**UNITED STATES****SECURITIESAND EXCHANGE COMMISSIONWashington, D.C.  20549**

 

**FORM 10-Q**

 

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

 

**For thequarterly period ended March 31, 2005**

 

**or**

 

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

 

**For thetransition period from        to        .**

** **

**CommissionFile No.  001-32248**

 

**GRAMERCYCAPITAL CORP.**(Exact name of registrant as specified in its charter)

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

 

**420Lexington Avenue, New York, New York 10170**(Address of principal executive offices - zip code)

 

**(212) 297-1000**(Registrant’s telephone number, including area code)

 

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

 

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

 

The number of sharesoutstanding of the registrant’s common stock, $0.001 par value, was 18,833,000at May 11, 2005.

 

 

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**GRAMERCYCAPITAL CORP.**

 

**INDEX**

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

 

2

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

 

**ITEM 1.****  FINANCIALSTATEMENTS**

 

**Gramercy Capital Corp.Consolidated Balance Sheets(Amounts in thousands, except share and per share data)**

 
| ** **                                                                                                                                                                               | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                               | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| ** **                                                                                                                                                                               | ** ** | **(Unaudited)**    | ** ** | ** **            | ** ** |
| **Assets:**                                                                                                                                                                              |       |               |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                               |       | $                  | 4,421      |                  | $          | 39,094 |   |
| Restricted cash                                                                                                                                                                          |       | 2,357              |       | 1,901                 |       |
| Loans and other  lending investments, net                                                                                                                                                |       | 590,826            |       | 395,717               |       |
| Commercial  mortgage backed securities, net                                                                                                                                              |       | 10,921             |       | 10,898                |       |
| Stock  subscriptions receivable                                                                                                                                                          |       | —             |       | 60,445                |       |
| Accrued interest                                                                                                                                                                         |       | 2,795              |       | 2,921                 |       |
| Deferred  financing costs                                                                                                                                                                |       | 3,802              |       | 2,044                 |       |
| Deferred costs                                                                                                                                                                           |       | 175                |       | 189                   |       |
| Derivative  instruments, at fair value                                                                                                                                                   |       | 1,092              |       | 249                   |       |
| Other assets                                                                                                                                                                             |       | 5,326              |       | 589                   |       |
| Total assets                                                                                                                                                                             |       | $                  | 621,715    |                  | $          | 514,047 |   |
|                                                                                                                                                                                     |       |               |       |                  |       |
| **Liabilities  and Stockholders’ Equity:**                                                                                                                                          |       |               |       |                  |       |
| Credit  facilities                                                                                                                                                                       |       | $                  | 342,291    |                  | $          | 238,885 |   |
| Management fees  payable                                                                                                                                                                 |       | 1,588              |       | 416                   |       |
| Dividends  payable                                                                                                                                                                       |       | 4,072              |       | 1,951                 |       |
| Accounts payable  and accrued expenses                                                                                                                                                   |       | 2,010              |       | 1,935                 |       |
| Other  liabilities                                                                                                                                                                       |       | 2,357              |       | 1,901                 |       |
| Total  liabilities                                                                                                                                                                       |       | 352,318            |       | 245,088               |       |
|                                                                                                                                                                                     |       |               |       |                  |       |
| Commitments and  contingencies                                                                                                                                                           |       | —             |       | —                |       |
|                                                                                                                                                                                     |       |               |       |                  |       |
| **Stockholders’  Equity:**                                                                                                                                                          |       |               |       |                  |       |
| Preferred stock,  par value $0.001, 25,000,000 shares authorized, no shares issued or outstanding                                                                                        |       | —             |       | —                |       |
| Common stock,  par value $0.001, 100,000,000 shares authorized, 18,833,000 and 18,812,500 shares issued and outstanding at  March 31, 2005 and December 31, 2004, respectively |       | 19                 |       | 19                    |       |
| Additional  paid-in-capital                                                                                                                                                              |       | 267,663            |       | 268,558               |       |
| Accumulated  other comprehensive income                                                                                                                                                  |       | 1,121              |       | 282                   |       |
| Retained  earnings                                                                                                                                                                       |       | 594                |       | 100                   |       |
| Total  stockholders’ equity                                                                                                                                                         |       | 269,397            |       | 268,959               |       |
| Total  liabilities and stockholders’ equity                                                                                                                                         |       | $                  | 621,715    |                  | $          | 514,047 |   |

 

The accompanying notesare an integral part of these financial statements.

 

3

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**GramercyCapital Corp.Consolidated Statement of Income(Unaudited, amounts in thousands, except per share data)**

 
| ** **                                                                       | ** ** | **For the Three  Months Ended  March 31, 2005** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| **Revenues**                                                                     |       |                                                 |       |
| Investment income                                                                |       | $                                                    | 10,250     |   |
| Other income                                                                     |       | 440                                                  |       |
| Total revenues                                                                   |       | 10,690                                               |       |
|                                                                             |       |                                                 |       |
| **Expenses**                                                                     |       |                                                 |       |
| Interest expense                                                                 |       | 2,801                                                |       |
| Management fees                                                                  |       | 1,668                                                |       |
| Depreciation and  amortization                                                   |       | 22                                                   |       |
| Marketing,  general and administrative                                           |       | 1,633                                                |       |
| Total expenses                                                                   |       | 6,124                                                |       |
|                                                                             |       |                                                 |       |
| Net income  available to common stockholders                                     |       | $                                                    | 4,566      |   |
|                                                                             |       |                                                 |       |
| **Basic  earnings per share:**                                                   |       |                                                 |       |
| Net income  available to common stockholders                                     |       | $                                                    | 0.24       |   |
| **Diluted  earnings per share:**                                                 |       |                                                 |       |
| Net income  available to common stockholders                                     |       | $                                                    | 0.24       |   |
| Dividends per  common share                                                      |       | $                                                    | 0.22       |   |
| Basic weighted  average common shares outstanding                                |       | 18,833                                               |       |
| Diluted weighted  average common shares and common share equivalents outstanding |       | 19,018                                               |       |

 

Theaccompanying notes are an integral part of these financial statements.

 

4

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**Gramercy Capital Corp.Consolidated Statement of Stockholders’Equity(Unaudited, amounts in thousands, except share data)**

 
| ** **                                    | ** ** | ** **    | ** ** | ** ** | ** ** | **Additional Paid-  In-Capital** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Retained  Earnings** | ** ** | **Total** | ** ** | **Comprehensive  Income** | ** ** |
|-----------------------------------------------|------------|---------------|------------|------------|------------|----------------------------------|------------|-----------------------------------------------|------------|------------------------|------------|-----------|------------|---------------------------|------------|
| **Common**                                    | ** ** |
| **Stock**                                     | ** ** |
| **Shares**                                    | ** ** | **Par Value** | ** ** |
| **Balance at December 31,  2004**        |       | 18,813        |       | $          | 19         |                             | $          | 268,558                                       |       | $                      | 282        |      | $          | 100                       |       | $ | 268,959 |   |   |   |
| Net income                                    |       |          |       |       |       |                             |       |                                          |       | 4,566                  |       | 4,566     |       | $                         | 4,566      |   |
| Net unrealized gain on derivative instruments |       |          |       |       |       |                             |       | 839                                           |       |                   |       | 839       |       | 839                       |       |
| Costs related to  common stock offerings      |       |          |       |       |       | (1,538                           | )          |                                          |       |                   |       | (1,538    | )          |                      |       |
| Stock-based  compensation – fair value   |       |          |       |       |       | 643                              |       |                                          |       |                   |       | 643       |       |                      |       |
| Deferred  compensation plan, net              |       | 20            |       | —     |       |                             |       |                                          |       |                   |       | —    |       |                      |       |
| Cash distributions  declared                  |       |          |       |       |       |                             |       |                                          |       | (4,072                 | )          | (4,072    | )          |                      |       |
| **Balance  at March 31, 2005**           |       | 18,833        |       | $          | 19         |                             | $          | 267,663                                       |       | $                      | 1,121      |      | $          | 594                       |       | $ | 269,397 |   | $ | 5,405 |   |

 

The accompanying notesare an integral part of these financial statements

 

5

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**Gramercy Capital Corp.****Consolidated Statement of Ca****sh Flows(Unaudited, amounts in thousands)**

 
| ** **                                                                                                           | ** ** | **For the Three  Months Ended  March 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| **Operating  Activities**                                                                                            | ** ** | ** **                                           | ** ** |
| Net income  available to common stockholders                                                                         |       | $                                                    | 4,566      |   |
| Adjustments to  reconcile net income available to common stockholders to net cash provided by  operating activities: |       |                                                 |       |
| Depreciation and  amortization                                                                                       |       | 22                                                   |       |
| Amortization of  discount on investments                                                                             |       | 248                                                  |       |
| Changes in  operating assets and liabilities:                                                                        |       |                                                 |       |
| Accrued interest                                                                                                     |       | 126                                                  |       |
| Other assets                                                                                                         |       | 242                                                  |       |
| Management fees  payable                                                                                             |       | 1,172                                                |       |
| Accounts  payable, accrued expenses and other liabilities                                                            |       | 74                                                   |       |
| Net cash  provided by operating activities                                                                           |       | 6,450                                                |       |
| **Investing  Activities**                                                                                            |       |                                                 |       |
| New investment  originations                                                                                         |       | (221,157                                             | )          |
| Principal  collections on investments                                                                                |       | 20,776                                               |       |
| Deferred loan  costs                                                                                                 |       | 14                                                   |       |
| Net cash used in  investing activities                                                                               |       | (220,367                                             | )          |
| **Financing  Activities**                                                                                            |       |                                                 |       |
| Proceeds from  credit facilities                                                                                     |       | 103,406                                              |       |
| Net proceeds  from sale of common stock                                                                              |       | 59,547                                               |       |
| Deferred  financing costs                                                                                            |       | (1,758                                               | )          |
| Dividends paid                                                                                                       |       | (1,951                                               | )          |
| Net cash  provided by financing activities                                                                           |       | 159,244                                              |       |
| Net increase in  cash and cash equivalents                                                                           |       | (34,673                                              | )          |
| Cash and cash  equivalents at beginning of period                                                                    |       | 39,094                                               |       |
| Cash and cash  equivalents at end of period                                                                          |       | $                                                    | 4,421      |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

6

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**Gramercy Capital Corp.Notes To CondensedConsolidated Financial Statements(Unaudited, amounts in thousands, except share and per share data)March 31, 2005**

 

**1.**      Organization

** **

Gramercy Capital Corp. (the Company or Gramercy), was organized inMaryland on April 1, 2004 as a commercial real estate specialty financecompany focused on originating and acquiring, for our own account, fixed andfloating rate mortgage loans, bridge loans, subordinate interests in mortgageloans, distressed debt, mortgage-backed securities, mezzanine loans, andpreferred equity interests in entities that own commercial real estate inaddition to acquiring and owning properties leased on a long-term, net leasebasis to credit tenants, primarily in the United States.

 

In connection with the completion of our initial public offering in August 2004,Gramercy contributed the proceeds of such offering in exchange for units oflimited partnership interest in GKK Capital LP, a Delaware limited partnership,or the Operating Partnership. Substantially all of Gramercy’s operations are conducted through and allassets are held by the Operating Partnership. Gramercy, as the sole general partner of, and holder of 100% of thecommon units of, the Operating Partnership, has responsibility and discretionin the management and control of the Operating Partnership, and the limitedpartners of the Operating Partnership, in such capacity, have no authority totransact business for, or participate in the management activities of, theOperating Partnership.  Accordingly, weconsolidate the accounts of the Operating Partnership.

 

We are externally managed and advised by GKK Manager LLC, or theManager, a majority-owned subsidiary of SL Green Realty Corp., or SLGreen.  At March 31, 2005, SL Greenalso owned approximately 25% of the outstanding shares of our common stock. Wequalified as a real estate investment trust, or REIT, under the InternalRevenue Code commencing with our taxable year ending December 31,2004.  To maintain our tax status as aREIT, we plan to distribute at least 90% of our taxable income.  Unless the context requires otherwise, allreferences to “we,” “our,” and “us” means Gramercy Capital Corp.

 

As of March 31, 2005, we held investments of approximately$601,747 net of fees, discounts, repayments, asset sales and unfundedcommitments with an average spread to LIBOR of 532 basis points for ourfloating rate investments and an average yield of 10.8% for our fixed rateinvestments.

 

**Basis of QuarterlyPresentation**

** **

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

 

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

 

**2.**      Significant Accounting Policies

** **

**Principles of Consolidation**

** **

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

 

**Cash andCash Equivalents**

 

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

 

7

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**Restricted Cash**

** **

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

** **

### **Loans and Investments**

 

Loans held for investmentare intended to be held to maturity and, accordingly, are carried at cost, netof unamortized loan origination costs and fees, discounts, repayments, sales ofpartial interests in loans and unfunded commitments unless such loan orinvestment is deemed to be impaired. We invest in preferred equity intereststhat allow us to participate in a percentage of the underlying property’s cashflows from operations and proceeds from a sale or refinancing.  At the inception of each such investment, wemust determine whether such investment should be accounted for as a loan, jointventure or as an interest in real estate.

 

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

 

If upon completion of 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.  There was no loan loss allowanceat March 31, 2005.

 

Our Manager evaluates our assets on a regular basis to determine ifthey continue to satisfy our investment criteria. Subject to certainrestrictions applicable to REITs, our Manager may cause us to sell ourinvestments opportunistically and use the proceeds of any such sale for debtreduction, additional acquisitions or working capital purposes.

 

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

#### ** **

In accordance withapplicable GAAP, mortgage-backed securities (“MBS”) are classified asavailable-for-sale securities.  As aresult, changes in fair value will be recorded as a balance sheet adjustment toaccumulated other comprehensive income, which is a component of stockholdersequity, rather than through our statement of operations.  If available-for-sale securities wereclassified as trading securities, there could be substantially greatervolatility in earnings from period-to-period as these investments would bemarked to market and any reduction in the value of the securities versus theprevious carrying value would be considered an expense on our statement ofoperations. We had no investments as of March 31, 2005 that were accountedfor as trading securities.

 

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

#### ** **

All MBS will be carriedon the balance sheet at fair value.  Wedetermine the fair value of MBS based on the types of securities in which wehave invested.  For liquid, investment-gradesecurities, we consult with dealers of such securities to periodically obtainupdated market pricing for the same or similar instruments.  For non-investment grade securities, weactively monitor the performance of the underlying properties and loans andupdate our pricing model to reflect changes in projected cash flows.  The value of the securities is derived byapplying discount rates to such cash flows based on current market yields.  The yields employed are obtained from our ownexperience in the market, advice from dealers and/or information obtained inconsultation 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 fair value of an available-for-sale security is less than theamortized cost, we consider whether there is an other-than-temporary impairmentin the value of the security (for example, whether the security will be soldprior 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 of lossrealization.

 

#### **Revenue Recognition**

#### ** **

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

 

8

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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 aportion of our investments to a third party. To the extent the fair value received for an investment exceeds theamortized cost of that investment and FASB Statement No. 140, or SFAS 140,“Accounting for Transfers and Servicing of Financial Assets and Extinguishmentsof Liabilities,” criteria is met, under which control of the asset that is soldis surrendered making it a “true sale,” a gain on the sale will be recordedthrough earnings as other income.**

#### ** **

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

#### ** **

The expense for possible credit losses in connection with debtinvestments is the charge to earnings to increase the allowance for possiblecredit losses to the level that management estimates to be adequate consideringdelinquencies, loss experience and collateral quality.  Other factors considered relate to geographictrends and project diversification, the size of the portfolio and currenteconomic conditions.  Based upon thesefactors, we establish the provision for possible credit losses by category ofasset.  When it is probable that we willbe unable to collect all amounts contractually due, the account is consideredimpaired.

 

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 repossessed collateral is charged to theallowance for credit losses.  As of March 31,2005, we did not have an allowance for credit losses.

 

**Deferred Costs**

** **

Deferred costs consist of fees and direct costs incurred to originatenew investments and are amortized using the effective yield method over therelated term of the investment.

 

**DeferredFinancing Costs**

 

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

 

**StockBased Employee Compensation Plans**

 

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

 

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

 

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

 

9

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

 

| ** **                       | ** ** | **2005**  | ** ** | **2004** | ** ** |
|----------------------------------|------------|-----------|------------|----------|------------|
| Dividend yield                   |       | 8.5       | %          | 10.0     | %          |
| Expected life of  option         |       | 6.7 years |       | 7 years  |       |
| Risk-free  interest rate         |       | 4.27      | %          | 4.10     | %          |
| Expected stock  price volatility |       | 18.7      | %          | 18.0     | %          |

 

**Incentive Distribution (Class B LimitedPartner Interest)**

 

TheClass B limited partner interest is entitled to receive an incentivereturn equal to 25% of the amount by which funds from operations (as defined inthe partnership agreement of the Operating Partnership) plus certain accountinggains exceed the product of our weighted average stockholders equity (asdefined in the partnership agreement of the Operating Partnership) multipliedby 9.5% (divided by 4 to adjust for quarterly calculations).  We will record any distributions on the Class Blimited partner interests as an incentive distribution expense in the periodwhen earned and when payment of such amounts has become probable and reasonablyestimable in accordance with the partnership agreement.  These cash distributions will reduce theamount of cash available for distribution to our common unitholders in ourOperating Partnership and to common stockholders.  No amounts were earned or accrued withrespect to the Class B limited partner interests as of March 31,2005.

 

#### **Derivative Instruments**

#### ** **

**In thenormal course of business, we use a variety of derivative instruments tomanage, or hedge, interest rate risk.  Werequire that hedging derivative instruments be effective in reducing the interestrate 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 normal course of business, we are exposed to the effect ofinterest rate changes and limit these risks by following established riskmanagement policies and procedures 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 use a variety ofcommonly used derivative products that are considered plain vanilladerivatives.  These derivatives typicallyinclude interest rate swaps, caps, collars and floors.  We expressly prohibit the use ofunconventional derivative instruments and using derivative instruments fortrading or speculative purposes. Further, we have a policy of only entering into contracts with majorfinancial institutions based upon their credit ratings and other factors.

 

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

 

We may employ swaps, forwards or purchased options to hedge qualifyingforecasted transactions.  Gains andlosses related to these transactions are deferred and recognized in net incomeas interest expense in the same period or periods that the underlyingtransaction occurs, expires or is otherwise terminated.

 

10

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All hedges held by us are deemed to be highly effective in meeting thehedging objectives established by our corporate policy governing interest raterisk management.  The effect of ourderivative instruments on our financial statements is discussed more fully inNote 13.

 

# **IncomeTaxes**

#  

Gramercy elected to betaxed 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 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 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.

 

**Underwriting Commissions and Costs**

 

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

** **

**Organization Costs**

** **

Costs incurred toorganize Gramercy in 2004 were expensed as incurred.

 

**EarningsPer Share**

 

We present both basic anddiluted earnings per share, or EPS. Basic EPS excludes dilution and is computed by dividing net incomeavailable to common stockholders by the weighted average number of commonshares outstanding during the period. Diluted EPS reflects the potential dilution that could occur ifsecurities or other contracts to issue common stock were exercised or convertedinto common stock, where such exercise or conversion would result in a lowerEPS amount.  Diluted EPS at March 31,2005 reflects the dilutive effect of stock options.

 

**Use ofEstimates**

 

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

 

**Concentrationsof Credit Risk**

 

**Financial instruments that potentially subject us to concentrations ofcredit risk consist primarily of cash investments, debt investments andaccounts receivable.  Gramercy places itscash investments in excess of insured amounts with high quality financialinstitutions.  Our Manager performsongoing analysis of credit risk concentrations in our debt investment portfolioby evaluating exposure to various markets, underlying property types,investment structure, term, sponsors, tenant mix and other credit metrics.  Two investments accounted for more than 24%of our total investments as of March 31, 2005. Two investments accountedfor more than 31% of the revenue earned on our investments for the three monthsended March 31, 2005.**

** **

**Recently Issued AccountingPronouncements**

** **

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

 

11

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

 

**The aggregatecarrying values, allocation by product type and weighted average coupons of ourinvestments as of March 31, 2005 were as follows:**

** **
| ** **                                     | ** ** | **Carrying Value  ($ in thousands)** | ** ** | **Allocation by  Investment  Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average  Spread over  LIBOR** | ** ** |
|------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------|------------|--------------------------------|------------|-------------------------------------------------|------------|
| Whole loans                                    |       | $                                         | 251,411    |                                | 42         | %                              | —     |                                            | 306        |  bps |
| Subordinate  mortgage interests, floating rate |       | 224,273                                   |       | 37                                  | %          | —                         |       | 648                                             |  bps  |
| Subordinate  mortgage interests, fixed rate    |       | 34,700                                    |       | 6                                   | %          | 9.60                           | %          | —                                          |       |
| Mezzanine loans,  floating rate                |       | 65,992                                    |       | 11                                  | %          | —                         |       | 934                                             |  bps  |
| Mezzanine loans,  fixed rate                   |       | 2,729                                     |       | 0                                   | %          | 14.53                          | %          | —                                          |       |
| Preferred equity                               |       | 11,721                                    |       | 2                                   | %          | —                         |       | 900                                             |  bps  |
| Commercial  mortgage backed securities         |       | 10,921                                    |       | 2                                   | %          | 13.49                          | %          | —                                          |       |
| Total / Average                                |       | $                                         | 601,747    |                                | 100        | %                              | 10.76      | %                                               | 532        |  bps |

** **

For the three monthsended March 31, 2005 the Company’s investment income was generated by thefollowing investment types:

 

| **Investment  Type**            | ** ** | **Investment  Income** | ** ** | **% of Total** | ** ** |
|---------------------------------|------------|------------------------|------------|----------------|------------|
| Subordinate  mortgage interests |       | $                      | 5,643      |           | 55         | % |
| Whole loans                     |       | 2,992                  |       | 29             | %          |
| Mezzanine loans                 |       | 948                    |       | 9              | %          |
| Preferred Equity                |       | 306                    |       | 3              | %          |
| CMBS                            |       | 361                    |       | 4              | %          |
|                            |       | $                      | 10,250     |           | 100        | % |

 

At March 31, 2005,our investment portfolio had the following geographic diversification:

 

| **Region** | ** ** | **Carrying Value** | ** ** | **% of Total** | ** ** |
|------------|------------|--------------------|------------|----------------|------------|
| Northeast  |       | $                  | 299,179    |           | 50         | % |
| South      |       | 129,067            |       | 21             | %          |
| Midwest    |       | 63,473             |       | 10             | %          |
| West       |       | 57,577             |       | 10             | %          |
| Various    |       | 52,451             |       | 9              | %          |
|       |       | $                  | 601,747    |           | 100        | % |

** **

**In connectionwith our preferred equity investment, we have guaranteed a portion of theoutstanding principal balance of the first mortgage loan, up to approximately$1,400, that is a financial obligation of the entity in which we have investedin the event of a borrower default under such loan.  The loan matures in 2032.  As compensation, we received a creditenhancement fee of $125 from the borrower in exchange for the guarantee, whichis recognized as the fair value of the guarantee and has been recorded on ourbalance sheet as a liability.  Theliability will be amortized over the life of the guarantee using thestraight-line method and corresponding fee income will be recorded.  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.**      Debt Obligations

** **

We have two facilitieswith Wachovia Capital Markets, LLC or one or more of its affiliates.  The first facility is a $500,000 repurchasefacility.  This facility was increased to$350,000 from $250,000 effective January 3, 2005, and subsequentlyincreased to $500,000 effective April 22, 2005.  As part of the April 2005 increase to$500,000, the initial term of the facility was modified to reflect a staggeredterm in which $250,000 matures in August 2007, $150,000 matures in December 2007and the remaining $100,000 matures in June 2008.  Also in conjunction with the April 2005upsize, the $50,000 credit facility we previously maintained with Wachovia wasconsolidated into the $500,000 repurchase facility.  The $500,000 facility bears interest atspreads of 1.25% to 3.50% over a 30-day LIBOR and, based on our expectedinvestment activities, provides for advance rates that vary from 50% to 95%based upon the collateral provided under a borrowing base calculation.  The lender has a consent right to theinclusion of investments in this facility, determines periodically the marketvalue of the investments, and has the right to require additional

 

12

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collateral if the estimated market value of the included investmentsdeclines.  At March 31, 2005 we hadborrowings of $296,167 under this facility. We can utilize the $25,000 revolving credit facility described below tofund requirements for additional collateral pursuant to the warehouse financingor to fund the acquisition of assets.

 

The second facility is a$25,000 revolving credit facility with a term of two years.  Amounts drawn under this facility for liquiditypurposes bear interest at a spread over LIBOR of 525 basis points.  Amounts drawn under this facility foracquisition purposes bear interest at a spread over LIBOR of 225 basis points.  Amounts drawn under this facility forliquidity purposes must be repaid within 105 days.  Amounts drawn under this facility generallywill be secured by assets established under a borrowing base calculation unlesscertain financial covenants are satisfied. These covenants are generally more restrictive than those set forthbelow.  At March 31, 2005 we had noborrowings under this facility.

 

We have an additionalrepurchase facility of $200,000 with Goldman Sachs Mortgage Company, anaffiliate of Goldman Sachs & Co. This facility has an initial term of three years with one six-monthextension option.  This facility bearsinterest at spreads of 1.125% to 2.75% over a 30-day LIBOR and, based on ourexpected investment activities, provides for advance rates that vary from 75%to 90% based upon the collateral provided under a borrowing basecalculation.  As with the Wachoviafacility, the lender has a consent right to the inclusion of investments inthis facility, determines periodically the market value of the investments, andhas the right to require additional collateral if the estimated market value ofthe included investments declines.  At March 31,2005 we had borrowings of $46,124 under this facility.

 

The terms of both of our repurchase facilities and our credit facilityinclude covenants that****(a) limitour maximum total indebtedness to no more than 85% of our total assets, (b) requireus to maintain minimum liquidity of at least $10,000 for the first two yearsand $15,000 thereafter, (c) our fixed charge coverage ratio shall at notime be less than 1.50 to 1.00, (d) our minimum interest coverage ratioshall at no time be less than 1.75 to 1.00, (e) require us to maintainminimum tangible net worth of not less than the greater of (i) $129,750,or (i) plus (ii) 75% of the proceeds of our subsequent equityissuances and (f) restrict the maximum amount of our totalindebtedness.  The covenants alsorestrict us from making distributions in excess of a maximum of 103% of ourfunds from operations (as defined by the National Association of Real EstateInvestment Trusts) through July 2005 and 100% thereafter, except that wemay in any case pay distributions necessary to maintain our REIT status.  Under our facilities with Wachovia CapitalMarkets LLC, an event of default will be triggered if GKK Manager LLC ceases tobe the Manager.

 

The revolving credit facility and the repurchase facilities requirethat we pay down borrowings under these facilities as principal payments on ourloans and investments are received.

 

At March 31, 2005 borrowings under the Wachovia and Goldmanrepurchase facilities were secured by the following investments:

 

| **Investment  Type**            | ** ** | **Carrying Value** | ** ** |
|---------------------------------|------------|--------------------|------------|
| Whole loans                     |       | $                  | 144,086    |   |
| Subordinate  mortgage interests |       | 260,842            |       |
| CMBS                            |       | 10,921             |       |
|                            |       | $                  | 415,849    |   |

 

**5.**      Operating PartnershipAgreement

 

After the closing of our initial public offering, we owned all of the Class Alimited partner interests in our Operating Partnership.  The Class B limited partner interestsare owned 83% by SL Green Operating Partnership, L.P. and 17% by theManager.  SL Green Operating Partnership,L.P. intends to own at least 70% of the Class B limited partner interests.

 

**6.**      Related Party Transactions

 

In connection with ourinitial public offering, we entered into a Management Agreement with GKKManager LLC, which provides for an initial term through December 2007 withautomatic one-year extension options and is subject to certain terminationrights.  We pay the Manager an annualmanagement fee equal to 1.75% of our gross stockholders equity (as defined inthe Management Agreement).  For the threemonths ended March 31, 2005, we paid or had payable an aggregate ofapproximately $1,204 to the Manager under this agreement.

 

13

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The Manager and SL GreenOperating Partnership, L.P., hold 17 units and 83 units, respectively, of the Class Blimited partner interests of the Operating Partnership. SL Green OperatingPartnership, L.P. intends to own at least 70 units of the Class B limitedpartner interests. To provide an incentive for the Manager to enhance the valueof the common stock, the Manager and SL Green Operating Partnership, L.P. areentitled through their ownership of Class B limited partner interests ofthe Operating Partnership to an incentive return equal to 25% of the amount bywhich funds from operations (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).  We will recordany distributions 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.  No amounts wereearned or accrued with respect to such Class B limited partner intereststhrough March 31, 2005.

 

We are obligated to reimburse the Manager for its costs incurred underan Asset Servicing Agreement and a separate Outsourcing Agreement between ourManager and SL Green Operating Partnership, L.P.  The Asset Servicing Agreement provides for anannual fee payable by us of 0.15% of the carrying value of our investments,excluding certain defined investments for which other servicing arrangementsare executed and further reduced by fees paid directly to outside servicers byus which have been approved by SL Green Operating Partnership, L.P.  The Outsourcing Agreement provides a feepayable by us of $1,250 per year, increasing 3% annually over the prioryear.  For the three months ended March 31,2005, we paid or had payable an aggregate of $313 and $151 to our Manager underthe Outsourcing and Asset Servicing Agreements, respectively.

 

In connection with the5,500,000 shares of common stock that were sold on December 3, 2004 andsettled on December 31, 2004 and January 3, 2005 in a privateplacement, we have agreed to pay the Manager a fee of $1,000 as compensationfor financial advisory, structuring and costs incurred on our behalf.   This fee has been recorded as a reduction inthe proceeds of the private placement. Apart from legal fees and stock clearing charges totaling $245, no otherfees were paid by us to an investment bank, broker/dealer or other financialadvisor in connection with the private placement, resulting in total costs of1.3% of total gross proceeds.

 

On March 31, 2005 we posted a deposit of $5,000 to SL Green RealtyCorp., or SL Green, for a potential equity investment in a joint venture.  On April 29, 2005, we closed on a $57,503investment in a joint venture with SL Green to acquire, own and operate theSouth Building located at One Madison Avenue, New York, New York, or theProperty.  The joint venture, which wascreated to acquire, own and operate the Property, is owned 45% by awholly-owned subsidiary of us and 55% by a wholly-owned subsidiary of SL Green;the joint venture interests are pari passu. Also on April 29, 2005, the joint venture completed the acquisition ofthe Property from Metropolitan Life Insurance Company for the purchase price ofapproximately $802,800 plus closing costs, financed in part through a $690,000first mortgage loan on the Property.  TheProperty comprises approximately 1.2 million square feet and is almost entirelynet leased to Credit Suisse First Boston (USA), or CSFB, pursuant to a leasewith a 15-year remaining term.

 

**Effective May 1, 2005 we are party to a lease agreement with SLGGraybar Sublease LLC, an affiliate of SL Green, for our corporate offices at420 Lexington Avenue, New York, NY.  The leaseis for approximately five thousand square feet with an option to lease anadditional approximately two thousand square feet and carries a term of tenyears with rents of approximately $249 per annum for year one rising to $315per annum in year ten.**

** **

**Bright Star Couriers LLC, or Bright Star, provides messenger services tous.  Bright Star is owned by Gary Green,a son of Stephen L. Green.  The aggregateamount of fees paid by us for such services for the three months ended March 31,2005 was less than $1.**

** **

**SL Green Operating Partnership, L.P. has invested $75,000 in a preferredequity interest that is subordinate to one of our investments with a book valueof $62,086 as of March 31, 2005.**

** **

**7.**      DeferredCosts

** **

Deferredcosts at March 31, 2005 consisted of the following (in thousands):

 

| Deferred financing             |   | $     | 4,487  |   |
|--------------------------------|--------|-------|--------|--------|
| Deferred  acquisition          |   | 219   |   |
|                           |   | 4,706 |   |
| Less accumulated  amortization |   | (729  | )      |
|                           |   | $     | 3,977  |   |

 

14

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Deferred financing costsrelate to our existing repurchase and credit facilities with Wachovia andGoldman Sachs and are amortized on a straight-line basis to interest expensebased on the remaining term of the related facility.

 

Deferred acquisition costsconsist of fees and direct costs incurred to originate our investments.

 

**8.**      Fair Value of Financial Instruments

** **

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

 

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

 

Disclosureabout fair value of financial instruments is based on pertinent informationavailable to us at March 31, 2005. Although we are not aware of any factors that would significantly affectthe reasonable fair value amounts, such amounts have not been comprehensivelyrevalued for purposes of these financial statements since that date and currentestimates of fair value may differ significantly from the amounts presentedherein.

 

**9.**      Stockholders’ Equity

** **

**Common Stock**

 

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

 

Asof the date of our formation, April 12, 2004, we had 500,000 shares ofcommon stock outstanding valued at approximately $200,000.  On August 2, 2004 we completed ourinitial public offering of 12,500,000 shares of common stock resulting in netproceeds of approximately $177,600, which was used to fund investments andcommence our operations.  As of March 31,2005, 333,000 restricted shares had also been issued under our 2004 EquityIncentive Plan, or the Equity Incentive Plan. These shares have a vesting period of three to four years and are notentitled to receive distributions declared by us on our common stock until suchtime as the shares have vested or the shares have been designated to receivedividends by the Compensation Committee of our Board of Directors.

 

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

 

Asof March 31, 2005, 18,833,000 shares of common stock and no shares ofpreferred stock were issued and outstanding.

 

**EquityIncentive 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 InternalRevenue Code of 1986, as amended, or ISOs, (ii) the grant of stock optionsthat do not qualify, or NQSOs, (iii) the grant of stock options in lieu ofcash directors’ fees and (iv) grants of shares of restricted andunrestricted common stock.  The exerciseprice of stock options will be determined by the compensation committee, butmay not be less than 100% of the fair market value of the shares of commonstock on the date of grant.  At March 31,2005, approximately 1,883,300 shares of common stock were available forissuance under the Equity Incentive Plan.

 

15

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

 

A summary of the statusof our stock options as of March 31, 2005 are presented below:

 

| ** **                    | ** ** | **2005**                 | ** ** |
|-------------------------------|------------|--------------------------|------------|
| ** **                    | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Balance at  beginning of year |       | 640,500                  |       | $ | 15.05 |   |
| Granted                       |       | 10,000                   |       | $ | 20.49 |   |
| Exercised                     |       | —                   |       | $ | — |   |
| Lapsed or  cancelled          |       | —                   |       | $ | — |   |
| Balance at end  of period     |       | 650,500                  |       | $ | 15.13 |   |

** **

Alloptions were granted within a price range of $15.00 to $21.00.  The remaining weighted average contractuallife of the options was 9.35 years.  Ofthe options granted 59% will vest equally over a three-year period and theremaining 41% will vest equally over a four-year period.  Compensation expense of $16 was recordedduring the three months ended March 31, 2005 related to the issuance ofstock options.

 

Asof March 31, 2005, 333,000 restricted shares had been issued under theEquity Incentive Plan.  Of the shares ofrestricted stock issued, approximately 89% will vest equally over a three-yearperiod and the remaining 11% will vest equally over a four-year period.  These shares are not entitled to receivedistributions declared by us on our common stock until such time as the shareshave vested.  Unvested shares may beentitled to receive dividends at the discretion of the Compensation Committeeof our Board of Directors.  Holders ofrestricted shares are prohibited from selling such shares until they vest butare provided the ability to vote such shares beginning on the date of grant.  Compensation expense of $627 was recordedduring the three months ended March 31, 2005 related to the issuance ofrestricted shares.

 

**Earnings per Share**

** **

Earningsper share for the three months ended March 31, 2005 is computed asfollows:

 

| **Numerator  (Income)**                      | ** ** | **Three months  ended March  31, 2005** | ** ** |
|----------------------------------------------|------------|-----------------------------------------|------------|
| Basic Earnings:                              |       |                                    |       |
| Net income  available to common stockholders |       | $                                       | 4,566      |   |
| Effect of dilutive  securities               |       | ---                                     |       |
| Diluted  Earnings:                           |       |                                    |       |
| Net income  available to common stockholders |       | $                                       | 4,521      |   |
|                                         |       |                                    |       |
| **Denominator  (Weighted Average Shares)**   |       |                                    |       |
| Basic                                        |       |                                    |       |
| Shares available  to common stockholders     |       | 18,833                                  |       |
| Effect of  Diluted Securities:               |       |                                    |       |
| Stock options                                |       | 185                                     |       |
| Diluted Shares                               |       | 19,018                                  |       |

 

16

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**10.**    MinorityInterest

** **

**After the closing of our initial public offering, we ownedall of the Class A limited partner interests in our OperatingPartnership.  The Class B limitedpartner interests are owned 83% by SL Green Operating Partnership, L.P. and 17%by our Manager. SL Green Operating Partnership, L.P. intends to own at least70% of the Class B limited partner interests.**

** **

**11.**    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.**

** **

**12.**    Commitments and Contingencies

** **

We and ourOperating Partnership are not presently involved in any material litigationnor, to our knowledge, is any material litigation threatened against us or ourinvestments, other than routine litigation arising in the ordinary course ofbusiness.  Management believes the costs,if any, incurred by us and our Operating Partnership related to litigation willnot materially affect our financial position, operating results or liquidity.

 

Our corporateoffices at 420 Lexington Avenue, New York, NY are subject to an operating leaseagreement with SLG Graybar Sublease LLC, an affiliate of SL Green, effective May 1,2005.  The lease is for approximately fivethousand square feet with an option to lease an additional approximately twothousand square feet and carries a term of ten years with rents ofapproximately $249 per annum for year one rising to $315 per annum in year ten.

 

The followingis a schedule of future minimum lease payments under our operating leaseas of March 31, 2005.

 

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

 

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

** **

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

 

The following table summarizes the notional and fair value of ourderivative financial instrument at March 31, 2005.  All derivative instruments have beendesignated as cash flow hedges.  For thethree months ended March 31, 2005 $1 was attributable to the ineffectiveportion of our derivative’s change in fair value and was recognized as anincrease in interest expense.  Thenotional value is an indication of the extent of our involvement in thisinstrument at that time, but does not represent exposure to credit, interestrate or market risks (in thousands):

 
| ** **          | ** ** | **Notional  Value** | ** ** | **Strike  Rate** | ** ** | **Effective  Date** | ** ** | **Expiration  Date** | ** ** | **Fair  Value** | ** ** |
|---------------------|------------|---------------------|------------|------------------|------------|---------------------|------------|----------------------|------------|-----------------|------------|
| Interest Rate  Swap |       | $                   | 10,729     |             | 3.36       | %                   | 8/2004     |                 | 12/2007    |            | $          | 242 |   |
| Interest Rate  Swap |       | $                   | 31,686     |             | 2.25       | %(1)                | 11/2004    | (1)                  | 4/2005     | (1)             | $          | 797 |   |
| Interest Rate  Swap |       | $                   | 3,465      |             | 3.30       | %(2)                | 2/2005     | (2)                  | 2/2006     | (2)             | $          | 53 |   |

 

17

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(1)   This swap has a step-up component with a strike rate of3.86%, an effective date of April 2005 and an expiration of November 2009.  The total fair value of the initial swap andthe step-up provisions are reflected in the fair value.

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

 

OnMarch 31, 2005, the derivative instruments were reported as an asset attheir fair value of $1,092.  Offsettingadjustments are represented as deferred gains and are a component ofAccumulated Other Comprehensive Income of $1,121.  Currently, all derivative instruments aredesignated as effective hedging instruments. Over time, the realized and unrealized gains and losses held inAccumulated Other Comprehensive Income will be reclassified into earnings asinterest expense in the same periods in which the hedged interest paymentsaffect earnings.

 

We are hedgingexposure to variability in future interest payments on its debt facilities.

 

**14.**    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.**

** **

**15.**    Segment Reporting

** **

**Statement of Financial Accounting Standard No. 131, or“SFAS No. 131,” establishes standards for the way that public entitiesreport information about operating segments in their annual financialstatements.  We are a REIT focused onoriginating and acquiring loans and securities related to real estate andcurrently operate in only one segment.**

** **

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

** **

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

 

| ** **                            | ** ** | **2005** | ** ** |
|---------------------------------------|------------|----------|------------|
| Derivative  instruments at fair value |       | $        | 839        |   |
|                                       |            |          |            |  |

** **

**17.**    Subsequent Events

** **

On April 29, 2005, we closed on a $57,503 million investment in a jointventure with SL Green to acquire, own and operate the South Building located atOne Madison Avenue, New York, New York, or the Property.  The joint venture, which was created toacquire, own and operate the Property, is owned 45% by a wholly-ownedsubsidiary of us and 55% by a wholly-owned subsidiary of SL Green; the jointventure interests are pari passu.  Alsoon April 29, 2005, the joint venture completed the acquisition of the Propertyfrom Metropolitan Life Insurance Company for the purchase price of approximately$802,800 plus closing costs, financed in part through a $690,000 first mortgageloan on the Property.  The Propertycomprises approximately 1.2 million square feet and is almost entirely netleased to Credit Suisse First Boston (USA), or CSFB, pursuant to a lease with a15-year remaining term.

** **

On April 22, 2005our repurchase facility with Wachovia Capital Markets LLC or one or more of itsaffiliates was increased from $350,000 to $500,000.  In connection with this increase, the $50,000credit facility we previously held with Wachovia Capital Markets LLC or one ormore of its affiliates was consolidated into the repurchase facility and theinitial term of the facility was modified to reflect a staggered term in which$250,000 matures in August 2007, $150,000 matures in December 2007and the remaining $100,000 matures in June 2008.

 

18

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**ITEM2:  Management’s****Discussion and Analysis of Financial Condition and Resultsof Operations**

 

**Overview**

** **

We are a commercial realestate specialty finance company formed in April of 2004 focused onoriginating and acquiring, for our own account, fixed and floating ratemortgage loans, bridge loans, subordinate interests in mortgage loans,distressed debt, mortgage-backed securities, mezzanine loans and preferredequity interests in entities that own commercial real estate in addition to acquiringand owning properties leased on a long-term, net lease basis to credit tenants,primarily in the United States.  Weconduct substantially all of our operations through our operating partnership,GKK Capital LP.  We are externallymanaged and advised by GKK Manager LLC, or the Manager, a majority-ownedsubsidiary of SL Green Realty Corp., or SL Green.  We have elected to be taxed as a REIT underthe Internal Revenue Code and generally will not be subject to federal incometaxes to the extent we distribute our income to our stockholders.  However, we may establish taxable REITsubsidiaries to effect various taxable transactions.  Those taxable REIT subsidiaries would incurfederal, state and local taxes on the taxable income from theiractivities.  Unless the context requiresotherwise, all references to “we,” “our” and “us” mean Gramercy Capital Corp.

 

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

 

Since our inception, we have completed transactions in a variety ofmarkets and secured by several property types. During this period, the market for commercial real estate debt hascontinued to demonstrate low rates of default, high relative returns andtremendous inflows of capital. Consequently, the market for debt instruments has evidenced moderatelydeclining yields and more flexible credit standards and loan structures.  In particular, “conduit” originators whopackage whole loans for resale to investors have driven debt yields lower whilemaintaining substantial liquidity because of the strong demand for theresulting securities.  Because of reducedprofits in the most liquid sectors of the mortgage finance business, severallarge institutions have begun originating large bridge loans for the purpose ofgenerating interest income, rather than the typical focus on tradingprofits.  In this environment we havefocused on areas where we have comparative advantages rather than competing forproduct merely on the basis of yield or structure.  This has particularly included whole loanorigination in markets and transactions where we have an advantage due toknowledge or relationships we have or our largest shareholder, SL Green, has orwhere 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 historic valuations of most of thecorresponding assets.  Because of thesignificant increase in the value of institutional quality assets relative tohistoric norms, we typically focus on positions in which a customaryrefinancing at loan maturity would provide for a return of our investment.  Because of our relatively small size at thistime, we can meet our growth objectives with a moderate amount of newinvestment activity.

 

Because of the high relative valuation of debt instruments in the currentmarket and a generally increasing rate environment, we have carefully managedour exposure to interest rate changes that could affect our liquidity.  We generally match our assets and liabilitiesin terms of base interest rate (generally 30-day LIBOR) and expectedduration.  We raised $95.0 million ofadditional equity in December 2004 and January 2005 to reduce ouroutstanding indebtedness and maintain sufficient liquidity for our investmentportfolio.  Based on current marketconditions, we believe a collateralized debt obligation, or CDO, could achieveour financing and return objectives, but we continue to carefully manage ourliquidity until such time as a CDO can be consummated.

 

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As of March 31, 2005,we held investments of approximately $601.7 million and net of fees, discounts,repayments, asset sales and unfunded commitments.  The aggregate carrying values, allocation byproduct type and weighted average coupons of our investments as of March 31,2005 were as follows:

 
| ** **                                     | ** ** | **Carrying Value  ($ in thousands)** | ** ** | **Allocation by  Investment  Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average  Spread over  LIBOR** | ** **      |
|------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------|------------|--------------------------------|------------|-------------------------------------------------|-----------------|
| Whole loans                                    |       | $                                         | 251,411    |                                | 42         | %                              | —     |                                            | 306             |  bps  |
| Subordinate  mortgage interests, floating rate |       | 224,273                                   |       | 37                                  | %          | —                         |       | 648                                             |  bps  |
| Subordinate  mortgage interests, fixed rate    |       | 34,700                                    |       | 6                                   | %          | 9.60                           | %          | —                                          |            |
| Mezzanine loans,  floating rate                |       | 65,992                                    |       | 11                                  | %          | —                         |       | 934                                             |  bps       |
| Mezzanine loans,  fixed rate                   |       | 2,729                                     |       | 0                                   | %          | 14.53                          | %          | —                                          |            |
| Preferred equity                               |       | 11,721                                    |       | 2                                   | %          | —                         |       | 900                                             |  bps  |
| Commercial  mortgage backed securities         |       | 10,921                                    |       | 2                                   | %          | 13.49                          | %          | —                                          |            |
| Total / Average                                |       | $                                         | 601,747    |                                | 100        | %                              | 10.76      | %                                               | 532             |  bps  |

** **

The following discussionrelated to our consolidated financial statements should be read in conjunctionwith the financial statements appearing in Item 8 of the Annual Report on Form 10-K.

 

**CriticalAccounting Policies**

** **

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

 

**Loans and Investments**

 

Loans held for investmentare intended to be held to maturity and, accordingly, are carried at cost, netof unamortized loan origination costs and fees, discounts, repayments, sales ofpartial interests in loans and unfunded commitments unless such loan orinvestment is deemed to be impaired. We invest in preferred equity intereststhat allow us to participate in a percentage of the underlying property’s cashflows from operations and proceeds from a sale or refinancing.  At the inception of each such investment, wemust determine whether such investment should be accounted for as a loan, jointventure or as an interest in real estate.

 

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

 

If upon completion of thevaluation, the fair value of the underlying collateral securing the impairedloan is less than the net carrying value of the loan, an allowance is createdwith a corresponding charge to the provision for loan losses.  The allowance for each loan is maintained ata level we believe is adequate to absorb probable losses.  There was no loan loss allowance at March 31,2005.

 

Our Manager evaluates our assets on a regular basis to determine ifthey continue to satisfy our investment criteria. Subject to certainrestrictions applicable to REITs, our Manager may cause us to sell ourinvestments opportunistically and use the proceeds of any such sale for debtreduction, additional acquisitions or working capital purposes.

 

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

 

In accordance withapplicable GAAP, mortgage-backed securities are classified asavailable-for-sale securities.  As aresult, changes in fair value will be recorded as a balance sheet adjustment toaccumulated other comprehensive income, which is a component of stockholdersequity, rather than through our statement of operations.  If available-for-sale securities wereclassified as trading securities, there could be substantially greatervolatility in earnings from period-to-period as these investments would bemarked to market and any reduction in the value of the securities versus theprevious carrying value would be considered an expense on our statement ofoperations.  We had no investments as of March 31,2005 that were accounted for as trading securities.

 

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

#### ** **

All mortgage-backedsecurities are carried on the balance sheet at fair value.  We determine the fair value ofmortgage-backed securities based on the types of securities in which we haveinvested.  For liquid, investment-gradesecurities, we consult with dealers of such securities to periodically obtainupdated market pricing for the same or similar instruments.  For non-investment grade securities, weactively monitor the performance of the underlying properties and loans andupdate our pricing model to reflect changes in projected cash flows.  The value of the securities is derived byapplying discount rates to such cash flows based on current market yields.  The yields employed are obtained from theexperience of our Manager 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 fair value of an available-for-sale security is less than theamortized cost, we consider whether there is an other-than-temporary impairmentin the value of the security (for example, whether the security will be soldprior 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.

 

#### **Revenue Recognition**

#### ** **

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

 

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.

 

Insome instances we may sell all or a portion of our investments to a thirdparty.  To the extent the fair valuereceived for an investment exceeds the amortized cost of that investment andFASB 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 other income.

 

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

#### ** **

The expense for possible credit losses in connection with debtinvestments is the charge to earnings to increase the allowance for possiblecredit losses to the level that management estimates to be adequate consideringdelinquencies, loss experience and collateral quality.  Other factors considered relate to geographictrends and project diversification, the size of the portfolio and current economicconditions.  Based upon these factors, weestablish the provision for possible credit losses by category of asset.  When it is probable that we will be unable tocollect all amounts contractually due, the account is considered impaired.

 

Where impairment isindicated, a valuation write-down or write-off is measured based upon theexcess of the recorded investment amount over the net fair value of thecollateral, as reduced by selling costs. Any deficiency between the carrying amount of an asset and the net salesprice of repossessed collateral is charged to the allowance for creditlosses.  As of March 31, 2005, wemaintained a balance of $0 in our reserve.

 

**Incentive Distribution (Class B LimitedPartner Interest)**

 

**The Class Blimited partner interests are entitled to receive an incentive return equal to25% of the amount by which funds from operations (as defined in the partnershipagreement of the Operating Partnership) plus certain accounting gains exceedthe product of our weighted average stockholders equity (as defined in thepartnership agreement of the Operating Partnership) multiplied by 9.5% (dividedby 4 to adjust for quarterly calculations).**  We willrecord any distributions on the Class B limited partner interests as anincentive distribution expense in the period when earned and when payment ofsuch amounts has become probable and reasonably

 

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**estimablein accordance 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.  No amounts wereearned or accrued with respect to the Class B limited partner interests asof March 31, 2005.**

** **

**Derivative Instruments**

** **

**In thenormal course of business, we use a variety of derivative instruments tomanage, or hedge, interest rate risk.  Werequire that hedging derivative instruments be effective in reducing theinterest rate risk exposure that they are designated to hedge.  This effectiveness is essential 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 approximation ofvalue, and such value may never actually be realized.**

** **

In the normal course of business, we are exposed to the effect ofinterest rate changes and limit these risks by following established riskmanagement policies and procedures 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 use a variety ofcommonly used derivative products that are considered plain vanilladerivatives.  These derivatives typicallyinclude interest rate swaps, caps, collars and floors.  We expressly prohibit the use ofunconventional derivative instruments and using derivative instruments fortrading or speculative purposes. Further, we have a policy of only entering into contracts with majorfinancial institutions based upon their credit ratings and other factors.

 

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

** **

We may employ swaps, forwards or purchased options to hedge qualifyingforecasted transactions.  Gains andlosses related to these transactions are deferred and recognized in net incomeas interest expense in the same period or periods that the underlyingtransaction occurs, expires or is otherwise terminated.

 

All hedges held by us are deemed to be highly effective in meeting thehedging objectives established by our corporate policy governing interest raterisk management.

 

**Income Taxes**

 

We have 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 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 adversely affectour 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.

 

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**Results of Operations**

 

***For the three months ended March 31,2005 (dollars in thousands)***

 

*Revenue*

 

Investment income of$10,250 for the three months ended March 31, 2005 was generated on ourwhole loans, senior mortgage interests, subordinate mortgage interests,mezzanine loans, preferred equity interests and CMBS investments.  $1,250 was earned on fixed rate investmentswith a weighted average yield of 10.76%. The remaining $9,000 relates to floating rate investments with aweighted average interest rate of LIBOR plus 5.32%.

 

Other income of $440 forthe three months ended March 31, 2005 is comprised primarily of incomerecorded on the sale of a senior mortgage interest of $413.  $27 represents interest earned on cashbalances.

 

*Expenses*

 

Interest expense was $2,801 for the three months ended March 31,2005, of which $2,297 represents interest on borrowings on our masterrepurchase facilities with Wachovia Capital Markets LLC and Goldman SachsMortgage Company which had a weighted average spread to LIBOR of 207 basispoints for the same period.  Theremaining balance in interest expense is comprised of $109 of interest expenserelated to our two interest rate swap contracts and $395 of amortization ofdeferred financing costs related, primarily, to the closing of our facilitieswith Wachovia and with Goldman.

 

Management fees of $1,668 for the three months ended March 31,2005 represents fees paid or payable to the Manager of $1,204 under ourmanagement agreement and fees paid or payable to SL Green OperatingPartnership, L.P. of $313 and $151 under our outsourcing and servicingagreements, respectively.  These fees andthe relationship between us, the Manager and SL Green Operating Partnership,L.P. are discussed further in “Related Party Transactions.”

 

Marketing, general and administrative expenses were $1,633 for thethree months ended March 31, 2005, which represents professional fees,stock-based compensation, insurance and general overhead costs.

 

Stock-based compensation expense included in marketing, general andadministrative expenses was $643 for the three months ended March 31,2005.  This represents the cost ofrestricted stock and options granted or to be granted to certain of ourexecutive officers and directors.  Of theshares of restricted stock issued, approximately 89% will vest equally over athree-year period and the remaining 11% will vest equally over a four-yearperiod.  Of the options granted, 59% willvest equally over a three-year period and the remaining 41% will vest equallyover a four-year period.  Thecompensation expense recorded for the three months ended March 31, 2005represents a ratable portion of the expense of the issuance of these sharesover their vesting period.

 

**Liquidity and Capital Resources**

 

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

** **

Our ability to meet our long-term liquidity and capital resourcerequirements will be subject to obtaining additional debt financing and equitycapital.  If we are unable to renew,replace or expand our sources of financing on substantially similar terms, itmay have an adverse effect on our business and results of operations.  In addition, an event of default is triggeredunder our repurchase facility with Wachovia Capital Markets LLC if themanagement agreement with GKK Manager LLC is terminated.  Depending on market conditions, our debtfinancing will be in the range of 70% to 80% of the carrying value of our totalassets.  Any indebtedness we incur willlikely be subject to continuing covenants and we will likely be required tomake continuing representations and warranties about our company in connectionwith such debt.  Our debt financing termsmay require us to keep uninvested cash on hand, or to maintain a certainportion of our assets free of liens, each of which could serve to limit ourborrowing ability.  Moreover, our debtmay be secured by our assets.  If wedefault in the 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 facilities will reduce ourliquidity and limit our ability to leverage our assets.

 

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To maintain our status as a REIT under the Internal Revenue Code, wemust distribute annually at least 90% of our taxable income.  These distribution requirements limit ourability to retain earnings and thereby replenish or increase capital foroperations.  However, we believe that oursignificant capital resources and access to financing will provide us withfinancial flexibility at levels sufficient to meet current and anticipatedcapital requirements, including funding new lending and investmentopportunities.

 

**Indebtedness**

** **

**The table below summarizes borrowings under our Wachovia and Goldmanrepurchase facilities at March 31, 2005 (dollars in thousands).**

** **

| ** **                              | ** ** | **March 31,** | ** ** |
|-----------------------------------------|------------|--------------------|------------|
| **Debt  Summary:**                      | ** ** | **2005**           | ** ** |
| **Balance**                             |       |               |       |
| Fixed rate                              |       | $                  | —     |   |
| Variable rate                           |       | 342,291            |       |
| Total                                   |       | $                  | 342,291    |   |
|                                    |       |               |       |
| Effective  interest rate for the period |       | LIBOR + 2.07       | %          |

** **

**Repurchase Facilities**

** **

We currently have two repurchase facilitieswith an aggregate of $700 million of total debt capacity.  In August 2004 we closed on a $250million repurchase facility with Wachovia Capital Markets LLC.  This facility was then increased to $350million on January 3, 2005 and subsequently increased to $500 million on April 22,2005.  As part of the April 2005increase to $500 million, the initial term of this facility was modified toreflect a staggered term in which $250 million matures in August 2007,$150 million matures in December 2007 and the remaining $100 millionmatures in June 2008.  Also inconjunction with the April 2005 upsize, the $50 million credit facility wepreviously maintained with Wachovia was consolidated into the $500 millionrepurchase facility.  The $500 million facility bears interest atspreads of 1.25% to 3.50% over 30-day LIBOR and, based on our investmentactivities, provides for advance rates that vary from 50% to 95% based upon thecollateral provided under a borrowing base calculation.  The lender has a consent right with respectto the inclusion of investments in this facility, determines periodically themarket value of the investments, and has the right to require additionalcollateral if the estimated market value of the included investments declines.   At March 31, 2005 we had an outstandingbalance of $296.2 million on this facility at a weighted average spread toLIBOR of 2.12%.

 

**On January 3, 2005 we closed an additional repurchase facility of$200 million with Goldman Sachs Mortgage Company, an affiliate of Goldman Sachs &Co.  This facility has an initial term ofthree years with one six-month extension option.  This facility bears interest at spreads of1.125% to 2.75% over a 30-day LIBOR and, based on our investment activities,provides for advance rates that vary from 75% to 90% based upon the collateralprovided under a borrowing base calculation. As with the Wachovia repurchase facility, the lender has a consent rightto the inclusion of investments in this facility, determines periodically themarket value of the investments, and has the right to require additionalcollateral if the estimated market value of the included investments declines.At March 31, 2005 we had an outstanding balance of $46.1 million on thisrepurchase facility at a weighted average spread to LIBOR of 1.80%.**

** **

The repurchase facilities require that we pay down borrowings underthese facilities as principal payments on our loans and investments arereceived.

 

**Assets pledged as collateral under thesefacilities may include stabilized and transitional first mortgage whole loans,first mortgage B-notes, mezzanine loans, and rated CMBS or commercial realestate CDO securities originated or acquired by us.**

** **

**Credit Facility**

** **

We currently have one $25million credit facility with WachoviaCapital Markets LLC. with a term of two years.  Amounts drawn under this facility forliquidity purposes bear interest at a spread over LIBOR of 525 basispoints.  Amounts drawn under thisfacility for acquisition purposes bear interest at a spread over LIBOR of 225basis points.  Amounts drawn under thisfacility for liquidity purposes must be repaid within 105 days.  Amounts drawn under this facility generallywill be secured by assets established under a borrowing base calculation unlesscertain financial covenants are satisfied. These covenants are generally more restrictive than those set forthbelow.  At March 31, 2005 we did nothave any borrowings under our credit facilities.

 

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

 

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**Restrictive Covenants**

** **

**The terms of both of our repurchase facilities and our credit facilityinclude covenants that (a) limit our maximum total indebtedness to no morethan 85% of our total assets, (b) require us to maintain minimum liquidityof at least $10 million for the first two years and $15 million thereafter, (c) ourfixed charge coverage ratio shall at no time be less than 1.50 to 1.00, (d) ourminimum interest coverage ratio shall at no time be less than 1.75 to 1.00, (e) requireus to maintain minimum tangible net worth of not less than the greater of (i) $129.75million, or (i) plus (ii) 75% of the proceeds of our subsequentequity issuances and (f) restrict the maximum amount of our totalindebtedness.  The covenants alsorestrict us from making distributions in excess of a maximum of 103% of ourfunds from operations (as defined by the National Association of Real EstateInvestment Trusts) through July 2005 and 100% thereafter, except that wemay in any case pay distributions necessary to maintain our REIT status.  Under our facilities with Wachovia CapitalMarkets LLC, an event of default will be triggered if GKK Manager LLC ceases tobe the Manager.  As of March 31,2005, we were in compliance with all such covenants.**

** **

To maintain our status as a REIT under the Internal Revenue Code, wemust distribute annually at least 90% of our taxable income.  These distribution requirements limit ourability to retain earnings and thereby replenish or increase capital foroperations.  However, we believe that oursignificant capital resources and access to financing will provide us withfinancial flexibility at levels sufficient to meet current and anticipatedcapital requirements, including funding new lending and investmentopportunities.

 

**Capitalization**

** **

As of March 31, 2005, we had 18,833,000 shares of common stockoutstanding.

 

**Market Capitalization**

 

At March 31, 2005,borrowings under our repurchase facilities and our revolving credit facilitiesrepresented 48% of our consolidated market capitalization of $710 million(based on a common stock price of $19.50 per share, the closing price of ourcommon stock on the New York Stock Exchange on March 31, 2005).  Market capitalization includes ourconsolidated debt and common stock.

 

**ContractualObligations**

 

Combinedaggregate principal maturities of borrowings under our repurchase facilitiesand revolving credit facility and our obligations under our operating lease asof March 31, 2005 are as follows (in thousands):

 

| ** ** | ** ** | **Repurchase  Facilities** | ** ** | **Revolving  Credit  Facility** | ** ** | **Operating  Leases** | ** ** | **Total** | ** ** |
|------------|------------|----------------------------|------------|---------------------------------|------------|-----------------------|------------|-----------|------------|
| 2005       |       | $                          | —     |                            | $          | —                |       | $         | 145        |   | $ | — |   |
| 2006       |       | —                     |       | —                          |       | 252                   |       | —    |       |
| 2007       |       | 296,167                    |       | —                          |       | 256                   |       | 296,167   |       |
| 2008       |       | 46,124                     |       | —                          |       | 261                   |       | 46,124    |       |
| 2009       |       |                       |       |                            |       | 265                   |       |      |       |
| Thereafter |       |                       |       |                            |       | 1,633                 |       |      |       |
|       |       | $                          | 342,291    |                            | —     |                  | $          | 2,812     |       | $ | 342,291 |   |
|            |            |                            |            |                                 |            |                       |            |           |            |  |  |  |  |

 

**Dividends**

 

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

 

**RelatedParty Transactions**

 

In connection with ourinitial public offering, we entered into a Management Agreement with GKKManager LLC, which provides for an initial term through December 2007 withautomatic one-year extension options and is subject to certain terminationrights.  We pay

 

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the Manager an annualmanagement fee equal to 1.75% of our gross stockholders equity (as defined inthe Management Agreement).  For the threemonths ended March 31, 2005, we paid or had payable an aggregate ofapproximately $1,204 to the Manager under this agreement.

 

The Manager and SL GreenOperating Partnership, L.P., hold 17 units and 83 units, respectively, of the Class Blimited partner interests of the Operating Partnership. SL Green OperatingPartnership, L.P. intends to own at least 70 units of the Class B limitedpartner interests. To provide an incentive for the Manager to enhance the valueof the common stock, the Manager and SL Green Operating Partnership, L.P. areentitled through their ownership of Class B limited partner interests ofthe Operating Partnership to an incentive return equal to 25% of the amount bywhich funds from operations (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).  We will recordany distributions 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.  No amounts wereearned or accrued with respect to such Class B limited partner intereststhrough March 31, 2005.

 

We are obligated to reimburse the Manager for its costs incurred underan Asset Servicing Agreement and a separate Outsourcing Agreement between ourManager and SL Green Operating Partnership, L.P.  The Asset Servicing Agreement provides for anannual fee payable by us of 0.15% of the carrying value of our investments,excluding certain defined investments for which other servicing arrangementsare executed and further reduced by fees paid directly to outside servicers byus which have been approved by SL Green Operating Partnership, L.P.  The Outsourcing Agreement provides a feepayable by us of $1,250 per year, increasing 3% annually over the prioryear.  For the three months ended March 31,2005, we paid or had payable an aggregate of $313 and $151 to our Manager underthe Outsourcing and Asset Servicing Agreements, respectively.

 

In connection with the5,500,000 shares of common stock that were sold on December 3, 2004 andsettled on December 31, 2004 and January 3, 2005 in a private placement, wehave agreed to pay the Manager a fee of $1,000 as compensation for financialadvisory, structuring and costs incurred on our behalf.  This fee has been recorded as a reduction inthe proceeds of the private placement.  Apartfrom legal fees and stock clearing charges of $245, no other fees were paid byus to an investment bank, broker/dealer or other financial advisor in connectionwith the private placement, resulting in total costs of 1.3% of total grossproceeds.

 

On March 31, 2005 we posted a deposit of $5 million to SL Green for apotential equity investment in a joint venture. On April 29, 2005, we closed on a $57.5 million investment in a jointventure with SL Green to acquire, own and operate the South Building located atOne Madison Avenue, New York, New York, or the Property.  The joint venture, which was created toacquire, own and operate the Property, is owned 45% by a wholly-ownedsubsidiary of us and 55% by a wholly-owned subsidiary of SL Green; the jointventure interests are pari passu.  Alsoon April 29, 2005, the joint venture completed the acquisition of the Propertyfrom Metropolitan Life Insurance Company for the purchase price of $802.8million plus closing costs, financed in part through a $690.0 million firstmortgage loan on the Property.  TheProperty comprises approximately 1.2 million square feet and is almost entirelynet leased to Credit Suisse First Boston (USA), or CSFB, pursuant to a leasewith a 15-year remaining term.

 

**Effective May 1, 2005 we are party to a lease agreement with SLGGraybar Sublease LLC, an affiliate of SL Green Realty Corp., for our corporateoffices at 420 Lexington Avenue, New York, NY. The lease is for approximately five thousand square feet with an optionto lease an additional approximately two thousand square feet and carries aterm of ten years with rents of approximately $249 per annum for year onerising to $315 per annum in year ten.**

** **

**Bright Star Couriers LLC, or Bright Star, provides messenger services tous.  Bright Star is owned by Gary Green,a son of Stephen L. Green.  The aggregateamount of fees paid by us for such services for the three months ended March 31,2005 was less than $1.**

** **

**SL Green Operating Partnership, L.P. has invested $75,000 in a preferredequity interest that is subordinate to one of our investments with a book valueof $62,086 as of March 31, 2005.**

** **

**Fundsfrom Operations**

 

FFO is a widely recognizedmeasure of REIT performance.  We computeFFO in accordance with standards established by the National Association ofReal Estate Investment Trusts, or NAREIT, which may not be comparable to FFOreported by other REITs that do not compute FFO in accordance with the NAREITdefinition, or that interpret the NAREIT definition differently than wedo.  The revised White Paper on FFOapproved by the Board of Governors of NAREIT in April 2002 defines FFO asnet income (loss) (computed in accordance with GAAP), excluding gains (orlosses) from debt restructuring and sales of properties, plus real estaterelated depreciation and amortization and after adjustments for unconsolidatedpartnerships and joint ventures.  We presentFFO

 

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because we consider it animportant supplemental measure of our operating performance and believe that itis frequently used by securities analysts, investors and other interestedparties in the evaluation of REITS.  Wealso use FFO as one of several criteria to determine performance-based bonusesfor members of our senior management. FFO is intended to exclude GAAP historical cost depreciation andamortization of real estate and related assets, which assumes that the value ofreal estate assets diminishes ratably over time.  Historically, however, real estate valueshave risen or fallen with market conditions. Because FFO excludes depreciation and amortization unique to realestate, gains and losses from property dispositions and extraordinary items, itprovides a performance measure that, when compared year over year, reflects theimpact to operations from trends in occupancy rates, rental rates, operatingcosts, interest costs, providing perspective not immediately apparent from netincome.  FFO does not represent cashgenerated from operating activities in accordance with GAAP and should not beconsidered as an alternative to net income (determined in accordance withGAAP), as an indication of our financial performance or to cash flow fromoperating activities (determined in accordance with GAAP) as a measure of ourliquidity, nor is it indicative of funds available to fund our cash needs,including our ability to make cash distributions.

 

Funds from Operations forthe three months ended March 31, 2005 is as follows (in thousands):

 

| ** **                                                                                  | ** ** | **Three Months  Ended  March 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| Net income  available to common stockholders                                                |       | $                                             | 4,566      |   |
| Add:                                                                                        |       |                                          |       |
| Depreciation and  amortization                                                              |       | 417                                           |       |
| Less:                                                                                       |       |                                          |       |
| Amortization of  deferred financing costs and depreciation on non-rental real estate assets |       | (417                                          | )          |
| Funds from  operations – basic                                                         |       | 4,566                                         |       |
| Dividends on  preferred shares                                                              |       | —                                        |       |
| Funds from  operations – diluted                                                       |       | $                                             | 4,566      |   |
| Cash flows  provided by operating activities                                                |       | $                                             | 1,450      |   |
| Cash flows used  in investing activities                                                    |       | $                                             | (195,367   | ) |
| Cash flows  provided by financing activities                                                |       | $                                             | 159,244    |   |

 

**Forward-Looking Information**

 

This report includescertain statements that may be deemed to be “forward-looking statements” withinthe meaning of Section 27A of the Securities Act of 1933, as amended, orthe Act, and Section 21E of the Securities Exchange Act of 1934, asamended, or the Exchange Act.  Suchforward-looking statements relate to, without limitation, our future capitalexpenditures, dividends and acquisitions (including the amount and naturethereof) and other trends of the real estate industry, debt capital andcommercial markets, business strategies, and the expansion and growth of ouroperations.  These statements are basedon certain assumptions and analyses made by us in light of our Manager’sexperience and our Manager’s perception of historical trends, currentconditions, expected future developments and other factors we believe areappropriate.  We intend suchforward-looking statements to be covered by the safe harbor provisions forforward-looking statements contained in Section 27A of the Act and Section 21Eof the Exchange Act.  Such statements aresubject to a number of assumptions, risks and uncertainties which may cause ouractual results, performance or achievements to be materially different fromfuture results, performance or achievements expressed or implied by theseforward-looking statements. Forward-looking statements are generally identifiable by the use of thewords “may,” “will,” “should,” “expect,” “anticipate,” “estimate,” “believe,” “intend,”“project,” “continue,” or the negative of these words, or other similar wordsor terms.  Readers are cautioned not toplace undue reliance on these forward-looking statements.  These assumptions, risks and uncertaintiesinclude, but are not limited to:

 

•      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;

 

•      GKK Manager LLCremaining as our Manager;

 

•      our ability toqualify as a REIT in any taxable year;

 

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

 

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

 

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

 

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

 

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**ITEM 3.  Quantitative and Qu**alitativeDisclosure About Market Risk

** **

Market risk includesrisks that arise from changes in interest rates, commodity prices, equityprices and other market changes that affect market sensitive instruments.  In pursuing our business plan, we expect thatthe primary market risks to which we will be exposed are real estate andinterest rate risks.

 

#### **Real Estate Risk**

#### ** **

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

 

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

###### ** **

Interest rate risk is highly sensitive to many factors, includinggovernmental monetary and tax policies, domestic and international economic andpolitical considerations and other factors beyond our control.

 

Our operating resultswill depend in large part on differences between the income from our assets andour borrowing costs.  Most of our assetsand borrowings are expected to be variable-rate instruments that we willfinance with variable rate debt.  Theobjective of this strategy is to minimize the impact of interest rate changeson the spread between the yield on our assets and our cost of funds.  We enter into hedging transactions withrespect to all liabilities relating to fixed rate assets in the future.  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 our assets to market 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 may be 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 of our strategies to date, our netincome will generally increase if LIBOR increases and decreases if LIBORdecreases, but this may not always be true in the future.  Our exposure to interest rates will also beaffected by our overall corporate leverage, which we anticipate will be 70% to80% of the carrying value of our assets; but our actual leverage depends on ourmix of assets.

 

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

 

**ITEM 4.  Controls and P**rocedures

** **

**Evaluation of Disclosure Controls and Procedures**

** **

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in our Exchange Act reports is recorded, processed, summarizedand reported within the time periods specified in the SEC’s rules andforms, and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure basedclosely on the definition of “disclosure controls and procedures” in Rule 13a-15(e).  In designing and evaluating the disclosurecontrols and procedures, management recognized that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.  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.

 

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

 

**Changes in Internal Controls over Financial Reporting**

** **

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

 

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**PART II****OTHERINFOR****MATION**

 

##### **ITEM 1.**  LEGAL PROCEEDINGS

##### ** **

See Note 12 to theConsolidated Financial Statements

 

##### **ITEM2.**  CHANGESIN SECURITIES AND USE OF PROCEEDS

##### ** **

None

 

#### **ITEM3.**  DEFAULTSUPON SENIOR SECURITIES

#### ** **

None

 

#### **ITEM4.**  SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

#### ** **

None

 

#### **ITEM5.**  OTHERINFORMATION

#### ** **

None

 

**ITEM 6.****  EXHIBITS****AND REPORTS ON FORM 8-K**

 

(a)           Exhibits:

 

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

** **

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

** **

**4.1 Specimen Common Stock Certificate, incorporated by reference to theCompany’s Registration Statement on Form S-11 (No. 333-114673),declared effective by the Commission on July 27, 2004.**

** **

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

** **

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

** **

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

** **

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

** **

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

** **

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

 

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

 

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

** **

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

** **

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

** **

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

** **

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

** **

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

** **

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

** **

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

** **

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

** **

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

** **

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

** **

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

 

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

 

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

 

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

 

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**SIGNATURES**

 

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

 

 
|   | GRAMERCY CAPITAL CORP. |
|--------|------------------------|
|   |                   |
|   |                   |
|   | By:                    |    /s/  Robert R. Foley |   |
|   |                   | Robert R. Foley |
|   |                   | Chief Financial Officer |
|   |                   |
|   |                   |   |
| Date:  | May 11, 2005      |   |

 

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