of $20.21 per share.  The size of the pool will be 10% of theoutperformance amount in excess of the 30% benchmark, subject to a maximumlimit equal to the lesser of 4% of our outstanding shares and units of limitedpartnership interest as of the end of the performance period, or 1,200,000shares.  If our total return tostockholders from June 1, 2005 to any subsequent date exceeds 80% and remainsat that level or higher for 30 consecutive days, then a minimum performance poolwill be established.  In the event thepotential performance pool reaches the maximum dilution cap before May 31, 2008and remains at that level or higher for 30 consecutive days, the performanceperiod will end early and the pool will be formed on the last day of such threemonth period.  Each participant’s awardunder the 2005 Outperformance Plan is designated as a specified percentage ofthe aggregate performance pool to be allocated to such participant assuming the30% benchmark is achieved.  Individualawards under the 2005 Outperformance Plan will be made in the form ofpartnership units, or LTIP Units, that may ultimately become exchangeable forshares of our common stock or cash, at our election.  Under the 2005 Outperformance Plan, LTIPUnits have been granted and additional LTIP Units may be granted in the futureprior to the determination of the performance pool; however, these LTIP Unitswill only vest upon satisfaction of performance and other thresholds, and willnot be entitled to distributions until after the performance pool, or minimumperformance pool, is established.  The2005 Outperformance Plan provides that if a pool is established, eachparticipant will also be entitled to the distributions that would have beenpaid on the number of LTIP Units earned, had they been issued at the beginningof the performance period.  Those

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distributions will be paid in the form of additional LTIP Units.  Once a performance pool has been established,the earned LTIP Units will receive regular quarterly distributions on a perunit basis equal to the dividends per share paid on our common stock, whetheror not they are vested.  Any LTIP Unitsthat are not earned upon the establishment of the performance pool will beautomatically forfeited, and the LTIP Units that are earned will be subject to time-basedvesting, with 50% of the LTIP Units earned vesting in May 2009 and the balancevesting one year later based on continued employment with our Manager or SLGreen.   We will record the expenseof the restricted stock award in accordance with FASB Statement No.123(R).  Compensation expense of $293 and$881 was recorded for the three and nine months ended September 30, 2006,respectively, related to the 2005 Outperformance Plan.

**Deferred Stock Compensation Plan forDirectors**

Under our Independent Director’s Deferral Program, whichcommenced April 2005, our independent directors may elect to defer up to100% of their annual retainer fee, chairman fees and meeting fees.  Unlessotherwise elected by a participant, fees deferred under the program shall becredited in the form of phantom stock units.  The phantom stock units areconvertible into an equal number of shares of common stock upon such directors’termination of service from the Board of Directors or a change in control byus, as defined by the program.  Phantom stock units are credited to eachindependent director quarterly using the closing price of our common stock onthe applicable dividend record date for the respective quarter.  Eachparticipating independent director who elects to receive fees in the form ofphantom stock units has the option to have their account credited for anequivalent amount of phantom stock units based on the dividend rate for eachquarter or have dividends paid in cash.

As of September 30, 2006 there were approximately 13,030phantom stock units outstanding, of which 9,301 units are vested.

**Earnings per Share**

Earnings per share for the threeand nine months ended September 30, 2006 and 2005 is computed as follows:
|                                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **Numerator (Income)**                 | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Basic Earnings:                             |       |                                                 |       |                                                |       |   |   |   |   |
| Net income available to common stockholders |       | $                                                    | 14,536     |                                                | $          | 8,577 |   | $ | 37,907 |   | $ | 20,599 |   |
| Effect of  dilutive securities              |       | —                                               |       | —                                              |       | — |   | — |   |
| Diluted Earnings:                           |       |                                                 |       |                                                |       |   |   |   |   |
| Net income available to common stockholders |       | $                                                    | 14,536     |                                                | $          | 8,577 |   | $ | 37,907 |   | $ | 20,599 |   |
|                                        |       |                                                 |       |                                                |       |   |   |   |   |
| **Denominator  (Weighted Average Shares)**  |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Shares available to common stockholders     |       | 25,832                                               |       | 19,603                                              |       | 24,336 |   | 19,093 |   |
| Effect of Diluted  Securities:              |       |                                                 |       |                                                |       |   |   |   |   |
| Stock-based compensation plans              |       | 1,189                                                |       | 1,184                                               |       | 1,184 |   | 524 |   |
| Phantom stock units                         |       | 13                                                   |       | 1                                                   |       | 13 |   | 1 |   |
| Diluted Shares                              |       | 27,034                                               |       | 20,788                                              |       | 25,533 |   | 19,618 |   |

 

**15. Benefit Plans**

**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.**

**16.**       Commitments and Contingencies

We and our Operating Partnership are not presently involvedin any material litigation nor, to our knowledge, is any material litigationthreatened against us or our investments, other than routine litigation arisingin the ordinary course of business. Management believes the costs, if any, incurred by our OperatingPartnership and us related to litigation will not materially affect ourfinancial position, operating results or liquidity.

Our corporate offices at 420 Lexington Avenue, New York, NewYork are subject to an operating lease agreement with SLG Graybar Sublease LLC,an affiliate of SL Green, effective May 1, 2005.  The lease is for approximately five thousandsquare feet with an option to lease an additional approximately two thousandsquare feet and carries a term of ten years with rents on the entire seventhousand

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square feet of approximately $249 per annum for year onerising to $315 per annum in year ten.

The following is a schedule of future minimum lease paymentsunder our operating lease as of September 30, 2006.
|                               | ** ** | **Operating  Lease** | ** ** |
|-------------------------------|------------|----------------------|------------|
| 2006                          |       | $                    | 64         |   |
| 2007                          |       | 256                  |       |
| 2008                          |       | 261                  |       |
| 2009                          |       | 265                  |       |
| 2010                          |       | 283                  |       |
| Thereafter                    |       | 1,351                |       |
| Total minimum  lease payments |       | $                    | 2,480      |   |

 

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

FASB No. 133, or SFAS 133, “Accounting for DerivativeInstruments and Hedging Activities,” which became effective January 1, 2001,requires Gramercy to recognize all derivatives on the balance sheet at fairvalue.  Derivatives that are not hedgesmust be adjusted 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 fairvalue of our derivative financial instrument at September 30, 2006.  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:
|                     | ** ** | **Benchmark Rate** | ** ** | **Notional  Value** | ** ** | **Strike  Rate** | ** ** | **Effective  Date** | ** ** | **Expiration  Date** | ** ** | **Fair  Value** | ** ** |
|---------------------|------------|-------------------------|------------|---------------------|------------|------------------|------------|---------------------|------------|----------------------|------------|-----------------|------------|
| Interest Rate  Swap |       | 3 month LIBOR           |       | $                   | 40,000     |             | 4.420      | %                   | 7/2005     |                 | 2/2014     |            | $          | 1,325 |   |
| Interest Rate Swap  |       | 1 month LIBOR           |       | 31,686              |       | 3.855            | %          | 7/2005              |       | 11/2009              |       | 979             |       |
| Interest Rate  Swap |       | 1 month LIBOR           |       | 27,500              |       | 5.500            | %          | 8/2006              |       | 9/2016               |       | (989            | )          |
| Interest Rate  Swap |       | 3 month LIBOR           |       | 24,979              |       | 5.445            | %          | 8/2006              |       | 7/2016               |       | (752            | )          |
| Interest Rate  Cap  |       | 3 month LIBOR           |       | 23,713              |       | 5.700            | %          | 11/2005             |       | 12/2007              |       | 5               |       |
| Interest Rate  Cap  |       | 1 month LIBOR           |       | 20,000              |       | 6.000            | %          | 4/2006              |       | 4/2007               |       | —          |       |
| Interest Rate  Cap  |       | 1 month LIBOR           |       | 14,120              |       | 5.500            | %          | 12/2005             |       | 1/2007               |       | —          |       |
| Interest Rate  Swap |       | 3 month LIBOR           |       | 12,000              |       | 9.850            | %          | 8/2006              |       | 8/2011               |       | (108            | )          |
| Basis Swap          |       | 1 month PRIME           |       | 9,363               |       | 722 bps          |       | 8/2006              |       | 12/2007              |       | (1              | )          |
| Interest Rate  Swap |       | 1 month LIBOR           |       | 6,402               |       | 4.760            | %          | 1/2006              |       | 3/2015               |       | 99              |       |
| Interest Rate  Swap |       | 1 month LIBOR           |       | 3,960               |       | 4.959            | %          | 12/2005             |       | 12/2015              |       | 16              |       |
| Interest Rate  Swap |       | 1 month LIBOR           |       | 3,465               |       | 4.280            | %          | 7/2005              |       | 12/2009              |       | 65              |       |
| Interest Rate  Swap |       | 3 month LIBOR           |       | 3,465               |       | 5.178            | %          | 4/2006              |       | 3/2010               |       | (26             | )          |
| Total               |       |                    |       | $                   | 220,653    |             |       |                |       |                 |       |            | $          | 613 |   |

 

At September 30, 2006, thederivative instruments were reported as an asset at their fair value of$613.  Offsetting adjustments are representedas deferred gains or losses in Accumulated Other Comprehensive Income.  During the nine months ended September 30,2005 we reclassified through earnings $2,745 representing the gains and lossespreviously reported in Accumulated Other Comprehensive Income, which werereclassified into earnings at the same time that the forecasted transactionassociated with derivative instrument affected earnings.  Over time, the realized and unrealized gainsand losses held in Accumulated Other Comprehensive Income will be reclassifiedinto earnings in the same periods in which the hedged interest payments affectearnings.

We are hedgingexposure to variability in future interest payments on our debt facilities andcash flows for future transactions except in the case of swaps we may enterinto from time to time, including TROR swaps, which are intended to hedgeproceeds from the sale of fixed rate mortgage loan assets held as available forsale.

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**18.  IncomeTaxes**

We have elected tobe taxed as a REIT, under Sections 856 through 860 of the Internal Revenue Codebeginning with our taxable year ending December 31, 2004.  To qualify as a REIT, we must meet certainorganizational 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 are organized and will 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.

For the three andnine months ended September 30, 2006, we recorded $795 and $1,178 of income taxexpense, respectively, in income from continuing operations for incomeattributable to our wholly-owned taxable REIT subsidiaries as compared to $500and $1,000 recorded in the three and nine months ended September 30, 2005,respectively. We have assumed an effective tax rate for the periods endedSeptember 30, 2006 of 46% taking into consideration the anticipated applicableU.S. federal statutory tax rate at September 30, 2006 of 34% and state andlocal taxes.

**19.  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.**

**20.  Segment Reporting**

**Statementof Financial Accounting Standard No. 131, or “SFAS No. 131,” establishesstandards for the way that public entities report information about operatingsegments in their annual financial statements. We are a REIT focused primarily on originating and acquiring loans andsecurities related to real estate and under the provisions of SFAS No. 131currently operate in only one segment.**

**21. Supplemental Disclosure of Non-Cash Investing and Financing Activities**

Followingthe conversion of the entity that owns 200 Franklin Square Drive into a DST, wesold approximately 75% of our security interests in the DST to a third party,reducing our final ownership interest to 25.0%. We received total cash consideration of $12,800 for these interests andthe buyer assumed 75% of the DST’s underlying mortgage debt.  As a result of the transaction, the propertyis no longer consolidated onto our balance sheet, but instead is accounted foras an equity method investment.

The following table represents non-cashactivities recognized in other comprehensive income:
|                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Deferred gains  on derivative instruments |       | $        | 390        |     | $          | 2,224 |   |
|                                           |            |          |            |          |            |  |  |

 

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**ITEM2:  Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

**Overview**

We are a nationalcommercial real estate specialty finance company that focuses on the directorigination and acquisition of whole loans, subordinate interests in wholeloans, mezzanine loans, preferred equity, and net lease investments involvingcommercial properties throughout the United States. When evaluating transactions,we assess our risk-adjusted return and target transactions with yields thatensure an equitable balance between risks and return.  We conduct substantially all of ouroperations through our operating partnership, GKK Capital LP.  We are externally managed and advised by GKKManager LLC, or the Manager, a majority-owned subsidiary of SL Green RealtyCorp., or SL Green.  We have elected tobe taxed as a REIT under the Internal Revenue Code and generally will not besubject to federal income taxes to the extent we distribute our income to ourstockholders.  However, we may establishTRSs to effect various taxable transactions. Those TRSs would incur federal, state and local taxes on the taxableincome from their activities.  Unless thecontext requires otherwise, all references to “we,” “our” and “us” meanGramercy 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 financing, syndication,and securitization executions to achieve excess returns.  By providing a single source of financing fordevelopers and sponsors, we streamline the lending process, provide greatercertainty for borrowers, and retain the high yield debt instruments that wemanufacture.  By originating, rather thanbuying, whole loans, subordinate interests in whole loans, mezzanine debt andpreferred equity, we strive to deliver superior returns to our stockholders.

Since ourinception, we have completed transactions in a variety of markets and securedby a variety of property types, and the market for commercial real estate debthas continued to demonstrate low rates of default, high relative returns andinflows of capital.  Consequently, themarket for debt instruments has evidenced moderately declining yields and moreflexible credit standards and loan structures. In particular, “conduit” originators who package whole loans for resaleto investors have driven debt yields lower while maintaining substantialliquidity because of the strong demand for the resulting securities.  Because of reduced profits in the most liquidsectors of the mortgage finance business, several large institutions have begunoriginating large bridge loans for the purpose of generating interest income,rather than the typical focus on trading profits.  In this environment we have focused on areaswhere we have comparative advantages rather than competing for product merelyon the basis of yield or structure.  Thishas particularly included whole loan origination in markets and transactionswhere we have an advantage due to (i) knowledge or relationships we have, (ii)knowledge or relationships of our largest stockholder, SL Green, and (iii)where we have an ability to better assess and manage risks over time.  When considering investment opportunities insecondary market transactions in tranched debt, we generally avoid first lossrisk in larger transactions due to the high current valuation of the underlyingreal estate relative to historic valuation levels.  Because of the significant increase in thevalue of institutional quality assets relative to historic norms, we typicallyfocus on positions in which a conventional refinancing at loan maturity wouldprovide for a complete return of our investment.

Because of thehigh relative valuation of debt instruments in the current market and agenerally increasing rate environment, we have carefully managed our exposureto interest rate changes that could affect our liquidity.  We generally match our assets and liabilitiesin terms of base interest rate (generally three month LIBOR) and expectedduration.  We raised $95,000 ofadditional equity in December 2004 and January 2005 to reduce our outstandingindebtedness and maintain sufficient liquidity for our investment portfolio.  We have sold a total of $150,000 of trustpreferred securities in three $50,000 issuances in May and August 2005 andJanuary 2006 through wholly-owned subsidiaries of the Operating Partnershipwith 30 year terms.  The securitiesissued in May bear interest at a fixed rate of 7.57% for the first ten yearsending, the securities issued in August bear interest at a fixed rate of 7.75%for the first ten years and the securities issued in January 2006 bear interestat a fixed rate of 7.65% for the first ten years.  After the first ten years, the 2005 issuancesbear interest at three-month LIBOR plus 300 basis points while the 2006issuance bears interest at three-month LIBOR plus 270 basis points.  The proceeds from the issuances of the trustpreferred securities were used to fund existing and future investment opportunities.   In July 2005 we closed on $1,000,000 of CDOswhich extended the term of our liabilities and reduced our overall cost offunds with respect to debt investments financed by the CDO and previouslyfinanced by our repurchase agreements, to approximately 49 basis points overLIBOR, excluding transaction costs.  Oursecond $1,000,000 CDO was closed in August 2006 at a weighted average interestspread of approximately 37 basis points, excluding transaction costs.  The proceeds of the CDOs were used torefinance our repurchase facilities and to fund additional investmentactivities.  In September 2005 we sold3,833,333 shares of common stock resulting in net proceeds of approximately$97,800 and in May 2006 we sold 3,000,000 shares of common stock resulting innet proceeds of approximately $80,000. The proceeds of these offerings were used to fund loan acquisitions andoriginations, repay outstanding principal amounts under our repurchase facilitiesand for general corporate purposes.  InMay 2006 we also closed on a $100,000 unsecured credit facility with an initialterm of three years and interest spreads between 1.90% and 2.10%.

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As of September 30, 2006, we held loans andother lending investments of $2,064,058 net of fees, discounts, and unfundedcommitments with an average spread to LIBOR of 357 basis points for ourfloating rate investments, and an average yield of 10.27% for our fixed rateinvestments.  As of September 30, 2006,we also held interests in four credit tenant lease, or CTL, investmentscomprised of a 49.75% tenancy-in-common, or TIC, interest in 55 Corporate Drivein Bridgewater, New Jersey,and three joint ventureinvestments.

**The aggregate carrying values, allocated by producttype and weighted average coupons of our loans and other lending investments asof September 30, 2006 and December 31, 2005 were as follows:**
|                                                      | ** ** | **Carrying Value (1)  ($ in thousands)** | ** ** | **Allocation by  Investment Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average Spread over  LIBOR (2)** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                                     | ** ** | **2005**                                     | ** ** | **2006**                                 | ** ** | **2005**                                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Whole loans,  floating rate                          |       | $                                                            | 1,284,562  |                                         | $          | 561,388                                  |       | 62                                                                     | %          | 46 | % | — |   | — |   | 314 bps |   | 325 bps |   |
| Whole loans,  fixed rate                             |       | 80,700                                                       |       | 94,448                                       |       | 4                                        | %          | 8                                                                      | %          | 11.94 | % | 10.67 | % | — |   | — |   |
| Subordinate  interests in whole loans, floating rate |       | 337,813                                                      |       | 362,983                                      |       | 17                                       | %          | 30                                                                     | %          | — |   | — |   | 397 bps |   | 443 bps |   |
| Subordinate  interests in whole loans, fixed rate    |       | 48,513                                                       |       | 37,104                                       |       | 2                                        | %          | 3                                                                      | %          | 8.72 | % | 8.80 | % | — |   | — |   |
| Mezzanine loans,  floating rate                      |       | 187,727                                                      |       | 82,793                                       |       | 9                                        | %          | 7                                                                      | %          | — |   | — |   | 548 bps |   | 858 bps |   |
| Mezzanine loans,  fixed rate                         |       | 68,590                                                       |       | 43,352                                       |       | 3                                        | %          | 4                                                                      | %          | 9.08 | % | 8.51 | % | — |   | — |   |
| Preferred  equity, floating rate                     |       | 11,879                                                       |       | 11,795                                       |       | 1                                        | %          | 1                                                                      | %          | — |   | — |   | 900 bps |   | 900 bps |   |
| Preferred  equity, fixed rate                        |       | 44,274                                                       |       | 11,882                                       |       | 2                                        | %          | 1                                                                      | %          | 10.79 | % | 10.27 | % | — |   | — |   |
| Total / Average                                      |       | $                                                            | 2,064,058  |                                         | $          | 1,205,745                                |       | 100                                                                    | %          | 100 | % | 10.27 | % | 9.78 | % | 357 bps |   | 417 bps |   |

 

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**(1)  Debt investmentsare presented after scheduled amortization payments and prepayments, and arenet of unamortized fees, discounts, asset sales and unfunded commitments.**

**(2)**          Spreads over an indexother than LIBOR have been adjusted to a LIBOR based equivalent.

**Critical Accounting Policies**

## Our discussion and analysis of financial condition and results ofoperations is based on our financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States,known as GAAP. These accounting principles require us to make some complex andsubjective decisions and assessments. Our most critical accounting policies involve decisions and assessments,which could significantly affect our reported assets, liabilities andcontingencies, as well as our reported revenues and expenses.  We believe that all of the decisions andassessments upon which our financial statements are based were reasonable atthe time made based upon information available to us at that time.  We evaluate these decisions and assessments onan ongoing basis.  Actual results maydiffer from these estimates under different assumptions or conditions.  We have identified our most criticalaccounting policies to be the following:

### **Loansand Investments and Loans Held for Sale**

Loans held forinvestment are intended to be held to maturity and, accordingly, are carried atcost, net of unamortized loan origination fees, discounts, repayments, sales ofpartial interests in loans, and unfunded commitments unless such loan orinvestment is deemed to be impaired. Loans held for sale are carried at the lower of cost or market valueusing available market information obtained through consultation with dealersor other originators of such investments. We may originate or acquire preferred equity interests that allow us toparticipate in a percentage of the underlying property’s cash flows fromoperations and proceeds from a sale or refinancing.  Should we make such a preferred equityinvestment, we must determine whether that investment should be accounted foras a loan, joint venture or as an interest in real estate.

Specific valuation allowances are established forimpaired loans based on the fair value of collateral on an individual loanbasis.  The fair value of the collateralis determined by selecting the most appropriate valuation methodology, ormethodologies, among several generally available and accepted  in the commercial real estate industry.  The determination of the most appropriatevaluation methodology is based on the key characteristics of the collateraltype.  These methodologies include theevaluation of operating cash flow from the property during the projectedholding period, and the estimated sales value of the collateral computed byapplying an expected capitalization rate to the stabilized net operating incomeof the specific property, less selling costs, all of which are discounted atmarket discount rates.

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If upon completion of the valuation, the fair value of the underlyingcollateral securing the impaired loan is less than the net carrying value ofthe loan, an allowance is created with a corresponding charge to the provisionfor loan losses.  The allowance for eachloan is maintained at a level we believe is adequate to absorb probablelosses.  We maintained a reserve of$1,460 and $1,030 at September 30, 2006 and December 31, 2005, respectively.

 

Our Managerevaluates our assets on a regular basis to determine if they continue tosatisfy our investment criteria. Subject to certain restrictions, our Managermay cause us to sell our investments opportunistically and use the proceeds ofany such sale for debt reduction, additional acquisitions or working capitalpurposes.

#### **Classificationsof Mortgage-Backed Securities**

Mortgage-backedsecurities, or MBS, are classified as available-for-sale securities.  As a result, changes in fair value will berecorded as a balance sheet adjustment to accumulated other comprehensiveincome, which is a component of stockholders equity, rather than through ourstatement of operations.  Ifavailable-for-sale securities were classified as trading securities, therecould be substantially greater volatility in earnings from period-to-period asthese investments would be marked to market and any reduction in the value ofthe securities versus the previous carrying value would be considered an expenseon our statement of operations. We had no investments as of September 30, 2006that were accounted for as trading securities.

#### **Valuationsof Mortgage-Backed Securities**

All MBS arecarried on the balance sheet at fair value. We determine the fair value of MBS based on the types of securities inwhich we have invested.  For liquid,investment-grade securities, we consult with dealers of such securities toperiodically obtain updated market pricing for the same or similarinstruments.  For non-investment gradesecurities, we actively monitor the performance of the underlying propertiesand loans and update our pricing model to reflect changes in projected cashflows.  The value of the securities isderived by applying discount rates to such cash flows based on current marketyields.  The yields employed are obtainedfrom our own experience in the market, advice from dealers and/or informationobtained in consultation with other investors in similar instruments.  Because fair value estimates may vary to somedegree, we must make certain judgments and assumptions about the appropriateprice to use to calculate the fair values for financial reportingpurposes.  Different judgments andassumptions could result in different presentations of value.

When the fairvalue of an available-for-sale security is less than the amortized cost, weconsider whether there is an other-than-temporary impairment in the value ofthe security (for example, whether the security will be sold prior to therecovery of fair value).  If, in ourjudgment, an other-than-temporary impairment exists, the cost basis of thesecurity is written down to the then-current fair value, and this loss isrealized and charged against earnings. The determination of other-than-temporary impairment is a subjectiveprocess, and different judgments and assumptions could affect the timing ofloss realization.

#### **CreditTenant Lease Investments**

Consolidated CTL investments are recorded at cost lessaccumulated depreciation.  Costs directlyrelated to the 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.

Results of operations of properties acquired are included inthe Statement of Income from the date of acquisition.

In accordance with FASB No. 144, or SFAS 144, “Accountingfor the Impairment of Disposal of Long-Lived Assets,” a property to be disposedof is reported at the lower of its carrying amount or its estimated fair value,less its cost to sell.  Once an asset isheld for sale, depreciation expense and straight-line rent adjustments are nolonger recorded and historic results are reclassified as DiscontinuedOperations.

In accordance with FASB No. 141, or SFAS 141, “BusinessCombinations,” we allocate the purchase price of real estate to land andbuilding and, if determined to be material, intangibles, such as the value ofabove, below and at-market leases and origination costs associated with thein-place leases.  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 associated within-place leases and tenant relationships are amortized over the expected termof 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

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balance of the related intangible will be written off. The tenant improvements and origination costs are amortized as an expense overthe remaining life of the lease (or charged against earnings if the lease isterminated prior to its contractual expiration date).  We assess fairvalue of the leases based on estimated cash flow projections that utilizeappropriate discount and capitalization rates and available market information. Estimates of future cash flows are based on a number of factors including thehistorical operating results, known trends, and market/economic conditions thatmay affect the property.

As of September 30, 2006, we had oneproportionately consolidated CTL investment representing a 49.75% TICinterest in 55 Corporate Drive in Bridgewater, New Jersey.  All income and expenses at this property arebeing capitalized and are not recognized in our results from operations as ofand for the period ended September 30, 2006, as the property is currently beingredeveloped.

**Investments in Unconsolidated Joint Ventures**

#### We account for our investments in unconsolidated joint ventures underthe equity method of accounting since we exercise significant influence, but donot unilaterally control, the entities and are not considered to be the primarybeneficiary under FIN 46.  In the joint ventures, the rights of the otherinvestor are protective and participating. Unless we are determined to be theprimary beneficiary, these rights preclude us from consolidating theinvestments.  The investments are recorded initially at cost as aninvestment in unconsolidated joint ventures, and subsequently are adjusted forequity in net income (loss) and cash contributions and distributions.  Anydifference between the carrying amount of the investments on our balance sheetand the underlying equity in net assets is amortized as an adjustment to equityin net income (loss) of unconsolidated joint ventures over the lesser of thejoint venture term or 40 years.  None of the joint venture debt isrecourse to us.  As of September 30, 2006we had investments of $58,512 in three unconsolidated joint ventures.

#### **RevenueRecognition**

Interest income ondebt investments is recognized over the life of the investment using theeffective 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 using the effective interest method.  Anticipated exit fees, whose collection isexpected, are also recognized over the term of the loan as an adjustment toyield.  Fees on commitments that expireunused are recognized at expiration. Fees received in exchange for the credit enhancement of another lender,either subordinate or senior to us, in the form of a guarantee are recognizedover the term of that guarantee using the straight-line method.

Income recognition is generally suspended for debt investments at theearlier of the date at which payments become 90 days past due or when, in ouropinion, a full recovery of income and principal becomes doubtful.  Income recognition is resumed when the loanbecomes contractually current and performance is demonstrated to be resumed.

In some instances we may sell all or a portion of our investments to athird party.  To the extent the fairvalue received for an investment exceeds the amortized cost of that investmentand FASB Statement No. 140, or SFAS 140, “Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities,” criteria ismet, under which control of the asset that is sold is surrendered making it a “truesale,” a gain on the sale will be recorded through earnings as otherincome.  To the extent an investment thatis sold has a discount or fees, which were deferred at the time the investmentwas made and were being recognized over the term of the investment, theunamortized portion of the discount or fees are recognized at the time of saleand recorded as a gain on the sale of the investment through other income.  We recognized $400 in gains from thesyndication of one fixed rate debt investment during the three months endedSeptember 30, 2006.  For the nine monthsended September 30, 2006 we recognized $1,828 in net gains from the sale ofthree fixed rate debt investments, one fixed rate debt commitment and thesyndication of portions of two floating rate debt investments.

Rental revenue is recognized on astraight-line basis over the term of the lease. The excess of rents recognizedover amounts contractually due pursuant to the underlying leases is included inother assets on the accompanying balance sheets. We may establish, on a currentbasis, an allowance against this account for future potential tenant credit losses,which may occur. The balance reflected on the balance sheet will be net of suchallowance.

In addition to base rent, thetenants in our CTL investments also pay all operating costs of owned propertyincluding real estate taxes.

#### **Reservefor Possible Loan Losses**

The expense for possible loan losses in connection with debt investmentsis the charge to earnings to increase the allowance for possible loan losses tothe level that management estimates to be adequate considering delinquencies,loss experience and collateral quality. Other factors considered relate to geographic trends and projectdiversification, the size of the portfolio and current economicconditions.  Based upon these factors, wemay establish the provision for possible loan losses by individual asset orcategory of asset.

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When it is probable that we will be unable to collect all amountscontractually due, the account is considered impaired.

Where impairment is indicated, a valuation write-down or write-off ismeasured based upon the excess of the recorded investment amount over the netfair value of the collateral, as reduced by selling costs.  Any deficiency between the carrying amount ofan asset and the net sales price of foreclosed collateral is charged tothe allowance for loan losses.  Wemaintained a reserve for possible loan losses of $1,460 against investmentswith a carrying value of $82,336 as of September 30, 2006, and a reserve forpossible loan losses of $1,030 against investments with a carrying value of$68,293 as of December 31, 2005, respectively.

**StockBased Compensation Plans**

We have a stock-based compensation plan, described more fully in Note14 to our Consolidated Financial Statements. We account for this plan using the fair value recognition provisions ofFASB Statement 123(R), “Share-Based Payment, a revision of FASB Statement No.123, Accounting for Stock-Based Compensation.”

The Black-Scholes option-pricing model was developed for use inestimating the fair value of traded options, which have no vesting restrictionsand are fully transferable.  In addition,option valuation models require the input of highly subjective assumptionsincluding the expected stock price volatility. Because our plan has characteristics significantly different from those oftraded 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 ourstock options.

Compensationcost for stock options, if any, is recognized ratably over the vesting periodof the award.  Our policy is to grantoptions with an exercise price equal to the quoted closing market price of ourstock on the business day preceding the grant date.  Awards of stock or restricted stock areexpensed as compensation on a current basis over the benefit period.

The fair value of each stockoption granted is estimated on the date of grant for awards to co-leasedemployees, and quarterly for options issued to non-employees, using theBlack-Scholes option pricing model with the following weighted averageassumptions for grants in 2006 and 2005.
|                                  | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|----------------------------------|------------|-----------|------------|-----------|------------|
| Dividend yield                   |       | 8.1       | %          | 8.4       | %          |
| Expected life of  option         |       | 6.7 years |       | 6.9 years |       |
| Risk-free  interest rate         |       | 4.12      | %          | 4.16      | %          |
| Expected stock price  volatility |       | 21.0      | %          | 19.1      | %          |

 

**IncentiveDistribution (Class B Limited Partner Interest)**

The Class Blimited partner interests are entitled to receive an incentive return equal to25% of the amount by which funds from operations, or FFO, (as defined in thepartnership agreement of the Operating Partnership which was amended andrestated in April 2006) plus certain accounting gains exceed the product of ourweighted average stockholders equity (as defined in the amended and restatedpartnership 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 partnerinterests as an incentive distribution expense in the period when earned andwhen payment of such amounts has become probable and reasonably estimable inaccordance with the partnership agreement. These cash distributions will reduce the amount of cash available fordistribution to our common unitholders in our Operating Partnership and tocommon stockholders.  We incurredapproximately $1,822 and $4,592 with respect to such Class B limited partnerinterests for the three and nine months ended September 30, 2006, respectively,and $1,038 for the three and nine months ended September 30, 2005.

**DerivativeInstruments**

**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 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 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**

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**approximationof value, and such value may never actually be realized.**

In the normalcourse of business, we are exposed to the effect of interest rate changes andlimit these risks by following established risk management policies andprocedures including the use of derivatives.  To address exposure to interest rates, we usederivatives primarily to hedge the mark-to-market risk of our liabilities withrespect to certain of our assets.  We mayalso use derivatives to hedge variability in sales proceeds to be received uponthe sale of loans held for sale.

We use a varietyof commonly used derivative products that are considered plain vanilladerivatives.  These derivatives typicallyinclude interest rate swaps, caps, collars and floors.  We also use total rate of return swaps, or TRORswaps, which are tied to the Lehman Brothers CMBS index. We expressly prohibitthe 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, “Accountingfor Derivative Instruments and Hedging Activities,” as amended by FASB No. 149,requires us to recognize all derivatives on the balance sheet at fairvalue.  Derivatives that are not hedgesmust be adjusted to fair value through income. If a derivative is a hedge, depending on the nature of the hedge, changesin the fair value of the derivative will either be offset against the change infair value of the hedged asset, liability, or firm commitment through earnings,or recognized in other comprehensive income until the hedged item is recognizedin earnings.  The ineffective portion ofa derivative’s change in fair value will be immediately recognized inearnings.  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 employswaps, forwards or purchased options to hedge qualifying forecastedtransactions.  Gains and losses relatedto these transactions are deferred and recognized in net income as interestexpense or other income in the same period or periods that the underlyingtransaction occurs, expires or is otherwise terminated.

All hedges held byus are deemed to be effective in meeting the hedging objectives established byour corporate policy governing interest rate risk management.  The effect of our derivative instruments onour financial statements is discussed more fully in Note 17 to our ConsolidatedFinancial Statements.

# **Income Taxes**

We elected to betaxed as a REIT, under Sections 856 through 860 of the Internal Revenue Code,beginning with our taxable year ending December 31, 2004.  To qualify as a REIT, we must meet certainorganizational and operational requirements, including a requirement to distributeat 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 our stockholders.  If we fail to qualify as a REIT in anytaxable year, we will then be subject to federal income taxes on our taxableincome at regular corporate rates and we will not be permitted to qualify fortreatment as a REIT for federal income tax purposes for four years followingthe year during which qualification is lost unless the Internal Revenue Servicegrants us relief under certain statutory provisions.  Such an event could materially adverselyaffect our net income and net cash available for distributions to stockholders.  However, we believe that we will be organizedand operate in such a manner as to qualify for treatment as a REIT and weintend to operate in the foreseeable future in such a manner so that we willqualify as a REIT for federal income tax purposes.  We may, however, be subject to certain stateand local taxes.

**Our TRSs are subject to federal,state and local taxes.**

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**Resultsof Operations (Amounts in thousands)**

### ***Comparison of thethree months ended September 30, 2006 to the three months ended September 30,2005***

***Revenues***
|                                                      | ** ** | **2006** | ** ** | **2005** | ** ** | **$ Change** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|-------------------|------------|
| Investment  income                                   |       | $        | 45,299     |     | $          | 21,060            |       | $ | 24,239 |   |
| Rental revenue,  net                                 |       | —   |       | 314      |       | (314              | )          |
| Gain on sales  and other income                      |       | 5,156    |       | 5,218    |       | (62               | )          |
| Total revenues                                       |       | $        | 50,455     |     | $          | 26,592            |       | $ | 23,863 |   |
|                                                 |       |     |       |     |       |              |       |
| Equity in net loss of  unconsolidated joint ventures |       | $        | (734       | )        | $          | (510              | )          | $ | (224 | ) |

 

Investment incomeis generated on our whole and bridge loans, subordinate interests in wholeloans, mezzanine loans, preferred equity interests and CMBS investments.  For the three months ended September 30,2006, $6,282 was earned on fixed rate investments while the remaining $39,017was earned on floating rate investments. The increase over the prior year is due primarily to a significantlyhigher number of investments in 2006 versus 2005.

**Rental revenue of $314 in 2005was earned on 200 Franklin Square Drive, which was acquired in September2005.  This amount includes the effect ofadjustments for straight-line rent and FASB 141 adjustments for below marketleases.  We did not hold any operating,consolidated real estate investments during the same period in 2006 as we nowaccount for our investment in 200 Franklin Square Drive as an investment injoint venture following the sale of 75% of the security interests in the entitythat owns the property.**

Other income of $5,156for the three months ended September 30, 2006 is comprised primarily of $2,412in gains recorded on the sale of loans and securities.  The remaining increase over the prior year isprimarily attributable to $2,100 in interest earned on restricted cash balancesin our two CDOs (only one of which was in place in the same period in 2005) andother cash balances held by us.  For thethree months ended September 30, 2005, other income of $5,218 was comprisedprimarily of income recorded on the sale of loans of $3,184, interest onrestricted cash balances in our first CDO of $1,212, and a one-time break-up fee paid by a potential borrower of$604.

**The loss on investments inunconsolidated joint ventures of $734 for the three months ended September 30,2006 represents our proportionate share of the losses generated by our jointventure interests including $1,948 of real estate-related depreciation andamortization, which when added back to our proportionate share of the losses,results in a contribution to FFO of $1,214. The loss on investments in unconsolidated joint ventures of $510 for thethree months ended September 30, 2005 was generated on only our investment inOne Madison Avenue in New York, New York. Our use of FFO as an important financial measure is discussed in moredetail below.**

***Expenses***
|                                        | ** ** | **2006** | ** ** | **2005** | ** ** | **$ Change** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|-------------------|------------|
| Interest expense                       |       | $        | 25,782     |     | $          | 11,250            |       | $ | 14,532 |   |
| Management fees                        |       | 4,409    |       | 2,726    |       | 1,683             |       |
| Incentive fee                          |       | 1,822    |       | 1,038    |       | 784               |       |
| Depreciation and  amortization         |       | 278      |       | 105      |       | 173               |       |
| Marketing,  general and administrative |       | 2,169    |       | 1,456    |       | 713               |       |
| Provision for  loan loss/(recovery)    |       | (70      | )          | 430      |       | (500              | )          |
| Provision for  taxes                   |       | 795      |       | 500      |       | 295               |       |
| Total expenses                         |       | $        | 35,185     |     | $          | 17,505            |       | $ | 17,680 |   |

 

Interest expensewas $25,782 for the three months ended September 30, 2006 compared to $11,250for the three months ended September 30, 2005. Interest expense for the three months ended September 30, 2006 consistedprimarily of $17,642 of interest on the investment grade tranches of our twoCDOs (only one of which was in place during the same period in 2005), $4,279 ofinterest on borrowings on our master repurchase facilities with Wachovia andGoldman, and $2,871 of expense accrued against our three $50,000 issuances oftrust preferred securities.  The $11,250of interest expense during the same period in 2005 was comprised primarily of$7,659 of interest on the investment grade tranches of our first CDO, $1,824 ofinterest on borrowings on our master repurchase facilities with Wachovia andGoldman, and $1,527 of interest expense accrued against only two $50,000issuances of trust preferred securities.

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Management feesincreased $1,683 for the three months ended September 30, 2006 to $4,409 versus$2,726 for the same period in 2005 due primarily to an increase in ourstockholder’s equity as a result of additional issuances of common equity andthe issuance of an additional $50,000 of trust preferred securities in 2006, onwhich base management fees are calculated. The remaining increase is comprised of $756 paid or payable to ourManager on investments in our two CDOs (only one of which was in place duringthe same period in 2005) in accordance with the CDO collateral managementagreements in lieu of the 0.15% fee otherwise payable to SL Green Operating Partnership,L.P. on those investments under the asset servicing agreement, higher fees paidor payable to SL Green Operating Partnership, L.P. under our outsourcing andservicing agreements due to the increase in our investment balances and thescheduled 3% annual increase in the fee payable under our outsourcingagreement.

We recorded anincentive fee expense of $1,822 during the three months ended September 30,2006 in accordance with requirements of the partnership agreement of theOperating Partnership which entitles owners of Class B limited partnerinterests in the Operating Partnership to an incentive return equal to 25% ofthe amount by which FFO (as defined in the partnership agreement of theOperating Partnership) plus certain accounting gains exceed the product of ourweighted average stockholders equity (as defined in the partnership agreementof the Operating Partnership) multiplied by 9.5% (divided by 4 to adjust forquarterly calculations).  This threshold wasexceeded by a lesser amount during the same period in 2005 resulting in a lowerrecorded expense.

The increase inmarketing, general and administrative expenses of $713 for the three monthsended September 30, 2006 versus the same period in 2005 was due primarily tohigher professional fees, stock-based compensation, insurance and generaloverhead costs.

### ***Comparison of thenine months ended September 30, 2006 to the nine months ended September 30,2005***

***Revenues***
|                                                      | ** ** | **2006** | ** ** | **2005** | ** ** | **$ Change** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|-------------------|------------|
| Investment  income                                   |       | $        | 116,313    |     | $          | 46,999            |       | $ | 69,314 |   |
| Rental revenue,  net                                 |       | 914      |       | 314      |       | 600               |       |
| Gain on sales  and other income                      |       | 13,724   |       | 8,727    |       | 4,997             |       |
| Total revenues                                       |       | $        | 130,951    |     | $          | 56,040            |       | $ | 74,911 |   |
|                                                 |       |     |       |     |       |              |       |
| Equity in net loss of  unconsolidated joint ventures |       | $        | (2,090     | )        | $          | (914              | )          | $ | (1,176 | ) |

 

Investment incomeis generated on our whole and bridge loans, subordinate interests in wholeloans, mezzanine loans, preferred equity interests and CMBS investments.  For the nine months ended September 30, 2006,$16,782 was earned on fixed rate investments while the remaining $99,531 wasearned on floating rate investments.  Theincrease over the prior year is due primarily to a significantly higher numberof investments in 2006 versus 2005.

**Rental revenue of $914 in 2006and $314 in 2005 was earned on 200 Franklin Square Drive, which was acquired inSeptember 2005.  This amount includes theeffect of adjustments for straight-line rent and FASB 141 adjustments forbelow-market leases.**

Other income of$13,724 for the nine months ended September 30, 2006 is comprised primarily ofgains recorded on the sale of loans and securities of $3,840, and the gain onthe sale of 75% of the security interests in the entity that owns 200 FranklinSquare Drive of $4,530.  The remaining increaseover the prior year is primarily attributable to interest on restricted cashbalances in our two CDOs (only one of which was in place in the same period of2005) and other cash balances held by us. For the nine months ended September30, 2005, other income of $8,727 was comprised primarily of income recorded onthe sale of loans of $6,565, interest on restricted cash balances in our firstCDO of approximately $1,212 and a one-time break-up fee paid by a potentialborrower of $604.

**The loss on investments inunconsolidated joint ventures of $2,090 for the nine months ended September 30,2006 represents our proportionate share of the losses generated by our jointventure interests including $5,805 of real estate-related depreciation andamortization, which when added back, results in a contribution to FFO of$3,715.  The loss on investments inunconsolidated joint venture of $914 for the nine months ended September 30,2005 was generated on only our investment in One Madison Avenue in New York,New York.  Our use of FFO as an importantfinancial measure is discussed in more detail below.**

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***Expenses***
|                                        | ** ** | **2006** | ** ** | **2005** | ** ** | **$ Change** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|-------------------|------------|
| Interest expense                       |       | $        | 64,280     |     | $          | 20,316            |       | $ | 43,964 |   |
| Management fees                        |       | 11,793   |       | 6,264    |       | 5,529             |       |
| Incentive fee                          |       | 4,592    |       | 1,038    |       | 3,554             |       |
| Depreciation and  amortization         |       | 962      |       | 232      |       | 730               |       |
| Marketing,  general and administrative |       | 7,719    |       | 4,722    |       | 2,997             |       |
| Provision for  loan loss               |       | 430      |       | 955      |       | (525              | )          |
| Provision for  taxes                   |       | 1,178    |       | 1,000    |       | 178               |       |
| Total expenses                         |       | $        | 90,954     |     | $          | 34,527            |       | $ | 56,427 |   |

 

Interest expensewas $64,280 for the nine months ended September 30, 2006 compared to $20,316for the nine months ended September 30, 2005. Interest expense for the nine months ended September 30, 2006 consistedprimarily of $38,964 of interest on the investment grade tranches of our twoCDOs (only one of which was in place during the same period in 2005), $13,586of interest on borrowings on our master repurchase facilities with Wachovia andGoldman, $8,303 of expense accrued against our three $50,000 issuances of trustpreferred securities, and the amortization of deferred financing costs relatedto our CDOs, repurchase facilities and unsecured facility.  The $20,316 of interest expense during thesame period in 2005 was comprised primarily of $7,659 of interest on theinvestment grade tranches of our first CDO, $10,480 of interest on borrowingson our master repurchase facilities with Wachovia and Goldman and $1,937 ofinterest expense accrued against only two $50,000 issuances of trust preferredsecurities.

Management feesincreased $5,529 for the nine months ended September 30, 2006 to $11,793 versus$6,264 for the same period in 2005 due primarily to an increase in ourstockholder’s equity as a result of additional issuances of common equity andthe issuance of $150,000 of trust preferred securities, on which basemanagement fees are calculated.  Theremaining increase is comprised of $1,756 paid or payable to our Manager oninvestments in our two CDOs (only one of which was in place during the sameperiod in 2005) in accordance with the CDO collateral management agreements inlieu of the 0.15% fee otherwise payable to SL Green Operating Partnership, L.P.on those investments under the asset servicing agreement, higher fees paid orpayable to SL Green Operating Partnership, L.P. under our outsourcing andservicing agreements due to the increase in our investment balances and thescheduled 3% annual increase in the fee payable under our outsourcingagreement.

We recorded anincentive fee expense of $4,592 during the nine months ended September 30, 2006in accordance with requirements of the partnership agreement of the OperatingPartnership which entitles owners of Class B limited partner interests in theOperating Partnership to an incentive return equal to 25% of the amount bywhich FFO (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).  This threshold wasreached for the first time during the three months ended September 30, 2005resulting in a lower total expense for 2005.

The increase inmarketing, general and administrative expenses to $7,719 for the nine monthsended September 30, 2006 versus the same period in 2005 was due primarily tohigher stock-based compensation, professional fees, insurance and generaloverhead costs and a nonrecurring charge of $525 for third-party professionalexpenses in connection with a possible business combination involving theacquisition of a publicly-traded commercial real estate finance company withbusiness lines considered by management to be highly complementary toours.  The decision to expense thesecosts was made once management concluded the proposed transaction was unlikelyto occur on terms advantageous to us.

## **Liquidityand Capital Resources**

**Liquidity is a measurement of theability to meet cash requirements, including ongoing commitments to repay borrowings,fund and maintain loans and investments, pay dividends and other generalbusiness needs.  Our principal sources ofworking capital and funds for additional investments primarily include: 1) cashflow from operations; 2) borrowings under our repurchase and credit facilities;3) our CDOs; 4) other forms of financing or additional securitizationsincluding CMBS or subsequent CDO offerings; 5) proceeds from common orpreferred equity offerings, 6) issuances of trust preferred securities and, toa lesser extent, 7) the proceeds from principal payments on our investments,and 8) the sale or syndication of certain of our debt investments.  We believe these sources of financing will besufficient to meet our short-term liquidity needs.**

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**Our ability to fund ourshort-term liquidity needs, including distributions to stockholders, throughcash flow from operations can be evaluated via the consolidated statement ofcash flows provided in our financial statements.  However, the net cash from operations or netcash used in operations disclosed on the statement of cash flows should beadjusted to exclude the effect of loans originated for sale and the proceeds ofloans sold during any respective reporting period.  These activities are included in cash flowfrom operations in accordance with GAAP, but constitute an integral part of ourinvestment activity.  Consequently, netcash flow from operations is not necessarily reflective of our true recurringoperating activities on a quarterly basis and our ability to fund our requireddistributions to stockholders through our operating activities.**

Our ability tomeet our long-term liquidity and capital resource requirements will be subjectto obtaining additional debt financing and equity capital.  Our inability to renew, replace or expand oursources of financing on substantially similar terms, may have an adverse effecton our business and results of operations. In addition, an event of default can be triggered under our repurchase facilitiesand our unsecured revolving credit facility if, among other things, themanagement agreement with our Manager is terminated.  Depending on market conditions, our debtfinancing will generally be in the range of 70% to 80% of the carrying value ofour total assets.  Any indebtedness weincur will likely be subject to continuing covenants and we will likely berequired to make continuing representations and warranties in connection withsuch debt.  Our debt financing terms mayrequire us to keep uninvested cash on hand, or to maintain a certain portion ofour assets free of liens, each of which could serve to limit our borrowingability.  Moreover, our debt may besecured by our assets.  If we default inthe payment of interest or principal on any such debt, breach anyrepresentation or warranty in connection with any borrowing or violate anycovenant in any loan document, our lender may accelerate the maturity of suchdebt requiring us to immediately repay all outstanding principal.  If we are unable to make such payment, ourlender could foreclose on our assets that are pledged as collateral to suchlender.  The lender could also sue us orforce us into bankruptcy.  Any such eventwould have a material adverse effect on our liquidity and the value of ourcommon stock.  In addition, postingadditional collateral to support our credit and repurchase facilities willreduce our liquidity and limit our ability to leverage our assets.

**To maintain our status as a REITunder the Internal Revenue Code, we must distribute annually at least 90% ofour taxable income.  These distributionrequirements limit our ability to retain earnings and thereby replenish orincrease capital for operations. However, we believe that our significant capital resources and access tofinancing, as noted above, will provide us with financial flexibility at levelssufficient to meet current and anticipated capital requirements, includingfunding new lending and investment opportunities.**

## **Cash Flows(Amounts in thousands)**

Net cash fromoperating activities increased $80,186 to $115,487 for the nine months endedSeptember 30, 2006 compared to cash provided of $35,301 for the nine monthsended September 30, 2005.  Operating cash flow was generated primarily byinterest income on our whole and bridge loans, subordinate interests in wholeloans, mezzanine loans and preferred equity interests and gains on loansales.  Increased cash flow from a largernumber of investments in 2006 versus 2005 and $102,392 of proceeds from thesales of loans was offset primarily by a $62,213 use of cash related to theorigination and subsequent sale of an investment during the nine months endedSeptember 30, 2006 whereas we did not originate any loans that were held forsale during the nine months ended September 30, 2005.

Net cash used in investing activities increased $369,656 to$1,008,956 for the nine months ended September 30, 2006 compared to $639,300used during the nine months ended September 30, 2005.  The primary reasonfor the additional use of cash is related to increased debt investmentoriginations of $592,721, offset by higher principal collections on our debtinvestments of $228,723.

Net cash provided by financing activities increased $272,519to $862,735 for the nine months ended September 30, 2006 compared to $590,216provided during the same period in 2005.  This increase was due primarilyto the issuance of $903,750 of collateralized debt obligations during the ninemonths ended September 30, 2006 versus only $810,500 during the same period in2005, net proceeds from consolidated mortgages payable of $94,525 and increasednet proceeds from our repurchase facilities of $180,257, offset by lowerproceeds from the sale of common stock during the nine months ended September30, 2006 versus the same period in 2005 of $76,347 and an increase in thedividend paid to our common stockholders.

**Capitalization**

Our authorized capital stockconsists of 125,000,000 shares, $0.001 par value, of which we have authorizedthe issuance of up to 100,000,000 shares of common stock, $0.001 par value pershare, and 25,000,000 shares of preferred stock, par value $0.001 per share.

As of the date of our formation,April 12, 2004, we had 500,000 shares of common stock outstanding valued atapproximately $200.  On August 2, 2004 wecompleted our initial public offering of 12,500,000 shares of common stockresulting in net proceeds of approximately $172.9 million, which was used tofund investments and commence our operations. As of September 30,

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2006, 350,000 restricted shareshad also been issued under our 2004 Equity Incentive Plan, or the EquityIncentive Plan.  These shares have avesting period of three to four years and are not entitled to receive distributionsdeclared by us on our common stock until such time as the shares have vested,or the shares have been designated to receive dividends by the CompensationCommittee of our Board of Directors.

On December 3, 2004, we sold5,500,000 shares of common stock resulting in net proceeds of approximately$93.7 million under a private placement exemption from the registrationrequirements of Section 5 of the Securities Act of 1933, as amended.  A total of 4,225,000 shares were sold to variousinstitutional investors and an additional 1,275,000 shares were sold to SLGreen Operating Partnership, L.P. pursuant to its contractual right to chooseto maintain a 25% ownership interest in the outstanding shares of our commonstock.  Of the 5,500,000 shares sold,2,000,000 shares were settled on December 31, 2004 and the remaining 3,500,000shares were settled on January 3, 2005.

On September 14, 2005, we sold3,833,333 shares of common stock, at a price of $25.80 per share, resulting innet proceeds of approximately $97.8 million. A total of 2,875,000 shares were sold through public offering and anadditional 958,333 shares were sold to SL Green Operating Partnership, L.P.pursuant to its contractual right to choose to maintain a 25% ownershipinterest in our outstanding shares of common stock.  Net proceeds were used for loan acquisitionsand originations, repayment of outstanding principal under one of ourrepurchase facilities and general corporate purposes.

On May 16, 2006, we sold3,000,000 shares of common stock, at a price of $26.75 per share, resulting innet proceeds of approximately $80.0 million. A total of 2,250,000 shares were sold through public offering and anadditional 750,000 shares were sold to SL Green Operating Partnership, L.P.pursuant to its contractual right to choose to maintain a 25% ownershipinterest in our outstanding shares of common stock.  After this offering, SL Green OperatingPartnership, L.P. owned 6,418,333 shares of our common stock.  Net proceeds were used for loan acquisitionsand originations, repayment of outstanding principal under our repurchasefacilities and general corporate purposes.

In August 2005 our $350 millionshelf registration statement was declared effective by the Securities andExchange Commission, or SEC.  This registration statement provides us withthe ability to issue common and preferred stock, depository shares andwarrants.  We currently have $170.9 million available under the shelf.

On May 10, 2006, we entered into a sales agreement with CantorFitzgerald & Co., as sales agent, to offer and sell up to 1,000,000 sharesof our common stock from time to time through the sales agent. On May 10, 2006,we also entered into a separate sales agreement with Merrill Lynch & Co.,Merrill Lynch, Pierce, Fenner & Smith Incorporated, as sales agent, tooffer and sell up to 1,000,000 shares of our common stock from time to timethrough the sales agent. To date we have not issued any shares under eitheragreement.

As of September 30, 2006,25,834,642 shares of common stock and no shares of preferred stock were issuedand outstanding.

**Outperformance Plan (Amounts in thousands except pershare data)**

In June 2005, the compensation committee of our board of directorsapproved a long-term incentive compensation program, the 2005 Outperformance Plan.  Participants in the 2005 Outperformance Plan,all of whom are co-leased employees, will share in a “performance pool” if ourtotal return to stockholders for the period from June 1, 2005 through May 31,2008 exceeds a cumulative total return to stockholders of 30% during themeasurement period over a base share price of $20.21 per share.  The size of the pool will be 10% of theoutperformance amount in excess of the 30% benchmark, subject to a maximumlimit equal to the lesser of 4% of our outstanding shares and units of limitedpartnership interest as of the end of the performance period, or 1,200,000shares.  If our total return tostockholders from June 1, 2005 to any subsequent date exceeds 80% and remainsat that level or higher for 30 consecutive days, then a minimum performancepool will be established.  In the eventthe potential performance pool reaches the maximum dilution cap before May 31,2008 and remains at that level or higher for 30 consecutive days, theperformance period will end early and the pool will be formed on the last dayof such 30-day period.  Each participant’saward under the 2005 Outperformance Plan is designated as a specifiedpercentage of the aggregate performance pool to be allocated to suchparticipant assuming the 30% benchmark is achieved.  Individual awards under the 2005Outperformance Plan will be made in the form of partnership units, or LTIPUnits, that may ultimately become exchangeable for shares of our common stockor cash, at our election.  Under the 2005Outperformance Plan, LTIP Units have been granted and additional LTIP Units maybe granted in the future prior to the determination of the performance pool;however, these LTIP Units will only vest upon satisfaction of performance andother thresholds, and will not be entitled to distributions until after theperformance pool, or minimum performance pool, is established.  The 2005 Outperformance Plan provides that ifa pool is established, each participant will also be entitled to thedistributions that would have been paid on the number of LTIP Units earned, hadthey been issued at the beginning of the performance period.  Those distributions will be paid in the formof additional LTIP Units.  Once aperformance pool has been established, the earned LTIP Units will receiveregular quarterly distributions on a per unit basis equal to the dividends pershare paid on our common stock, whether or not they are vested.  Any LTIP Units that are not earned upon theestablishment of the performance pool will be automatically forfeited, and theLTIP Units that are earned will be subject to time-based vesting, with 50% ofthe LTIP Units earned vesting in May 2009 and the balance vesting one yearlater based on continued employment with our Manager or SL Green.   We will record the expense of the restrictedstock award in accordance with FASB Statement No. 123(R). Compensation expenseof

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$293 and $881 was recorded for the three and nine months endedSeptember 30, 2006, respectively, related to the 2005 Outperformance Plan.

**Deferred Stock Compensation Plan forDirectors**

Under our Independent Director’s Deferral Program, whichcommenced April 2005, our independent directors may elect to defer up to100% of their annual retainer fee, chairman fees and meeting fees.  Unlessotherwise elected by a participant, fees deferred under the program shall becredited in the form of phantom stock units.  The phantom stock units areconvertible into an equal number of shares of common stock upon such directors’termination of service from the Board of Directors or a change in control byus, as defined by the program.  Phantom stock units are credited to eachindependent director quarterly using the closing price of our common stock onthe applicable dividend record date for the respective quarter.  Eachparticipating independent director who elects to receive fees in the form ofphantom stock units has the option to have their account credited for anequivalent amount of phantom stock units based on the dividend rate for eachquarter or have dividends paid in cash.

As of September30, 2006 there were approximately 13,030 phantom stock units outstanding, ofwhich 9,301 units are vested.

**MarketCapitalization**

At September 30,2006, our CDOs and borrowings under our repurchase facilities, unsecuredrevolving credit facility and mortgage loans (excluding our share of jointventure debt of $343.6 million) represented 74% of our consolidated marketcapitalization of $2.5 billion (based on a common stock price of $25.21 pershare, the closing price of our common stock on the New York Stock Exchange onSeptember 30, 2006).  Marketcapitalization includes our consolidated debt and common stock.

**Indebtedness**

**The table below summarizesborrowings under our Wachovia and Goldman repurchase facilities and any consolidatedmortgage debt or term loans at September 30, 2006 and 2005, respectively(amounts in thousands).**
| Debt Summary:                           | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Balance:**                                 |       |                         |       |                        |       |
| Fixed rate                                   |       | $                            | 94,525     | (1)                         | $          | 41,000 |   |
| Variable rate                                |       | 58,739                       |       | 117,366                     |       |
| Total                                        |       | $                            | 153,264    |                        | $          | 158,366 |   |
|                                         |       |                         |       |                        |       |
| **Effective  interest rate for the period:** |       |                         |       |                        |       |
| Fixed rate                                   |       | 5.75                         | %          | 4.90                        | %          |
| Variable rate                                |       | LIBOR+1.35                   | %          | LIBOR+1.59                  | %          |

 

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**(1) Wehave a 49.75% interest in the entity that is the obligor under the mortgage note.**

**RepurchaseFacilities**

We have tworepurchase facilities with an aggregate of $900,000 of total debtcapacity.  In August 2004 we closed on a$250,000 repurchase facility with Wachovia. This facility was then increased to $350,000 on January 3, 2005 andsubsequently increased to $500,000 on April 22, 2005.  On March 21, 2006 we further modified thefacility by reducing the interest spreads. As a result of the modifications, the $500,000 facility bears interestat spreads of 1.00% to 2.50% over three month LIBOR and, based on our expectedinvestment activities, provides for advance rates that vary from 60% to 100%based upon the collateral provided under a borrowing base calculation.  On October 13, 2006 we extended the facility’smaturity date until October 2009.  Thelender has a consent right with respect to the inclusion of investments in thisfacility, determines periodically the market value of the investments, and hasthe right to require additional collateral if the estimated market value of theincluded investments declines. We had no accrued interest and borrowings of$58,739 at a weighted average spread to LIBOR of 1.35%, and $67,717 at aweighted average spread to LIBOR of 1.50%, under this facility at September 30,2006 and December 31, 2005, respectively.

On January 3,2005, we closed an additional repurchase facility with Goldman.  On October 13, 2006 we increased thisfacility from $200,000 to $400,000 and extended its maturity date untilSeptember 2009.  On March 21, 2006 wemodified this facility by reducing the interest spreads.  As a result of the modifications, thefacility bears interest at spreads of 1.00% to 2.25% over three month LIBORand, based on our expected investment activities, provides for advance ratesthat vary from 40% to 85% based upon the collateral

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provided under aborrowing base calculation.  As with theWachovia repurchase facility, the lender has a consent right to the inclusionof investments in this facility, determines periodically the market value ofthe investments, and has the right to require additional collateral if theestimated market value of the included investments declines.  We had no accrued interest and no outstandingborrowings as of September 30, 2006, and accrued interest of $163 and borrowingsof $49,649 at a weighted average spread to LIBOR of 1.71% under this facilityat December 31, 2005.

The repurchasefacilities require that we pay down borrowings under these facilities asprincipal payments on the loans and investments pledged to these facilities arereceived.  Assets pledged as collateral under thesefacilities may include stabilized and transitional whole loans, subordinateinterests in whole loans, mezzanine loans, and rated CMBS or commercial realestate CDO securities originated or acquired by us.

In certaincircumstances, we have purchased debt investments from a counterparty andsubsequently financed the acquisition of those debt investments throughrepurchase agreements with the same counterparty.  We currently record the acquisition of thedebt investments as assets and the related repurchase agreements as financingliabilities gross on the consolidated balance sheets. Interest income earned onthe debt investments and interest expense incurred on the repurchaseobligations are reported gross on the consolidated income statements.  However, under a certain technicalinterpretation of FAS 140, such transactions may not qualify as a purchase byus.  We believe, and it is industrypractice, that we are accounting for these transactions in an appropriatemanner.  However, the result of thistechnical interpretation would prevent us from presenting the debt investmentsand repurchase agreements and the related interest income and interest expenseon a gross basis on our financial statements. Instead, we would present the net investment in these transactions withthe counterparty and a derivative with the corresponding change in fair valueof the derivative being recorded through earnings.  The value of the derivative would reflectchanges in the value of the underlying debt investments and changes in thevalue of the underlying credit provided by the counterparty.

**RestrictiveCovenants**

The terms of ourrepurchase facilities (together with any related guarantees) include covenantsthat****(a) limit our maximum totalindebtedness to no more than 85% of total assets under the Wachovia facility ora debt to equity ratio less than or equal to 5:1 under the Goldman facility,(b) require us to maintain minimum liquidity of at least $10,000 for the firsttwo years and $15,000 thereafter under the Goldman facility, and at least$15,000 under the Wachovia facility, (c) require our fixed charge coverageratio to be at no time less than 1.50 to 1.00, (d) require our minimum interestcoverage ratio to be at no time less than 1.75 to 1.00 under the Wachoviafacility, (e) require us to maintain minimum tangible net worth of not lessthan (i) $129,750, plus (ii) 75% of the net proceeds of our subsequent equityissuances following our initial public offering under the Goldman facility andnot less than (i) $400,000, plus (ii) 75% of the net proceeds of our subsequentequity issuances following the date of the October 2006 amendment under theWachovia facility and (f) restrict the maximum amount of our totalindebtedness.  The covenants alsorestrict us from making distributions in excess of a maximum of 100% of our FFO(as defined therein) under the Wachovia facility, except that we may in anycase pay distributions necessary to maintain our REIT status.  Anevent of default can be triggered if, among other things, GKK Manager LLC isterminated as our Manager.  As ofSeptember 30, 2006 and December 31, 2005, we were in compliance with all suchcovenants.

**UnsecuredRevolving Credit Facility**

In May 2006 weclosed on a $100,000 senior unsecured revolving credit facility with KeyBankwith an initial term of three years and a one-year extension option.  The facility is supported by a negativepledge of an identified asset base with advance rates that vary from 30% to 90%of the asset value provided under a borrowing base calculation.  The lender also has consent rights to theinclusion of assets in the borrowing base calculation.  The facility bears interest at 1.90% overthree month LIBOR to the extent our leverage ratio, defined as totalliabilities to total assets, including our proportionate share of theliabilities and assets of our unconsolidated subsidiaries, is less than 80% and2.10% over three month LIBOR to the extent out leverage ratio is equal to orgreater than 80%. We had no outstanding borrowings against this facility as ofSeptember 30, 2006.

The terms of theunsecured revolving credit facility include covenants that****(a) limit our maximum total indebtednessto no more than 85% of total assets, (b) require our fixed charge coverageratio to be at no time less than 1.50, (c) require our minimum interestcoverage ratio to be at no time less than 1.70, (d) require us to maintainminimum tangible net worth of not less than $370,000 plus 75% of the netproceeds from equity offerings completed after the closing of the facility and(e) restrict the maximum amount of our total indebtedness.  The covenants also restrict us from makingdistributions in excess of a maximum of 100% of our FFO (as defined by theNational Association of Real Estate Investment Trusts, or NAREIT), except thatwe may in any case pay distributions necessary to maintain our REIT status.  An event of default can be triggered on ourunsecured revolving credit facility if, among other things, GKK Manager LLC isterminated as our Manager. As ofSeptember 30, 2006, we were in compliance with all such covenants.

In conjunctionwith the closing of the unsecured revolving credit facility with KeyBank, our$25,000 revolving credit facility with

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Wachovia wasterminated.

#### **MortgageLoan**

We have oneconsolidated interest-only mortgage loan in an amount equal to our ownershippercentage in the entity multiplied by the outstanding principal balance of themortgage loan, which loan financed the acquisition of 55 Corporate Drive inJune 2006.  The mortgage has anoutstanding principal balance of $190,000, of which we have consolidated 49.75%or $94,525, with an effective interest rate of 5.75% and a term of tenyears.  Interest on this mortgage isbeing capitalized as of September 30, 3006 as the property is beingredeveloped.  Capitalized interest was$1,766 for the three and nine months ended September 30, 2006.

#### **Collateralized Debt Obligations**

During 2005 we issuedapproximately $1,000,000 of CDOs through two indirect subsidiaries, GramercyReal Estate CDO 2005-1 Ltd., or the 2005 Issuer, and Gramercy Real EstateCDO 2005-1 LLC, or the 2005 Co-Issuer. The CDO consists of $810,500 ofinvestment grade notes, $84,500 of non-investment grade notes, which wereco-issued by the 2005 Issuer and the 2005 Co-Issuer, and $105,000 of preferredshares, which were issued by the 2005 Issuer. The investment grade notes were issued with floating rate coupons with acombined weighted average rate of three-month LIBOR plus 0.49%.  We incurred approximately $11,957 of costsrelated to Gramercy Real Estate CDO 2005-1, which are amortized on a level-yieldbasis over the average life of the CDO.

On August 24, 2006 weissued an additional approximately $1,000,000 of CDOs through two newly-formedindirect subsidiaries, Gramercy Real Estate CDO 2006-1 Ltd., or the 2006Issuer, and Gramercy Real Estate CDO 2006-1 LLC, or the 2006 Co-Issuer. The CDOconsists of $903,750 of investment grade notes, $38,750 of non-investment gradenotes, which were co-issued by the 2006 Issuer and the 2006 Co-Issuer, and$57,500 of preferred shares, which were issued by the 2006 Issuer.  The investment grade notes were issued withfloating rate coupons with a combined weighted average rate of three-monthLIBOR plus 0.37%. We incurred approximately $11,356 of costs related toGramercy Real Estate CDO 2006-1, which are amortized on a level- yield basisover the average life of the CDO.

We retained allnon-investment grade securities, the preferred shares and the common shares inthe Issuer of each CDO.  The Issuer ineach CDO holds assets, consisting primarily of whole loans, subordinateinterests in whole loans, mezzanine loans and preferred equity investments,which serve as collateral for the CDO. Each CDO may be replenished, pursuant to certain rating agencyguidelines relating to credit quality and diversification, with substitutecollateral for loans that are repaid during the first five years of the CDO.Thereafter, the CDO securities will be retired in sequential order fromsenior-most to junior-most as loans are repaid. The financial statements of the Issuer of each CDO are consolidated inour financial statements. The investment grade notes are treated as a securedfinancing, and are non-recourse to us. Proceeds from the sale of the investmentgrade notes issued in each CDO were used to repay substantially all outstandingdebt under our repurchase agreements and to fund additional investments.

**JuniorSubordinated Debentures**

**On January 27, 2006, we completeda third issuance of $50,000 in unsecured trust preferred securities through aseparate newly formed DST, Gramercy Capital Trust III, or GCTIII, that is awholly-owned subsidiary of the Operating Partnership.  The securities bear interest at a fixed rateof 7.65% for the first ten years ending January 2016, with an effective rate of7.43% when giving effect to the swap arrangement previously entered into incontemplation of this financing. Thereafter the rate will float based on the three-month LIBOR plus 270basis points.**

**In May and August 2005, wecompleted issuances of $50,000 each in unsecured trust preferred securitiesthrough two DST’s, Gramercy Capital Trust I, or GCTI, and Gramercy CapitalTrust II, or GCTII, that are also wholly-owned subsidiaries of the OperatingPartnership.  The securities issued inMay 2005 bear interest at a fixed rate of 7.57% for the first ten years endingJune 2015 and the securities issued in August 2005 bear interest at a fixedrate of 7.75% for the first ten years ending October 2015.  Thereafter the rates will float based on thethree-month LIBOR plus 300 basis points.**

**All issuances of trust preferredsecurities require quarterly interest distributions; however, payments may bedeferred while the interest expense is accrued for a period of up to fourconsecutive quarters if the Operating Partnership exercises its right to defersuch payments.  The trust preferredsecurities are redeemable, at the option of the Operating Partnership, in wholeor in part, with no prepayment premium any time after June 30, 2010, October30, 2010 or January 30, 2011 for the securities issued by GCTI, GCTII andGCTIII, respectively.**

**GCTI, GCTII and GCTIII eachissued $1,550 aggregate liquidation amount of common securities, representing100% of the voting common stock of those entities to the Operating Partnershipfor a total purchase price of $4,650. GCTI, GCTII and GCTIII used the proceeds from the sale of the trustpreferred securities and the common securities to purchase the OperatingPartnership’s junior subordinated notes. The terms of the junior subordinated notes match the terms of the trustpreferred securities.  The notes aresubordinate and junior in right of payment to all present and future seniorindebtedness and certain other of our financial obligations.  We realized net**

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**proceeds from each offering ofapproximately $48,956.**

Our interests in GCTI, GCTII and GCTIII areaccounted for using the equity method and the assets and liabilities of thoseentities are not consolidated into our financial statements.  Interest on the junior subordinated notes isincluded in interest expense on our consolidated income statements while thevalue of the junior subordinated notes, net of our investment in the truststhat issued the securities, are presented as a separate item in ourconsolidated balance sheet.

**ContractualObligations**

Combined aggregate principal maturities of our CDOs, repurchasefacilities, trust preferred securities, revolving credit facility and ourobligations under our management agreement, outsourcing agreement, CDOcollateral management agreement and operating lease as of September 30, 2006are as follows (amounts in thousands):

 
| ** ** | ** ** | **CDOs**  | ** ** | **Repurchase  Facilities** | ** ** | **Trust  Preferred  Securities** | ** ** | **Mortgage  Note  Payable(2)** | ** ** | **Revolving  Credit  Facility** | ** ** | **Outsourcing  and  Management  Agreements (1)** | ** ** | **CDO  Collateral  Management  Agreements** | ** ** | **Operating  Lease** | ** ** | **Total** | ** ** |
|------------|------------|-----------|------------|----------------------------|------------|----------------------------------|------------|--------------------------------|------------|---------------------------------|------------|-------------------------------------------------------|------------|---------------------------------------------|------------|----------------------|------------|-----------|------------|
| 2006       |       | $         | —     |                       | $          | —                           |       | $                              | —     |                            | $          | —                                                |       | $                                           | —     |                 | $          | 3,035     |       | $ | 1,071 |   | $ | 64 |   | $ | 4,170 |   |
| 2007       |       | —    |       | —                     |       | —                           |       | —                         |       | —                          |       | 12,070                                                |       | 4,286                                       |       | 256                  |       | 16,612    |       |
| 2008       |       | —    |       | —                     |       | —                           |       | —                         |       | —                          |       | 12,111                                                |       | 4,286                                       |       | 261                  |       | 16,658    |       |
| 2009       |       | —    |       | 58,739                     |       | —                           |       | —                         |       | —                          |       | 12,152                                                |       | 4,286                                       |       | 265                  |       | 75,442    |       |
| 2010       |       | —    |       | —                     |       |                             |       | —                         |       | —                          |       | —                                                |       | 3,351                                       |       | 283                  |       | 3,634     |       |
| Thereafter |       | 1,714,250 |       | —                     |       | 150,000                          |       | 94,525                         |       | —                          |       | —                                                |       | 1,469                                       |       | 1,351                |       | 1,961,595 |       |
| Total      |       | $         | 1,714,250  |                       | $          | 58,739                           |       | $                              | 150,000    |                            | $          | 94,525                                                |       | —                                      |       | $                    | 39,368     |      | $          | 18,749 |   | $ | 2,480 |   | $ | 2,078,111 |   |
|            |            |           |            |                            |            |                                  |            |                                |            |                                 |            |                                                       |            |                                             |            |                      |            |           |            |  |  |  |  |  |  |  |  |  |

 

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(1)          Managementfee is calculated as 1.75% of our gross stockholders equity (as defined in the amendedand restated management agreement) on September 30, 2006, inclusive of thetrust preferred securities issued on May 20, 2005, August 9, 2005 and January27, 2006.

(2)          We have a49.75% interest in the entity that holds the mortgage.

**Off-Balance-Sheet Arrangements**

We have severaloff-balance-sheet investments, including joint ventures and structured financeinvestments.  These investments all have varying ownershipstructures.  Substantially all of our joint venture arrangements areaccounted for under the equity method of accounting as we have the ability toexercise significant influence, but not control over the operating andfinancial decisions of these joint venture arrangements.  Ouroff-balance-sheet arrangements are discussed in Note 4, “Investments inUnconsolidated Joint Ventures” in the accompanying financial statements.

**Dividends**

To maintain our qualification as a REIT, we must pay annual dividendsto our stockholders of at least 90% of our REIT taxable income, determinedbefore taking into consideration the dividends paid deduction and net capitalgains.  We intend to continue to payregular quarterly dividends to our stockholders.  Before we pay any dividend, whether forFederal income tax purposes or otherwise, which would only be paid out ofavailable cash to the extent permitted under our unsecured and secured creditand repurchase facilities, and our term loans, we must first meet both ouroperating requirements and scheduled debt service on our mortgages and loanspayable.

**RelatedParty Transactions (Amounts in thousands)**

In connection with our initial public offering, we entered into amanagement agreement with our Manager, which was subsequently amended andrestated in April 2006.  The amended andrestated agreement provides for a term through December 2009 with automaticone-year extension options and is subject to certain termination rights.  We pay our Manager an annual management feeequal to 1.75% of our gross stockholders equity (as defined in the amended andrestated management agreement) inclusive of our trust preferredsecurities.  We incurred expense to ourManager under this agreement of an aggregate of approximately $2,704 and $7,443for the three and nine months ended September 30, 2006, respectively, andapproximately $1,678 and $4,208 for the three and nine months ended September30, 2005, respectively.

To provide an incentivefor our Manager to enhance the value of our common stock, the holders of theClass B limited partner interests of the Operating Partnership are entitled toan incentive return equal to 25% of the amount by which FFO plus certainaccounting gains and losses (as defined in the partnership agreement of theOperating Partnership which was amended and restated in April 2006) exceed the productof our weighted average stockholders equity (as defined in the amended andrestated partnership 

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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 payments of suchamounts have become probable and reasonably estimable in accordance with thepartnership agreement.  We incurredapproximately $1,822 and $4,592 with respect to such Class B limited partnerinterests for the three and nine months ended September 30, 2006, respectivelyand $1,038 for the three and nine months ended September 30, 2005.

We are obligatedto reimburse our Manager for its costs incurred under an asset servicingagreement between our Manager and an affiliate of SL Green OperatingPartnership, L.P. and a separate outsourcing agreement between our Manager andSL Green Operating Partnership, L.P.  Theasset servicing agreement, which was amended and restated in April 2006,provides for an annual fee payable to SL Green Operating Partnership, L.P. byus of 0.05% of the book value of all credit tenant lease assets andnon-investment grade bonds and 0.15% of the book value of all otherassets.  The asset servicing fee may bereduced by SL Green Operating Partnership, L.P. for fees paid directly to outsideservicers by us.  The outsourcing agreementcurrently provides for a fee payable by us of $1,326 per year, increasing 3%annually over the prior year on the anniversary date of the outsourcingagreement in August of each year.  Forthe three months ended September 30, 2006 and 2005, we realized expense of $328and $319, respectively, and for the nine months ended September 30, 2006 and2005, we realized expense of $973 and $944, respectively, to our Manager underthe outsourcing agreement.  For the threemonths ended September 30, 2006 and 2005, we realized expense of $621 and $291,respectively, and for the nine months ended September 30, 2006 and 2005, werealized expense of $1,621 and $674, respectively, to our Manager under theasset servicing agreement.

In connection withthe closing of our first CDO in July 2005, the Issuer, Gramercy Real Estate CDO2005-1 Ltd., entered into a collateral management agreement with our Manager.Pursuant to the collateral management agreement, our Manager has agreed toprovide certain advisory and administrative services in relation to thecollateral debt securities and other eligible investments securing the CDOnotes.  The collateral managementagreement provides for a senior collateral management fee, payable quarterly inaccordance with the priority of payments as set forth in the indenture, equalto 0.15% per annum of the net outstanding portfolio balance, and an additionalsubordinate collateral management fee, payable quarterly in accordance with thepriority of payments as set forth in the indenture, equal to 0.25% per annum ofthe net outstanding portfolio balance. Net outstanding portfolio balance is the sum of the (i) aggregateprincipal balance of the collateral debt securities, excluding defaultedsecurities, (ii) aggregate principal balance of all principal proceeds held ascash and eligible investments in certain accounts, and (iii) with respect tothe defaulted securities, the calculation amount of such defaulted securities.As compensation for the performance of its obligations as collateral managerunder the first CDO, our Board of Directors has allocated to our Manager thesubordinate collateral management fee paid on securities not held by us.  The senior collateral management fee and balance of the subordinatecollateral management fee is allocated to us. For the three and nine months ended September 30, 2006 we realizedexpense of $518 and $1,518, respectively, to our Manager under such collateralmanagement agreement.

The amended andrestated management agreement provides that in connection with formations offuture collateralized debt obligations or other securitization vehicles, if acollateral manager is retained, our Manager or an affiliate will be thecollateral manager and will receive the following fees:  (i) 0.25% perannum of the book value of the assets owned for transitional “managed” CDOs,(ii) 0.15% per annum of the book value of the assets owned fornon-transitional “managed” CDOs, (iii) 0.10% per annum of the book value of theassets owned for static CDOs that own primarily non-investment grade bonds, and(iv) 0.05% per annum of the book value of the assets owned for static CDOs thatown primarily investment grade bonds; limited in each instance by the fees thatare paid to the collateral manager. The balance of the fees paid by the CDOsfor collateral management services are paid to us.  Collateral manager fees paid on our CDO thatclosed in August 2006 are governed by the amended and restated managementagreement as a transitional managed CDO. For the three and nine months ended September 30, 2006 we realizedexpense of $238 to our Manager under this agreement.

In connection withthe 5,500,000 shares of common stock that were sold on December 3, 2004 andsettled on December 31, 2004 and January 3, 2005 in a private placement, weagreed to pay our Manager a fee of $1,000 as compensation for financialadvisory, 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 initial investment in a joint venture with SL Green to acquire, own andoperate the South Building located at One Madison Avenue, New York, New York,or the South Building.  The jointventure, which was created to acquire, own and operate the South Building, isowned 45% by a wholly-owned subsidiary of us and 55% by a wholly-ownedsubsidiary of SL Green.  The jointventure interests are *pari passu*.  Also on April 29, 2005, the joint venturecompleted the acquisition of the South Building from Metropolitan LifeInsurance Company for the purchase price of approximately $802,800 plus**

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**closing costs, financed in partthrough a $690,000 first mortgage loan on the South Building.  The South Building comprises approximately1.2 million square feet and is almost entirely net leased to CS pursuant to alease with a 15-year remaining term.**

**On June 7, 2006 we closed on theacquisition of a 49.75% TIC interest in 55 Corporate Drive, located inBridgewater, New Jersey with a 0.25% interest to be acquired in the future.  The remaining 50% of the property is owned asa TIC interest by an affiliate of SL Green Operating Partnership, L.P..  The property is comprised of three buildingstotaling approximately six hundred and seventy thousand square feet which is100% net leased to an entity whose obligations are guaranteed by Sanofi-AventisGroup through April 2023. The transaction was valued at $236,000 and wasfinanced with a $190,000, 10-year, fixed-rate first mortgage loan.**

Commencing May 1, 2005 we are party to a lease agreementwith SLG Graybar Sublease LLC, an affiliate of SL Green, for our corporateoffices at 420 Lexington Avenue, New York, New York.  The lease is for approximately five thousandsquare feet with an option to lease an additional approximately two thousandsquare feet and carries a term of ten years with rents on the entire seventhousand square feet of approximately $249 per annum for year one rising to$315 per annum in year ten.  For thethree and nine months ended September 30, 2006, we paid $63 and $188 under thislease.

**BrightStar Couriers LLC, or Bright Star, provides messenger services to us.  Bright Star is owned by Gary Green, a son ofStephen L. Green, our Chairman.  Theaggregate amount of fees paid by us for such services for the three and ninemonths ended September 30, 2006 was $3 and $6, respectively, and less than $1for the three and nine months ended September 30, 2005.**

**SL GreenOperating Partnership, L.P. is an equity holder in the joint venture that isthe borrower on an investment with a book value of $29,026 as of December 31,2005.**

**On July14, 2005, we closed on the purchase from an SL Green affiliate of a $40,000mezzanine loan which bears interest at 11.20%. As part of that sale, the seller retained an interest-onlyparticipation.  We have determined thatthe yield on our mezzanine loan after giving effect to the interest-onlyparticipation retained by the seller is at market.  The mezzanine loan is secured by the equityinterests in an office property in New York, New York.**

**On February27, 2006, we closed on the purchase of a $90,000 whole loan, which bearsinterest at three month LIBOR plus 2.15%, to a joint venture in which SL Greenis an equity holder.  The loan is securedby 55 Corporate Drive in Bridgewater, New Jersey.  The loan was repaid in full in June 2006 withthe proceeds from new mortgage financing obtained in connection with the saleof the property, 49.75% of which is now owned by us through a TIC structure.**

**On March17, 2006, we closed on the purchase of a $25,000 mezzanine loan, which bearsinterest at three month LIBOR plus 8.00%, to a joint venture in which SL Greenis an equity holder.  The loan is securedby office and industrial properties in northern New Jersey.  The loan was repaid in full in May 2006.**

**On May 9,2006 we originated a $90,287 whole loan, which bears interest at three monthLIBOR plus 2.75%, to a joint venture in which SL Green is an equityholder.  The loan is secured by officeand industrial properties in northern New Jersey and has a book value of$89,966 as of September 30, 2006.**

**On August1, 2006 we acquired from a financial institution a 50% pari passu interest in a$65,000 preferred equity investment secured by an office property in New York,New York.  An affiliate of SL Greensimultaneously acquired and owns the other 50% pari passu interest.  The investment bears interest at a blendedfixed rate of 10.52%.**

**Duringthe nine months ended September 30, 2006, we earned fees of $162,500 from SLGreen representing SL Green’s proportionate share of fees for financing andstructural advisory services related to a specific potential transaction.**

**Fundsfrom Operations**

We present FFObecause we consider it an important supplemental measure of our operatingperformance and believe that it is frequently used by securities analysts,investors and other interested parties in the evaluation of REITS.  We also use FFO for the calculation of theincentive fee payable to the holders of Class B limited partner interests inthe Operating Partnership and as one of several criteria to determineperformance-based incentive compensation for members of our senior management,which may be payable in cash or equity awards. The revised White Paper on FFO approved by the Board of Governors of theNational Association of Real Estate Investment Trusts, or NAREIT, in April 2002defines FFO as net income (loss) (computed in accordance with GAAP), excludinggains (or losses) from debt restructuring, which are not a recurring part ofour business, and sales of properties, plus real

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estate-relateddepreciation and amortization and after adjustments for unconsolidatedpartnerships and joint ventures.  We consider gains and losses on the sales ofdebt investments and real estate investments structured as tenancy-in-commoninvestments to be a normal part of our recurring operations and thereforeinclude such gains and losses when arriving at FFO.  FFO does not represent cash generatedfrom operating activities in accordance with GAAP and should not be consideredas an alternative to net income (determined in accordance with GAAP), as anindication of our financial performance, or to cash flow from operatingactivities (determined in accordance with GAAP) as a measure of our liquidity,nor is it entirely indicative of funds available to fund our cash needs,including our ability to make cash distributions.  Our calculation of FFO may be different fromthe calculation used by other companies and, therefore, comparability may belimited.

FFOfor the three and nine months ended September 30, 2006 and 2005 are as follows(amounts in thousands):
|                                                  | ** ** | **For the Three  Months Ended  September 30,  2006** | ** ** | **For the Three  Months Ended  September 30,  2005** | ** ** | **For the Nine  Months Ended  September 30,  2006** | ** ** | **For the Nine  Months Ended  September 30,  2005** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Net income  available to common stockholders     |       | $                                                                        | 14,536     |                                                                     | $          | 8,577                                                                   |       | $                                                                       | 37,907     |   | $ | 20,599 |   |
| Add:                                             |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Depreciation and amortization                    |       | 1,375                                                                    |       | 1,012                                                                    |       | 4,119                                                                   |       | 1,966                                                                   |       |
| FFO adjustment for unconsolidated joint ventures |       | 1,948                                                                    |       | 1,784                                                                    |       | 5,806                                                                   |       | 2,984                                                                   |       |
| Less:                                            |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Non real estate depreciation and amortization    |       | (1,375                                                                   | )          | (926                                                                     | )          | (3,880                                                                  | )          | (1,880                                                                  | )          |
| Funds from  operations                           |       | $                                                                        | 16,484     |                                                                     | $          | 10,447                                                                  |       | $                                                                       | 43,952     |   | $ | 23,669 |   |
|                                             |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Funds from  operations per share - basic         |       | $                                                                        | 0.64       |                                                                     | $          | 0.53                                                                    |       | $                                                                       | 1.81       |   | $ | 1.24 |   |
| Funds from operations  per share - diluted       |       | $                                                                        | 0.61       |                                                                     | $          | 0.50                                                                    |       | $                                                                       | 1.72       |   | $ | 1.21 |   |

 

**CautionaryNote Regarding Forward-Looking Information**

Thisreport contains “forward-looking statements” within the meaning of Section 27Aof the Securities Act of 1933, as amended, or the Act, and Section 21E of theSecurities Exchange Act of 1934, as amended, or the Exchange Act.  You can identify forward-looking statementsby the use of forward-looking expressions such as “may,” “will,” “should,” “expect,”“anticipate,” “estimate,” “believe,” “intend,” “plan,” “project,” “continue,”or any negative or other variations on such expressions.  Forward-looking statements includeinformation 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;

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

·                  competition withother companies;

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·                  our ability tosatisfy complex rules in order for us to qualify as a REIT for federal incometax purposes and qualify for our exemption under the Investment Company Act,our operating partnership’s ability to satisfy the rules in order for it toqualify as a partnership for federal income tax purposes, the ability ofcertain of our subsidiaries to qualify as REITs, and the ability of certain ofour subsidiaries to qualify as taxable REIT subsidiaries for federal income taxpurposes, and our ability and the ability of our subsidiaries to operateeffectively 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.

Weundertake no obligation to publicly update or revise any forward-lookingstatements, whether as a result of future events, new information or otherwise.

The risks included here are not exhaustive.  Other sections of this report may includeadditional factors that could adversely affect our business and financialperformance.  Moreover, we operate in avery competitive and rapidly changing environment.  New risk factors emerge from time to time andit is not possible for management to predict all such risk factors, nor can itassess the impact of all such risk factors on our business or the extent towhich any factor, or combination of factors, may cause actual results to differmaterially from those contained in any forward-looking statements.  Given these risks and uncertainties,investors should not place undue reliance on forward-looking statements as aprediction of actual results.

**RecentlyIssued Accounting Pronouncements**

**Statement of Financial AccountingStandard No. 123(R), or SFAS No. 123(R) “Share-Based Payment, a revision ofFASB Statement No. 123, Accounting for Stock-Based Compensation,” requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair value.  Thenew standard is effective for interim or annual reporting periods beginningafter January 1, 2006.  Theimplementation of SFAS No. 123(R) did not have a material effect on ourfinancial position or results of operations for the three and nine months endedSeptember 30, 2006.**

**In June 2005, the FASB ratifiedthe consensus in EITF Issue No. 04-5, or Issue 04-5, Determining Whether aGeneral Partner, or the General Partners as a Group, Controls a LimitedPartnership or Similar Entity When the Limited Partners Have Certain Rights,which provides guidance in determining whether a general partner controls alimited partnership.  Issue 04-5 states that the general partner in alimited partnership is presumed to control that limited partnership.  Thepresumption may be overcome if the limited partners have either (1) thesubstantive ability to dissolve the limited partnership or otherwise remove thegeneral partner without cause or (2) substantive participating rights, whichprovide the limited partners with the ability to effectively participate insignificant decisions that would be expected to be made in the ordinary courseof the limited partnership’s business and thereby preclude the general partnerfrom exercising unilateral control over the partnership.  If the criteriain Issue 04-5 are met, a company could be required to consolidate certain ofits existing unconsolidated joint ventures.  Our adoption of Issue 04-5for new or modified limited partnership arrangements effective June 30, 2005and existing limited partnership arrangements effective January 1, 2006 did nothave a material effect on our financial position or results of operations forthe three and nine months ended September 30, 2006.**

In February 2006, the FASB issued Statement ofFinancial Accounting Standard No. 155, or SFAS No. 155, “Accounting for CertainHybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140”.SFAS No. 155 (1) permits fair value re-measurement for any hybrid financial instrumentthat contains an embedded derivative that would otherwise require bifurcation,(2) clarifies which interest-only strips and principal-only strips are notsubject to the requirements of FASB Statement No. 133, (3) establishes arequirement to evaluate interests in securitized financial assets to identifyinterests that are freestanding derivatives or that are hybrid financialinstruments that contain an imbedded derivative requiring bifurcation, (4)clarifies that concentrations of credit risk in the form of subordination arenot embedded derivatives, and (5) amends FASB Statement No. 140 to eliminatethe prohibition on a qualifying special-purpose entity from holding aderivative financial instrument that pertains to a beneficial interest in otherthan another derivative financial instrument. SFAS No. 155 is effective January1, 2007 and we are currently evaluating the effect, if any, that thispronouncement will have on our future financial results.

In July 2006, the FASBissued Interpretation No. 48, or FIN 48, “Accounting for Uncertainty inIncome Taxes”. This interpretation,among other things, creates a two-step approach for evaluating uncertain taxpositions. Recognition (step one) occurs when an enterprise concludes that atax position, based solely on its technical merits, is more-likely-than-not tobe sustained upon examination. Measurement (step two) determines the amount ofbenefit that more-likely-than-not will be realized upon settlement.Derecognition of a tax position that was previously recognized would occur whena company subsequently determines that a tax position no longer meets themore-likely-than-not threshold of being sustained. FIN 48 specificallyprohibits the use of a valuation allowance as a substitute for derecognition oftax positions, and it has expanded disclosure requirements.  FIN 48 is effective for fiscal years

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beginning after December15, 2006, in which the impact of adoption should be accounted for as acumulative-effect adjustment to the beginning balance of retained earnings. Weare currently evaluating the effect, if any, that this pronouncement will haveon our future financial results.

**In September 2006, the FASBissued Statement No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No.157 provides guidance for using fair value to measure assets and liabilities.This statement clarifies the principle that fair value should be based on theassumptions that market participants would use when pricing the asset orliability. SFAS No. 157 establishes a fair value hierarchy, giving the highestpriority to quoted prices in active markets and the lowest priority tounobservable data. SFAS No. 157 applies whenever other standards require assetsor liabilities to be measured at fair value. This statement is effective infiscal years beginning after November 15, 2007. We believe that the adoption ofthis standard on January 1, 2008 will not have a material effect on ourconsolidated financial statements.**

**InSeptember 2006, the Securities and Exchange Commission issued Staff AccountingBulletin No. 108 (“SAB 108”), which becomes effective beginning on January 1,2007. SAB 108 provides guidance on the consideration of the effects of priorperiod misstatements in quantifying current year misstatements for the purposeof a materiality assessment. SAB 108 provides for the quantification of theimpact of correcting all misstatements, including both the carryover andreversing effects of prior year misstatements, on the current year financialstatements. If a misstatement is material to the current year financialstatements, the prior year financial statements should also be corrected, eventhough such revision was, and continues to be, immaterial to the prior yearfinancial statements. Correcting prior year financial statements for immaterialerrors would not require previously filed reports to be amended. Suchcorrection should be made in the current period filings. We are currentlyevaluating the impact of adopting SAB 108.**

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

##### **Market Risk**

Market riskincludes risks that arise from changes in interest rates, commodity prices,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 in propertyvalues reduce the value of the collateral and the potential proceeds availableto 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 the timea loan is made, there can be no assurance that this will continue in thefuture. We employ careful business selection, rigorous underwriting and creditapproval processes and attentive asset management to mitigate these risks.

###### **InterestRate Risk**

Interest rate riskis highly sensitive to many factors, including governmental monetary and taxpolicies, domestic and international economic and political considerations andother factors beyond our control.

Our operatingresults will depend in large part on differences between the income from ourassets and our borrowing costs.  Most ofour assets and borrowings are variable-rate instruments that we finance withvariable rate debt.  The objective ofthis strategy is to minimize the impact of interest rate changes on the spreadbetween the yield on our assets and our cost of funds.  We enter into hedging transactions withrespect to all liabilities relating to fixed rate assets.  If we were to finance fixed rate assets withvariable rate debt and the benchmark for our variable rate debt increased, ournet income would decrease.  Furthermore,as most of our available financing provides for an ability of the lender tomark-to-market our assets and make margin calls based on a change in the valueof our assets, financing fixed rate assets with this debt creates the risk thatan increase in fixed rate benchmarks (such as “swap” yields) would decrease thevalue of our fixed rate assets.  We haveentered into certain swap transactions in anticipation of drawing upon ourmark-to-market debt to hedge against this risk. Some of our loans are subject to various interest rate floors.  As a result, if interest rates fall below thefloor rates, the spread between the yield on our assets and our cost of fundswill increase, which will generally increase our returns.  Because we generate income principally fromthe spread between the yields on our assets and the cost of our borrowing andhedging activities, our net income will generally increase if LIBOR increasesand decreases if LIBOR decreases, but this may not always be true in thefuture.  Our exposure to interest rateswill also be affected by our overall corporate leverage, which we generallytarget to be 70% to 80% of the carrying value of our assets, although ouractual leverage may vary depending on our mix of assets.

In theevent of a significant rising interest rate environment and/or economicdownturn, delinquencies and defaults could increase and result in loan lossesto 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.

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Theaggregate carrying values, allocated by product type and weighted averagecoupons of our loans and other lending investments as of September 30, 2006 andDecember 31, 2005 were as follows: 
|                                                      | ** ** | **Carrying Value (1)  ($ in thousands)** | ** ** | **Allocation by  Investment Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average Spread over  LIBOR (2)** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                                     | ** ** | **2005**                                     | ** ** | **2006**                                 | ** ** | **2005**                                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Whole loans,  floating rate                          |       | $                                                            | 1,284,562  |                                         | $          | 561,388                                  |       | 62                                                                     | %          | 46 | % | — |   | — |   | 314 bps |   | 325 bps |   |
| Whole loans,  fixed rate                             |       | 80,700                                                       |       | 94,448                                       |       | 4                                        | %          | 8                                                                      | %          | 11.94 | % | 10.67 | % | — |   | — |   |
| Subordinate  interests in whole loans, floating rate |       | 337,813                                                      |       | 362,983                                      |       | 17                                       | %          | 30                                                                     | %          | — |   | — |   | 397 bps |   | 443 bps |   |
| Subordinate  interests in whole loans, fixed rate    |       | 48,513                                                       |       | 37,104                                       |       | 2                                        | %          | 3                                                                      | %          | 8.72 | % | 8.80 | % | — |   | — |   |
| Mezzanine loans,  floating rate                      |       | 187,727                                                      |       | 82,793                                       |       | 9                                        | %          | 7                                                                      | %          | — |   | — |   | 548 bps |   | 858 bps |   |
| Mezzanine loans,  fixed rate                         |       | 68,590                                                       |       | 43,352                                       |       | 3                                        | %          | 4                                                                      | %          | 9.08 | % | 8.51 | % | — |   | — |   |
| Preferred  equity, floating rate                     |       | 11,879                                                       |       | 11,795                                       |       | 1                                        | %          | 1                                                                      | %          | — |   | — |   | 900 bps |   | 900 bps |   |
| Preferred  equity, fixed rate                        |       | 44,274                                                       |       | 11,882                                       |       | 2                                        | %          | 1                                                                      | %          | 10.79 | % | 10.27 | % | — |   | — |   |
| Total / Average                                      |       | $                                                            | 2,064,058  |                                         | $          | 1,205,745                                |       | 100                                                                    | %          | 100 | % | 10.27 | % | 9.78 | % | 357 bps |   | 417 bps |   |

 

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**(1)  Debt investmentsare presented after scheduled amortization payments and prepayments, and arenet of unamortized fees, discounts, asset sales and unfunded commitments.**

**(2)**          Spreads over an indexother than LIBOR have been adjusted to a LIBOR based equivalent.

As of September30, 2006, our investment portfolio had the following maturity characteristics:
| Year of Maturity     | ** ** | **Number of  Investments  Maturing** | ** ** | **Current  Carrying Value** | ** ** | **% of Total** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|----------------------------------|------------|--------------------------|------------|
| ** **                     | ** ** | ** **                                | ** ** | **(In thousands)**          | ** ** | ** **               | ** ** |
| 2006                           |       | 4                                         |       | $                                | 51,397     |                     | 2          | % |
| 2007                           |       | 28                                        |       | 715,942                          |       | 35                       | %          |
| 2008                           |       | 20                                        |       | 842,458                          |       | 41                       | %          |
| 2009                           |       | 14                                        |       | 283,309                          |       | 14                       | %          |
| 2010                           |       | 2                                         |       | 6,625                            |       | —                   |       |
| 2011                           |       | 2                                         |       | 56,910                           |       | 3                        | %          |
| Thereafter                     |       | 7                                         |       | 107,417                          |       | 5                        | %          |
| Total                          |       | 77                                        |       | $                                | 2,064,058  |                     | 100        | % |
|                           |       |                                      |       |                             |       |                     |       |
| Weighted average  maturity (1) |       |                                      |       | 1.9 years                        |       |                     |       |

 

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(1)          The calculation ofweighted average maturity is based upon the initial term of the investment anddoes not include option or extension periods or the ability to prepay theinvestment after a negotiated lock-out period, which may be available to theborrower.

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Combined aggregate principal maturities of our consolidated CDOs,repurchase facilities, trust preferred securities, mortgage note payable andrevolving credit facility as of September 30, 2006 are as follows:

 
|            | ** ** | **Collateralized  Debt  Obligations** | ** ** | **Repurchase  Facilities** | ** ** | **Trust  Preferred  Securities** | ** ** | **Mortgage  Note  Payable** | ** ** | **Unsecured  Revolving  Credit  Facility** | ** ** | **Total** | ** ** |
|------------|------------|---------------------------------------|------------|----------------------------|------------|----------------------------------|------------|-----------------------------|------------|--------------------------------------------|------------|-----------|------------|
| 2006       |       | $                                     | —     |                       | $          | —                           |       | $                           | —     |                                       | $          | —    |       | $ | — |   | $ | — |   |
| 2007       |       | —                                |       | —                     |       | —                           |       | —                      |       | —                                     |       | —    |       |
| 2008       |       | —                                |       | —                     |       | —                           |       | —                      |       | —                                     |       | —    |       |
| 2009       |       | —                                |       | 58,739                     |       | —                           |       | —                      |       | —                                     |       | 58,739    |       |
| 2010       |       | —                                |       | —                     |       | —                           |       | —                      |       | —                                     |       | —    |       |
| 2011       |       | —                                |       | —                     |       | —                           |       | —                      |       | —                                     |       | —    |       |
| Thereafter |       | 1,714,250                             |       | —                     |       | 150,000                          |       | 94,525                      | (1)        | —                                     |       | 1,958,775 |       |
| Total      |       | $                                     | 1,714,250  |                       | $          | 58,739                           |       | $                           | 150,000    |                                       | $          | 94,525    |       | — |   | $ | 2,017,514 |   |
|            |            |                                       |            |                            |            |                                  |            |                             |            |                                            |            |           |            |  |  |  |  |  |  |

 

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(1) Wehave a 49.75% interest in the entity that is the obligor under the mortgagenote.

The following table summarizes the notional and fairvalue of our derivative financial instrument at September 30, 2006.  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:

 
| ** **          | ** ** | **Benchmark Rate** | ** ** | **Notional  Value** | ** ** | **Strike  Rate** | ** ** | **Effective  Date** | ** ** | **Expiration  Date** | ** ** | **Fair  Value** | ** ** |
|---------------------|------------|-------------------------|------------|---------------------|------------|------------------|------------|---------------------|------------|----------------------|------------|-----------------|------------|
| Interest Rate  Swap |       | 3 month LIBOR           |       | $                   | 40,000     |             | 4.420      | %                   | 7/2005     |                 | 2/2014     |            | $          | 1,325 |   |
| Interest Rate  Swap |       | 1 month LIBOR           |       | 31,686              |       | 3.855            | %          | 7/2005              |       | 11/2009              |       | 979             |       |
| Interest Rate  Swap |       | 1 month LIBOR           |       | 27,500              |       | 5.500            | %          | 8/2006              |       | 9/2016               |       | (989            | )          |
| Interest Rate  Swap |       | 3 month LIBOR           |       | 24,979              |       | 5.445            | %          | 8/2006              |       | 7/2016               |       | (752            | )          |
| Interest Rate  Cap  |       | 3 month LIBOR           |       | 23,713              |       | 5.700            | %          | 11/2005             |       | 12/2007              |       | 5               |       |
| Interest Rate  Cap  |       | 1 month LIBOR           |       | 20,000              |       | 6.000            | %          | 4/2006              |       | 4/2007               |       | —          |       |
| Interest Rate  Cap  |       | 1 month LIBOR           |       | 14,120              |       | 5.500            | %          | 12/2005             |       | 1/2007               |       | —          |       |
| Interest Rate  Swap |       | 3 month LIBOR           |       | 12,000              |       | 9.850            | %          | 8/2006              |       | 8/2011               |       | (108            | )          |
| Basis Swap          |       | 1 month PRIME           |       | 9,363               |       | 722 bps          |       | 8/2006              |       | 12/2007              |       | (1              | )          |
| Interest Rate  Swap |       | 1 month LIBOR           |       | 6,402               |       | 4.760            | %          | 1/2006              |       | 3/2015               |       | 99              |       |
| Interest Rate  Swap |       | 1 month LIBOR           |       | 3,960               |       | 4.959            | %          | 12/2005             |       | 12/2015              |       | 16              |       |
| Interest Rate  Swap |       | 1 month LIBOR           |       | 3,465               |       | 4.280            | %          | 7/2005              |       | 12/2009              |       | 65              |       |
| Interest Rate  Swap |       | 3 month LIBOR           |       | 3,465               |       | 5.178            | %          | 4/2006              |       | 3/2010               |       | (26             | )          |
| Total               |       |                    |       | $                   | 220,653    |             |       |                |       |                 |       |            | $          | 613 |   |

 

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**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 communicated toour 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).  Notwithstandingthe foregoing, a control system, no matter how well designed and operated, canprovide only reasonable, not absolute, assurance that it will detect or uncoverfailures within the Company to disclose material information otherwise requiredto be set forth in the Company’s periodic reports.  Also, we may have investments in certainunconsolidated entities.  As we do notcontrol these entities, our disclosure controls and procedures with respect tosuch entities are necessarily substantially more limited than those we maintainwith respect to our consolidated subsidiaries.

As ofthe end of the period covered by this report, we carried out an evaluation,under the supervision and with the participation of our management, includingour Chief Executive Officer and our Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures.  Based upon that evaluation,our Chief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures were effective as of the end of the periodcovered by this report.

**Changes inInternal Controls over Financial Reporting**

**There were no changes in our internal control overfinancial reporting identified in connection with the evaluation of suchinternal control that occurred during Gramercy’s last fiscal quarter that havematerially affected, or are reasonably likely to materially**affect,Gramercy’s internal control over financial reporting.

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** **
| **PART II** | ** ** | **OTHER INFORMATION** |
|-------------|------------|-----------------------|
| ** **  | ** ** | ** **            |
| **ITEM 1.** | ** ** | **LEGAL PROCEEDINGS** |

We incorporate by reference the information required by this Item 1 of Part IIto the information regarding litigation in Note 16 to the ConsolidatedFinancial Statements contained in Part I of this report.
| **ITEM 1A.** | ** ** | **RISK FACTORS** |
|--------------|------------|------------------|

There have been no material changes to the risk factors disclosed in Item 1A ofPart I in our Annual Report on Form 10-K for the year ended December 31, 2005.
| **ITEM 2.** | ** ** | **UNREGISTERED SALES 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** |
|-------------|------------|----------------------------------------------------------|

 

None
| **ITEM 5.** | ** ** | **OTHER INFORMATION** |
|-------------|------------|-----------------------|

On August 24, 2006 we issued approximately $1.0 billion of collateralized debtobligations, or CDOs, through two newly-formed indirect subsidiaries, GramercyReal Estate CDO 2006-1 Ltd., or the 2006 Issuer, and Gramercy Real EstateCDO 2006-1 LLC, or the 2006 Co-Issuer, pursuant to an Indenture, dated as ofAugust 24, 2006, by and among the 2006Issuer, the 2006 Co-Issuer, GKK Liquidity LLC, as advancing agent, and WellsFargo Bank, National Association, as trustee, paying agent, calculation agent,transfer agent, custodial securities intermediary, backup advancing agent andnotes registrar.  The CDO consists of$903.75 million of investment grade notes, $38.75 million of non-investmentgrade notes, which were co-issued by the 2006 Issuer and the 2006 Co-Issuer,and $57.5 million of preferred shares, which were issued by the 2006Issuer.  The investment grade notes wereissued with floating rate coupons with a combined weighted average rate ofthree-month LIBOR plus 0.37%, excluding transaction costs.  The preferred shares are issued share capitalof the 2006 Issuer and are not secured. We incurred approximately $11.36 million of costs related to this CDO,which are amortized on a level-yield basis over the average life of the CDO.

Interestpayments on the notes are payable quarterly, beginning on October 25, 2006, toand including July 25, 2041, the stated maturity date of the notes.  Each ofthe advancing agent and the trustee, in its capacity as backup advancing agent,will be entitled to receive a quarterly fee under and in accordance with thepriority of payments set forth in the Indenture for their respective servicesperformed, calculated on the aggregate outstanding principal amount of theClass A notes and the Class B notes of the CDO.

The2006 Issuer is expected to purchase additional collateral debt securities in anaggregate principal amount equal to $180,259,090 over the ramp-up period, which generally is 270 days from thedate of issuance of the notes.  In addition,from the date of issuance of the notes until the date that is five yearsfollowing such date, the 2006 Issuer generally is permitted to reinvestprincipal proceeds in additional collateral debt securities meeting certainrequirements as set forth in the Indenture.

The 2006 Issuer enteredinto a Collateral Management Agreement with our Manager, as the collateralmanager.  Pursuant to the CollateralManagement Agreement, the collateral manager has agreed to provide certainadvisory and administrative services in relation to the collateral debtsecurities and other eligible investments securing the notes.  As compensation for the performance of itsobligations as collateral manager, the collateral manager will be entitled toreceive the following fees, each payable quarterly in accordance with thepriority of payments as set forth in the Indenture: (i) a senior collateralmanagement fee equal to 0.15% per annum of the net outstanding portfoliobalance, and (ii) an additional subordinate collateral management fee equal to0.25% per annum of the net outstanding portfolio balance.   In general, net outstanding portfoliobalance is the sum of the (i) aggregate principal balance of the collateraldebt securities, excluding defaulted securities, (ii) aggregate principalbalance of all principal proceeds held as cash and eligible investments incertain accounts, and (iii) with respect to the defaulted securities, thecalculation amount of such defaulted securities, in each case as determined inaccordance with the Indenture.

Each class of notes willmature at par on July 25, 2041, unless redeemed or repaid prior thereto.  Principal payments on each class of noteswill be made at the stated maturity in accordance with the priority of paymentsset forth in the Indenture.  It isanticipated, however, that the notes will be paid prior to the stated maturitydate in accordance with the priority of payments as set forth in theIndenture.  The CDO will have an expectedterm of up to 10 years, and provides for a 5-year reinvestment period duringwhich we can utilize the proceeds of loan repayments to finance newinvestments.  The calculation of theweighted average lives of the notes assumes certain collateral characteristicsand that there are no prepayments, defaults or delinquencies on the collateraldebt securities owned by the 2006 Issuer. There is no assurance that such assumptions will be met.

The notes are alsosubject to mandatory redemption on any interest payment date on which any ofthe coverage tests applicable to any class of notes is not met, as set forth inthe Indenture.  Any such mandatoryredemption of the notes are to be paid first from interest proceeds and thenfrom principal proceeds of the collateral debt securities in accordance withthe priority of payments as set forth in the Indenture and only to the extentnecessary to cause each of the coverage tests to be satisfied.

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Subject to certainconditions described in the Indenture, on any payment date occurring on orafter the payment date occurring in July 2009, the 2006 Issuer may redeem thenotes in whole but not in part, at the applicable redemption prices on anypayment date at the direction of holders of at least a majority of aggregateoutstanding notional amount of the preferred shares or at the direction of thecollateral manager unless the holders of at least a majority of the aggregateoutstanding notional amount of the preferred shares object.

From July 25, 2016 to thefirst payment date on which a Clean-up Call (as defined below) may be exercised(as described below), the notes and the preferred shares may be redeemed by the2006 Issuer, in whole or in part, at their applicable redemption prices if asuccessful auction of the collateral debt securities is completed in accordancewith the terms of the Indenture.  Underthe Indenture, a successful auction includes a purchase of all of thecollateral debt securities by the collateral manager or its affiliates for apurchase price equal to the total redemption price (as defined in theIndenture).

If certain events occurresulting in a tax or taxes imposed on the 2006 Issuer or withheld frompayments to the 2006 Issuer and with respect to which the 2006 Issuer receivesless than the full amount that the 2006 Issuer would have received had no such deductionoccurred, and such amount exceeds, in the aggregate, $1 million during any12-month period or the 2006 Issuer fails to maintain its status as a qualifiedREIT subsidiary, then the notes and the preferred shares will be redeemed bythe 2006 Issuer, in whole but not in part, at their applicable redemptionprices, at the direction of holders of at least a majority of the aggregateoutstanding notional amount of the preferred shares.

The 2006 Issuer may alsoredeem the notes at the direction of the collateral manager (a “Clean-up Call”),in whole but not in part, at the price equal to the applicable redemption priceon or after the payment date on which the aggregate outstanding principalbalance of the notes (excluding any applicable capitalized) has been reduced to10% of the aggregate outstanding principal balance of the notes on the date ofthe issuance of the notes.

The redemption price foreach class of notes is generally the aggregate outstanding principal balance ofsuch class to be redeemed, plus accrued and unpaid interest (includingdefaulted interest and, with respect to Class C notes through Class K notes,capitalized interest amounts).

The Indenture containscustomary events of defaults, including upon failure to pay principal orinterest when due and payable on the notes (in accordance with the terms of theIndenture) and a default in the performance of certain covenants or otheragreements of the 2006 Issuer or 2006 Co-Issuer under the Indenture (subject tocertain notice and cure periods).  If anevent of default occurs and is continuing (other than certainbankruptcy-related events of default, and, unless certain conditions are metunder the Indenture, an event of default that has arisen because the 2006Issuer has lost its status as a qualified REIT subsidiary), the trustee may,and will be required if directed by a majority of an applicable outstandingprincipal amount of notes as set forth in the Indenture, declare the principalof and accrued and unpaid interest on all the notes to be immediately due andpayable.  Such acceleration will alsoautomatically terminate the reinvestment period.

If an event of defaultshall have occurred and be continuing, the trustee will (subject to theexceptions noted below in clauses (i) and (ii)) retain the assets securing thenotes, collect and cause the collection the proceeds thereof, and apply allpayments and deposits on the assets and the notes in accordance with thepriority of payments and other applicable provisions as set forth in theIndenture, unless either:

(i) the trustee determines that the anticipatedproceeds of a sale or liquidation of the assets (after deducting reasonableexpenses) would be sufficient to discharge in full the amounts then due andunpaid on the notes and other amounts as set forth in the Indenture, and amajority of the most-senior class of notes then outstanding (or, if no notesare then outstanding, then a majority of the aggregate outstanding notionalamount of the preferred shares then outstanding) agrees with such determination;or

(ii) a majority of the aggregate outstanding balanceof each class of notes (each voting as a separate class) (and each hedgecounterparty, unless each such counterparty is paid in full the amounts due andunpaid), direct, subject to the provisions of the Indenture, the sale andliquidation of the assets.

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The notes representnon-recourse obligations of the 2006 Issuer and the 2006 Co-Issuer payablesolely from certain assets of the 2006 Issuer pledged under the Indenture.  To the extent the collateral debt securitiesand the other pledged assets are insufficient to make payments in respect ofthe notes, neither the 2006 Issuer nor the 2006 Co-Issuer will have anyobligation to pay any further amounts in respect of the notes.  The preferred shares are issued share capitalof the 2006 Issuer and are not secured.

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**ITEM 6.                  EXHIBITS**

 

(a)  Exhibits:
| Exhibit No. | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|-------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 3.1*        |       | Articles of Incorporation of the Company  (incorporated by reference to Exhibit 3.1 of the Company’s Amendment No. 5 to  its Registration Statement on Form S-11/A (No. 333-114673), which was filed  with the Commission on July 26, 2004 and declared effective by the Commission  on July 27, 2004)                                                                                                                                                                                                                       |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 3.2*        |       | Bylaws of the Company (incorporated by reference to  Exhibit 3.2 of the Company’s Amendment No. 2 to its Registration Statement on  Form S-11/A (No. 333-114673), which was filed with the Commission on June 23,  2004 and declared effective by the Commission on July 27, 2004)                                                                                                                                                                                                                                           |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.1*       |       | Amended and Restated Master Repurchase Agreement, dated as of October 13, 2006, by and among Gramercy  Warehouse Funding II LLC, GKK Trading Warehouse II LLC and Goldman Sachs  Mortgage Company (incorporated by reference to Exhibit 10.1 of the Company’s  Current Report on Form 8-K filed on October 19, 2006)                                                                                                                                                                                                         |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.2*       |       | Annex I to Amended and Restated Master Repurchase  Agreement, dated as of October 13, 2006,  by and among Gramercy Warehouse Funding II LLC, GKK Trading Warehouse  II LLC and Goldman Sachs Mortgage Company (incorporated by reference to  Exhibit 10.2 of the Company’s Current Report on Form 8-K filed on October 19,  2006)                                                                                                                                                                                            |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.3*       |       | Amended and Restated Master Repurchase Agreement, dated as of October 13, 2006, by and among Gramercy  Warehouse Funding I LLC, GKK Trading Warehouse I LLC, GKK 450 LEX LLC, and  the additional sellers from time to time parties thereto, the buyers from  time to time parties thereto, Wachovia Bank, National Association, as agent,  and Wachovia Capital Markets, LLC, as the sole lead arranger (incorporated by  reference to Exhibit 10.3 of the Company’s Current Report on Form 8-K filed  on October 19, 2006) |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.4+       |       | Indenture, dated as of August 24, 2006, by and among  Gramercy Real Estate CDO 2006-1, Ltd., as issuer, Gramercy Real Estate CDO  2006-1 LLC, as co-issuer, GKK Liquidity LLC, as advancing agent, and Wells  Fargo Bank, National Association, as trustee, paying agent, calculation  agent, transfer agent, custodial securities intermediary, backup advancing  agent and notes registrar                                                                                                                                      |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.5+       |       | Collateral Management Agreement, dated as of August  24, 2006, by and between Gramercy Real Estate CDO 2006-1, Ltd., as issuer and  GKK Manager LLC, as collateral manager                                                                                                                                                                                                                                                                                                                                                        |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 31.1+       |       | Certification by the Chief Executive Officer pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                                                                           |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 31.2+       |       | Certification by the Chief Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                                                                           |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 32.1+       |       | Certification by the Chief Executive Officer  pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                           |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 32.2+       |       | Certification by the Chief Financial Officer  pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                           |

 

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*                              Incorporated by reference.

 

+                              Filed herewith.

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**SIGNATURES**

Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.
|                                   | GRAMERCY CAPITAL CORP. |
|-----------------------------------|------------------------|
|                              |                   |   |
|                              |                   |   |
|                              | By:                    | /s/ Robert R.  Foley |   |
|                              |                   | Robert R. Foley |
|                              |                   | Chief Financial Officer |
|                              |                   |   |
|                              |                   |   |
| Date:  November 9, 2006 |                   |   |

 

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