**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

ý**            QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30,2005**

 

**or**

 

o**            TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from       to     .**

 

**Commission File No.  001-32248**

 

**GRAMERCYCAPITAL CORP.**

(Exact name of registrant as specified in itscharter)

 

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

 

**420 Lexington Avenue, New York, New York10170**

(Address of principal executive offices - zipcode)

 

**(212) 297-1000**

(Registrant’s telephone number, including areacode)

 

 

 

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

 

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

 

The number of shares outstanding of theregistrant’s common stock, $0.001 par value, was 22,794,309 at November 9,2005.

 

 

----

 

 

**GRAMERCY CAPITAL CORP.**

 

**INDEX**

 

 
| ** **     | ** **                                                                                                                                                                                                                     | ** ** |
|----------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|           |                                                                                                                                                                                                                           | ** ** |
| **PART I.**    | **FINANCIAL INFORMATION**                                                                                                                                                                                                      | ** ** |
| ** **     | ** **                                                                                                                                                                                                                     | ** ** |
| **ITEM 1.**    | **FINANCIAL STATEMENTS**                                                                                                                                                                                                       | ** ** |
| ** **     | ** **                                                                                                                                                                                                                     | ** ** |
|           | Consolidated Balance Sheets as of September 30, 2005 (unaudited) and  December 31, 2004                                                                                                                                        |       |
|           |                                                                                                                                                                                                                           |       |
|           | Consolidated Statements of Income for the three months  ended September 30, 2005 and 2004 and the nine months ended September 30,  2005 and the period from April 12, 2004 (formation) through September 30,  2004 (unaudited) |       |
|           |                                                                                                                                                                                                                           |       |
|           | Consolidated  Statement of Stockholders’ Equity for the nine months ended September 30,  2005 (unaudited)                                                                                                                 |       |
|           |                                                                                                                                                                                                                           |       |
|           | Consolidated Statements of Cash Flows for the nine  months ended September 30, 2005 and the period from April 12, 2004  (formation) through September 30, 2004 (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.**    | **UNREGISTERED  SALES OF EQUITY 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**                                                                                                                                                                                                                   |       |
|           |                                                                                                                                                                                                                           |       |
| **Signatures** |                                                                                                                                                                                                                           |

 

 

2

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

###### **ITEM1.**                                                     FinancialStatements

 

**Gramercy Capital Corp.**

**ConsolidatedBalance Sheets**

**(Amounts in thousands, except share and pershare data)**

 

** **
| ** **                                                                                                                                                                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                                                                                                                              | ** ** | **2005**          | ** ** | **2004**         | ** ** |
| ** **                                                                                                                                                                              | ** ** | **(Unaudited)**   | ** ** | ** **       | ** ** |
| **Assets:**                                                                                                                                                                             |       |              |       |             |       |
| Cash and  cash equivalents                                                                                                                                                              |       | $                 | 25,311     |             | $          | 39,094 |   |
| Restricted  cash                                                                                                                                                                        |       | 253,797           |       | 1,901            |       |
| Loans and  other lending investments, net                                                                                                                                               |       | 878,652           |       | 395,717          |       |
| Commercial  mortgage backed securities, net                                                                                                                                             |       | 10,999            |       | 10,898           |       |
| Investment  in unconsolidated joint venture                                                                                                                                             |       | 56,930            |       | —           |       |
| Loans held  for sale, net                                                                                                                                                               |       | 46,750            |       | —           |       |
| Operating  real estate, net                                                                                                                                                             |       | 51,259            |       | —           |       |
| Stock  subscriptions receivable                                                                                                                                                         |       | —            |       | 60,445           |       |
| Accrued  interest                                                                                                                                                                       |       | 6,347             |       | 2,921            |       |
| Deferred  financing costs                                                                                                                                                               |       | 17,880            |       | 2,044            |       |
| Deferred  costs                                                                                                                                                                         |       | 948               |       | 189              |       |
| Derivative  instruments, at fair value                                                                                                                                                  |       | 2,417             |       | 249              |       |
| Other assets                                                                                                                                                                            |       | 1,374             |       | 589              |       |
| Total assets                                                                                                                                                                            |       | $                 | 1,352,664  |             | $          | 514,047 |   |
|                                                                                                                                                                                    |       |              |       |             |       |
| **Liabilities  and Stockholders’ Equity:**                                                                                                                                         |       |              |       |             |       |
| Credit  facilities                                                                                                                                                                      |       | $                 | —     |             | $          | 238,885 |   |
| Collateralized  debt obligation                                                                                                                                                         |       | 810,500           |       | —           |       |
| Mortgage  note payable                                                                                                                                                                  |       | 41,000            |       | —           |       |
| Management  fees payable                                                                                                                                                                |       | 1,289             |       | 416              |       |
| Incentive  fee payable                                                                                                                                                                  |       | 1,038             |       | —           |       |
| Dividends  payable                                                                                                                                                                      |       | 10,159            |       | 1,951            |       |
| Accounts  payable and accrued expenses                                                                                                                                                  |       | 12,439            |       | 1,935            |       |
| Other  liabilities                                                                                                                                                                      |       | 4,779             |       | 1,901            |       |
| Junior subordinated deferrable interest debentures held by trusts  that issued trust preferred securities                                                                               |       | 100,000           |       | —           |       |
| Total  liabilities                                                                                                                                                                      |       | 981,204           |       | 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,  22,794,309 and 18,812,500 shares issued  and outstanding at September 30, 2005 and December 31, 2004, respectively |       | 23                |       | 19               |       |
| Additional  paid-in-capital                                                                                                                                                             |       | 368,931           |       | 268,558          |       |
| Accumulated  other comprehensive income                                                                                                                                                 |       | 2,506             |       | 282              |       |
| Retained  earnings                                                                                                                                                                      |       | —            |       | 100              |       |
| Total stockholders’ equity                                                                                                                                                         |       | 371,460           |       | 268,959          |       |
| Total  liabilities and stockholders’ equity                                                                                                                                        |       | $                 | 1,352,664  |             | $          | 514,047 |   |
|                                                                                                                                                                                         |            |                   |            |                  |            |  |  |  |  |  |  |

 

 

The accompanying notes are anintegral part of these financial statements.

 

3

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**Gramercy Capital Corp.**

**ConsolidatedStatements of Income**

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

 
| ** **                                                                                              | ** ** | **For the Three  Months Ended  September 30, 2005** | ** ** | **For the Three  Months Ended  September 30, 2004** | ** ** | **For the Nine  Months Ended  September 30, 2005** | ** ** | **For the Period  April 12, 2004  (formation)  through  September 30,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| **Revenues**                                                                                            |       |                                                |       |                                                |       |                                               |       |                                                                          |       |
| Investment income                                                                                       |       | $                                                   | 21,060     |                                                | $          | 1,227                                              |       | $                                                                             | 46,999     |   | $ | 1,227 |   |
| Rental revenue,  net                                                                                    |       | 314                                                 |       | —                                              |       | 314                                                |       | —                                                                        |       |
| Other income                                                                                            |       | 5,218                                               |       | 245                                                 |       | 8,727                                              |       | 245                                                                           |       |
| Total revenues                                                                                          |       | 26,592                                              |       | 1,472                                               |       | 56,040                                             |       | 1,472                                                                         |       |
|                                                                                                    |       |                                                |       |                                                |       |                                               |       |                                                                          |       |
| **Expenses**                                                                                            |       |                                                |       |                                                |       |                                               |       |                                                                          |       |
| Interest expense                                                                                        |       | 11,250                                              |       | 63                                                  |       | 20,316                                             |       | 63                                                                            |       |
| Management fees                                                                                         |       | 2,726                                               |       | 786                                                 |       | 6,264                                              |       | 786                                                                           |       |
| Incentive fee                                                                                           |       | 1,038                                               |       | —                                              |       | 1,038                                              |       | —                                                                        |       |
| Depreciation and  amortization                                                                          |       | 105                                                 |       | 5                                                   |       | 232                                                |       | 5                                                                             |       |
| Marketing,  general and administrative                                                                  |       | 1,456                                               |       | 332                                                 |       | 4,722                                              |       | 332                                                                           |       |
| Provision for  loan loss                                                                                |       | 430                                                 |       | —                                              |       | 955                                                |       | —                                                                        |       |
| Total expenses                                                                                          |       | 17,005                                              |       | 1,186                                               |       | 33,527                                             |       | 1,186                                                                         |       |
| Income from  continuing operations before equity in net loss of unconsolidated joint  venture and taxes |       | 9,587                                               |       | 286                                                 |       | 22,513                                             |       | 286                                                                           |       |
| Equity in net  loss of unconsolidated joint venture                                                     |       | (510                                                | )          | —                                              |       | (914                                               | )          | —                                                                        |       |
| Income from  continuing operations before taxes and GKK formation costs                                 |       | 9,077                                               |       | 286                                                 |       | 21,599                                             |       | 286                                                                           |       |
| Provision for  taxes                                                                                    |       | (500                                                | )          | —                                              |       | (1,000                                             | )          | —                                                                        |       |
| GKK formation  costs                                                                                    |       | —                                              |       | 275                                                 |       | —                                             |       | 275                                                                           |       |
| Net income  available to common stockholders                                                            |       | $                                                   | 8,577      |                                                | $          | 11                                                 |       | $                                                                             | 20,599     |   | $ | 11 |   |
|                                                                                                    |       |                                                |       |                                                |       |                                               |       |                                                                          |       |
| **Basic earnings per share:**                                                                           |       |                                                |       |                                                |       |                                               |       |                                                                          |       |
| Net income  available to common stockholders                                                            |       | $                                                   | 0.44       |                                                | $          | 0.00                                               |       | $                                                                             | 1.08       |   | $ | 0.00 |   |
| **Diluted earnings per share:**                                                                         |       |                                                |       |                                                |       |                                               |       |                                                                          |       |
| Net income  available to common stockholders                                                            |       | $                                                   | 0.41       |                                                | $          | 0.00                                               |       | $                                                                             | 1.05       |   | $ | 0.00 |   |
| Dividends per common  share                                                                             |       | $                                                   | 0.45       |                                                | $          | 0.00                                               |       | $                                                                             | 1.02       |   | $ | 0.00 |   |
| Basic weighted  average common shares outstanding                                                       |       | 19,603                                              |       | 13,313                                              |       | 19,093                                             |       | 13,313                                                                        |       |
| Diluted weighted  average common shares and common share equivalents outstanding                        |       | 20,788                                              |       | 13,321                                              |       | 19,618                                             |       | 13,321                                                                        |       |

 

 

 

 

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)**

 
| ** **                                     | ** ** | ** ** | ** ** | ** **     | ** ** | ** **        | ** ** | ** **      | ** ** | ** **   | ** ** | ** **        | ** ** |
|------------------------------------------------|------------|------------|------------|----------------|------------|-------------------|------------|-----------------|------------|--------------|------------|-------------------|------------|
| ** **                                     | ** ** | ** ** | ** ** | ** **     | ** ** | ** **        | ** ** | ** **      | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | ** **     | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Common** | ** ** | **Additional** | ** ** | **Other**         | ** ** | ** **      | ** ** | ** **   | ** ** | ** **        | ** ** |
| ** **                                     | ** ** | **Stock**  | ** ** | **Paid-**      | ** ** | **Comprehensive** | ** ** | **Retained**    | ** ** | ** **   | ** ** | **Comprehensive** | ** ** |
| ** **                                     | ** ** | **Shares** | ** ** | **Par Value**  | ** ** | **In-Capital**    | ** ** | **Income**      | ** ** | **Earnings** | ** ** | **Total**         | ** ** | **Income** | ** ** |
| **Balance  at  December 31, 2004**             |       | 18,813     |       | $              | 19         |              | $          | 268,558         |       | $            | 282        |              | $          | 100 |   | $ | 268,959 |   |   |   |
| Net income                                     |       |       |       |           |       |              |       |            |       | 20,599       |       | 20,599            |       | $ | 20,599 |   |
| Net unrealized gain on  derivative instruments |       |       |       |           |       |              |       | 2,224           |       |         |       | 2,224             |       | 2,224 |   |
| Net proceeds from common  stock offerings      |       | 3,833      |       | 4              |       | 96,585            |       |            |       |         |       | 96,589            |       |   |   |
| Stock-based compensation  — fair value    |       |       |       |           |       | 1,031             |       |            |       |         |       | 1,031             |       |   |   |
| Proceeds from stock  option exercises          |       | 128        |       | —         |       | 1,920             |       |            |       |         |       | 1,920             |       |   |   |
| Deferred compensation  plan, net               |       | 20         |       | —         |       | 881               |       |            |       |         |       | 881               |       |   |   |
| Cash distributions  declared                   |       |       |       |           |       | (44               | )          |            |       | (20,699      | )     | (20,743           | )     |   |   |
| **Balance  at  September 30, 2005**            |       | 22,794     |       | $              | 23         |              | $          | 368,931         |       | $            | 2,506      |              | $          | — |   | $ | 371,460 |   | $ | 22,823 |   |
|                                                |            |            |            |                |            |                   |            |                 |            |              |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |

 

 

 

 

The accompanying notesare an integral part of these financial statements

 

 

 

5

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

** **
| ** **                                                                                                          | ** ** | **For the Nine  Months Ended  September 30,  2005** | ** ** | **For the Period  April 12, 2004  (formation)  through  September 30,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| **Operating  Activities**                                                                                           | ** ** | ** **                                          | ** ** | ** **                                                                    | ** ** |
| Net income  available to common stockholders                                                                        |       | $                                                   | 20,599     |                                                                          | $          | 11 |   |
| Adjustments to reconcile net income available to common stockholders  to net cash provided by operating activities: |       |                                                |       |                                                                          |       |
| Depreciation and amortization                                                                                       |       | 1,966                                               |       | 5                                                                             |       |
| Amortization of discount on investments                                                                             |       | (772                                                | )          | 42                                                                            |       |
| Equity in net income of unconsolidated  joint venture                                                               |       | 914                                                 |       | —                                                                        |       |
| Provision for loan losses                                                                                           |       | 955                                                 |       | —                                                                        |       |
| Changes in  operating assets and liabilities:                                                                       |       |                                                |       |                                                                          |       |
| Accrued interest                                                                                                    |       | (3,426                                              | )          | (695                                                                          | )          |
| Other assets                                                                                                        |       | (924                                                | )          | (521                                                                          | )          |
| Management fees payable                                                                                             |       | 873                                                 |       | 786                                                                           |       |
| Incentive fee payable                                                                                               |       | 1,038                                               |       | —                                                                        |       |
| Accounts payable, accrued expenses and  other liabilities                                                           |       | 11,303                                              |       | 1,174                                                                         |       |
| Net cash  provided by operating activities                                                                          |       | 32,526                                              |       | 802                                                                           |       |
| **Investing  Activities**                                                                                           |       |                                                |       |                                                                          |       |
| New  investment originations                                                                                        |       | (733,902                                            | )          | (122,306                                                                      | )          |
| Principal  collections on investments                                                                               |       | 203,701                                             |       | —                                                                        |       |
| Investment  in operating real estate                                                                                |       | (50,496                                             | )          | —                                                                        |       |
| Investment  in joint venture                                                                                        |       | (57,844                                             | )          | —                                                                        |       |
| Change in  restricted cash for investments                                                                          |       | (250,663                                            | )          | —                                                                        |       |
| Deferred investment  costs                                                                                          |       | (759                                                | )          | (1,535                                                                        | )          |
| Net cash  used in investing activities                                                                              |       | (889,963                                            | )          | (123,841                                                                      | )          |
| **Financing  Activities**                                                                                           |       |                                                |       |                                                                          |       |
| Proceeds  from credit facilities                                                                                    |       | 676,290                                             |       | —                                                                        |       |
| Repayments  of credit facilities                                                                                    |       | (915,175                                            | )          | —                                                                        |       |
| Proceeds  from issuance of collateralized debt obligation                                                           |       | 810,500                                             |       | —                                                                        |       |
| Proceeds  from mortgage note payable                                                                                |       | 41,000                                              |       | —                                                                        |       |
| Settlement  of derivative instrument                                                                                |       | 320                                                 |       | —                                                                        |       |
| Proceeds  from stock options exercised                                                                              |       | 1,920                                               |       | —                                                                        |       |
| Net proceeds  from sale of common stock                                                                             |       | 158,912                                             |       | 173,240                                                                       |       |
| Issuance of  trust preferred securities                                                                             |       | 100,000                                             |       | —                                                                        |       |
| Deferred  financing costs                                                                                           |       | (17,575                                             | )          | —                                                                        |       |
| Dividends  paid                                                                                                     |       | (12,538                                             | )          | —                                                                        |       |
| Net cash  provided by financing activities                                                                          |       | 843,654                                             |       | 173,240                                                                       |       |
| Net  (decrease) / increase in cash and cash equivalents                                                             |       | (13,783                                             | )          | 50,201                                                                        |       |
| Cash and  cash equivalents at beginning of period                                                                   |       | 39,094                                              |       | 200                                                                           |       |
| Cash and  cash equivalents at end of period                                                                         |       | $                                                   | 25,311     |                                                                          | $          | 50,401 |   |

 

 

 

 

Theaccompanying notes are an integral part of these financial statements.

 

 

6

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**Gramercy Capital Corp.Notes To Consolidated Financial Statements(Unaudited, amounts in thousands, except share and per share data)September 30, 2005**

 

 

**1.  Organization**

 

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

 

Substantially all of Gramercy’soperations are conducted through GKK Capital LP, a Delaware limitedpartnership, or 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 andadvised by GKK Manager LLC, or the Manager, a majority-owned subsidiary of SLGreen Realty Corp., or SL Green.  AtSeptember 30, 2005, SL Green also owned approximately 25% of the outstandingshares of our common stock. We qualified as a real estate investment trust, orREIT, under the Internal Revenue Code commencing with our taxable year endingDecember 31, 2004 and expect to qualify for the current fiscal year.  To maintain our tax status as a REIT, we planto 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 September 30, 2005, weheld loans and other lending investments of approximately $936,401 net of fees,discounts, repayments, asset sales and unfunded commitments with an averagespread to LIBOR of 475 basis points for our floating rate investments and anaverage yield of 8.97% for our fixed rate investments.  As of September 30, 2005 we also held: (i) a$56,930 investment in an unconsolidated joint venture that owns the SouthBuilding located at One Madison Avenue in New York, New York, which is occupiedalmost entirely by Credit Suisse First Boston (USA), Inc., or CSFB, under a netlease with a 15 year remaining term; and (ii) a $51,259 investment in a 200,000square foot building in Somerset, New Jersey which is 100% net leased toPhilips Holding USA Inc, a wholly-owned subsidiary of Royal PhilipsElectronics, through December 2021.

 

**Basis of QuarterlyPresentation**

The accompanying financial statements havebeen prepared in accordance with accounting principles generally accepted inthe United States for interim financial information and with the instructionsto Form 10-Q and Article 10 of Regulation S-X. Accordingly, it does not include all of the information and footnotesrequired by accounting principles generally accepted in the United States, orGAAP, for complete financial statements. In management’s opinion, all adjustments (consisting of normal recurringaccruals) considered necessary for fair presentation have been included.  The 2005 operating results forthe period presented are not necessarily indicative of the results that may beexpected for the year ending December 31, 2005.  These financialstatements should be read in conjunction with the financial statements andaccompanying notes included in the Company’s annual report on Form 10-K for theyear ended December 31, 2004.

 

The balance sheet at December 31, 2004 hasbeen derived from the audited financial statement at that date, but does notinclude all the information and footnotes required by GAAP for completefinancial 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 Interest Entities.”  FIN 46 requires a variable interest entity,or VIE, to be consolidated by its primary beneficiary.  The primary beneficiary is the party thatabsorbs a majority of the VIE’s anticipated losses and/or a majority of theexpected returns.  We have evaluated ourinvestments for potential classification as variable interests by evaluatingthe sufficiency of the entities’ equity investment at risk to absorb losses,and determined that we are not the primary beneficiary for any of ourinvestments.  Entities which we do notcontrol and entities which are VIE’s, but where we are not the primarybeneficiary, are accounted for under the equity method.  All significant intercompany balances andtransactions have been eliminated.

 

 

 

7

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**Cash and Cash Equivalents**

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

** **

**RestrictedCash**

**Restricted cash consistsprimarily of $250,663 on deposit with the trustee of our Collateralized DebtObligation, or CDO, representing proceeds from our CDO issuance that will beused to fund future investments that will be acquired by the CDO trust.  Also included are the proceeds of repaymentsfrom loans serving as CDO collateral, which will be used to fund investments toreplace those trust assets which are repaid or sold by the trust, interestpayments received by the trustee on investments that serve as collateral forthe CDO, which are remitted to the Company on a quarterly basis in the monthfollowing the end of our fiscal quarter, and future funding obligations oncertain investments.  The remaining$3,134 consists of interest reserves held on behalf of borrowers.**

** **

**Loans and Investments and LoansHeld for Sale**

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. Loans held for sale are carried at the lower of cost or market valueusing available market information obtained through consultation with dealersor other originators of such investments. We may originate or acquire preferred equity interests that allow us toparticipate in a percentage of the underlying property’s cash flows fromoperations and proceeds from a sale or refinancing.  Should we make such a preferred equityinvestment, we must determine whether that investment should be accounted foras a loan, joint venture or as an interest in real estate.  Our current preferred equity investment doesnot entitle us to a percentage of the underlying property’s cash flows fromoperations or proceeds from a sale or refinancing and is, therefore, accountedfor as a loan.

 

Specific valuationallowances are established for impaired loans based on the fair value ofcollateral on an individual loan basis. The fair value of the collateral is determined by an evaluation ofoperating cash flow from the property during the projected holding period, andthe estimated sales value of the collateral computed by applying an expectedcapitalization rate to the stabilized net operating income of the specificproperty, less selling costs, all of which are discounted at market discountrates.

 

If upon completion of thevaluation, the fair value of the underlying collateral securing the impairedloan is less than the net carrying value of the loan, an allowance is createdwith a corresponding charge to the provision for loan losses.  The allowance for each loan is maintained ata level we believe is adequate to absorb probable losses.  At September 30, 2005 we maintained a reserveof $955.

 

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

#### ** **

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

Mortgage-backedsecurities, or MBS, are classified as available-for-sale securities.  As a result, changes in fair value will berecorded as a balance sheet adjustment to accumulated other comprehensiveincome, which is a component of stockholders equity, rather than through ourstatement of operations.  Ifavailable-for-sale securities were classified as trading securities, therecould be substantially greater volatility in earnings from period-to-period asthese investments would be marked to market and any reduction in the value ofthe securities versus the previous carrying value would be considered anexpense on our statement of operations. We had no investments as of September30, 2005 that were accounted for as trading securities.

#### ** **

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

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

 

** **

**8**

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appropriate price to useto calculate the fair values for financial reporting purposes.  Different judgments and assumptions couldresult in different presentations of value.

** **

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

 

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

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

 

In accordancewith FASB No. 144, or SFAS 144, “Accounting for the Impairment of Disposal ofLong-Lived Assets,” a property to be disposed of is reported at the lower ofits carrying amount or its estimated fair value, less its cost to sell.  Once an asset is held for sale, depreciationexpense and straight-line rent adjustments are no longer recorded and historicresults are reclassified as Discontinued Operations.

 

In accordance with FASB No.141, or SFAS 141, “Business Combinations,” we allocate the purchase price ofreal estate to land and building and, if determined to be material,intangibles, such as the value of above, below and at-market leases andorigination costs associated with the in-place leases.  We depreciate theamount allocated to building and other intangible assets over their estimateduseful lives, which generally range from three to 40 years.  The values ofthe above and below market leases are amortized and recorded as either anincrease (in the case of below market leases) or a decrease (in the case ofabove market leases) to rental income over the remaining term of the associatedlease.  The value associated with in-place leases and tenant relationshipsare amortized over the expected term of the relationship, which includes anestimated probability of the lease renewal, and its estimated term.  If atenant vacates its space prior to the contractual termination of the lease andno rental payments are being made on the lease, any unamortized balance of therelated intangible will be written off.  The tenant improvements andorigination costs are amortized as an expense over the remaining life of thelease (or charged against earnings if the lease is terminated prior to itscontractual expiration date).  We assess fair value of the leases based onestimated cash flow projections that utilize appropriate discount andcapitalization rates and available market information.  Estimates offuture cash flows are based on a number of factors including the historicaloperating results, known trends, and market/economic conditions that may affectthe property.

 

As a result of our evaluationunder SFAS No. 141 of our acquisition of 200 Franklin Square Drive, werecognized an increase of approximately $4 in rental revenue for the three andnine months ended September 30, 2005 for the amortization of below marketleases and lease origination costs, resulting from the reallocation of thepurchase price of the property.

 

At September 30, 2005 we heldtwo CTL investments totaling $108,189 comprised of a $56,930 investment in thejoint venture that acquired the South Building located at One Madison Avenue inNew York, New York, and a $51,259 investment in 200 Franklin Square Drive inSomerset, New Jersey.

 

**Investment inUnconsolidated Joint Venture**

#### **We account for our investment in anunconsolidated joint venture under the equity method of accounting since weexercise significant influence, but do not unilaterally control, the entity andare not considered to be the primary beneficiary under FIN 46.  In thejoint venture, the rights of the other investor are protective andparticipating. These rights preclude us from consolidating theinvestment.  The investment is recorded initially at cost, as aninvestment in an unconsolidated joint venture, and subsequently adjusted forequity in net income (loss) and cash contributions and distributions.  Anydifference between the carrying amount of the investments on our balance sheetand the underlying equity in net assets is amortized as an adjustment to equityin net income (loss) of unconsolidated joint ventures over the lesser of thejoint venture term or 40 years.  See Note 4.  None of the jointventure debt is recourse to us.**

 

 

9

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#### **RevenueRecognition**

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 isexpected, are also recognized over the term of the loan as an adjustment toyield.  Fees on commitments that expireunused are recognized at expiration. Fees received in exchange for the credit enhancement of another lender,either subordinate or senior to us, in the form of a guarantee are recognizedover the term of that guarantee using the straight-line method.

** **

Income recognition is generallysuspended for debt investments at the earlier of the date at which paymentsbecome 90 days past due or when, in our opinion, a full recovery of income andprincipal becomes doubtful.  Incomerecognition is resumed when the loan becomes contractually current andperformance is demonstrated to be resumed.

 

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

#### ** **

Rental revenue is recognized ona straight-line basis over the term of the lease. The excess of rentsrecognized over amounts contractually due pursuant to the underlying leases isincluded in other assets on the accompanying balance sheets. We may establish,on a current basis, an allowance against this account for future potentialtenant credit losses which may occur. The balance reflected on the balancesheet will be net of such allowance.

 

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

#### ** **

#### **Reservefor Possible Credit Losses**

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

 

Where impairment is indicated,a valuation write-down or write-off is measured based upon the excess of therecorded investment amount over the net fair value of the collateral, asreduced by selling costs.  Any deficiencybetween the carrying amount of an asset and the net sales price of repossessed collateralis charged to the allowance for credit losses. At September 30, 2005 we maintained a reserve for possible credit lossesof $955.

 

**Deferred Costs**

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

 

**Deferred Financing Costs**

Deferred financing costs represent commitment fees, legal and otherthird party costs associated with obtaining commitments for financing whichresult in a closing of such financing. These costs are amortized over the terms of the respective agreementsand the amortization is reflected in interest expense.  Unamortized deferred financing costs areexpensed when the associated debt is refinanced or repaid before maturity.  Costs incurred in seeking financingtransactions, which do not close, are expensed in the period in which it isdetermined that the financing will not close.

 

**Stock Based Employee Compensation Plans**

Wehave a stock-based employee compensation plan, described more fully in Note13.  We account for this plan using thefair value recognition provisions of FASB Statement No. 123, or SFAS 123, “Accountingfor Stock-Based Compensation.”

** **

** **

**10**

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

 

Thefair value of each stock option granted is estimated on the date of grant, andquarterly for options issued to non-employees, using the Black-Scholes optionpricing model with the following weighted average assumptions for grants in2005 and 2004.

 

| ** **                       | ** ** | **2005**  | ** ** | **2004** | ** ** |
|----------------------------------|------------|-----------|------------|----------|------------|
| Dividend  yield                  |       | 8.4       | %          | 10.0     | %          |
| Expected  life of option         |       | 6.9 years |       | 7 years  |       |
| Risk-free  interest rate         |       | 4.14      | %          | 4.10     | %          |
| Expected  stock price volatility |       | 19.1      | %          | 18.0     | %          |

#### ** **

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

The Class B limitedpartner interests are entitled to receive an incentive return equal to 25% ofthe amount by which funds from operations (as defined in the partnershipagreement of the Operating Partnership) plus certain accounting gains exceedthe product of our weighted average stockholders equity (as defined in thepartnership agreement of the Operating Partnership) multiplied by 9.5% (dividedby 4 to adjust for quarterly calculations). We will record any distributions on the Class B limited partnerinterests as an incentive distribution expense in the period when earned andwhen payment of such amounts has become probable and reasonably estimable inaccordance with the partnership agreement. These cash distributions will reduce the amount of cash available fordistribution to our common unitholders in our Operating Partnership and tocommon stockholders.  We incurredapproximately $1,038 with respect to such Class B limited partner interests forthe nine months ended September 30, 2005.

** **

#### **DerivativeInstruments**

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

** **

**Todetermine the fair value of derivative instruments, we use a variety of methodsand assumptions that are based on market conditions and risks existing at eachbalance sheet date. For the majority of financial instruments including mostderivatives, long-term investments and long-term debt, standard marketconventions and techniques such as discounted cash flow analysis,option-pricing models, replacement cost, and termination cost are used todetermine fair value.  All methods ofassessing fair value result in a general approximation of value, and such valuemay never actually be realized.**

 

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

 

** **

**11**

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** **

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

** **

**FASB No. 133, or SFAS 133, “Accountingfor Derivative Instruments and Hedging Activities,” which became effectiveJanuary 1, 2001, as amended by FASB No. 149, requires us to recognize allderivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value throughincome.  If a derivative is a hedge,depending on the nature of the hedge, changes in the fair value of thederivative will either be offset against the change in fair value of the hedgedasset, liability, or firm commitment through earnings, or recognized in othercomprehensive income until the hedged item is recognized in earnings.  The ineffective portion of a derivative’schange in fair value will be immediately recognized in earnings.  SFAS 133 may increase or decrease reportednet income and stockholders’ equity prospectively, depending on future levelsof LIBOR, swap spreads and other variables affecting the fair values ofderivative instruments and hedged items, but will have no effect on cash flows,provided the contract is carried through to full term.**

 

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

 

All hedges held by us aredeemed to be effective in meeting the hedging objectives established by ourcorporate policy governing interest rate risk management.  The effect of our derivative instruments onour financial statements is discussed more fully in Note 17.

 

**Income Taxes**

We elected to be taxed asa REIT, under Sections 856 through 860 of the Internal Revenue Code, beginningwith our taxable year ended December 31, 2004. To qualify as a REIT, we must meet certain organizational andoperational requirements, including a requirement to distribute at least 90% ofour ordinary taxable income to stockholders. As a REIT, we generally will not be subject to federal income tax ontaxable 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.

** **

Our taxable REIT subsidiaries, individually referred  to as a TRS, are subject to federal, state andlocal taxes.

 

**UnderwritingCommissions and Costs**

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

 

**Organization Costs**

**Costs incurred**toorganize Gramercy in 2004 were expensed as incurred.

 

**Earnings Per Share**

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

 

 

12

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**Use of Estimates**

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.

 

**Concentrations of Credit Risk**

**Financialinstruments that potentially subject us to concentrations of credit riskconsist primarily of cash investments, debt investments and accountsreceivable.  Gramercy places its cashinvestments in excess of insured amounts with high quality financialinstitutions.  Our Manager performsongoing analysis of credit risk concentrations in our debt investment portfolioby evaluating exposure to various markets, underlying property types,investment structure, term, sponsors, tenant mix and other credit metrics.  Four investments accounted for more than 27%of the total carrying value of our debt investments as of September 30, 2005.Three investments accounted for approximately 25% of the revenue earned on ourdebt investments for the three months ended September 30, 2005 and the samethree investments accounted for more than 29% of the revenue earned on our debtinvestments for the nine months ended September 30, 2005.**

** **

**Recently Issued AccountingPronouncements**

**SFAS No. 123(R), “Share-BasedPayment, a revision of FASB Statement No. 123, Accounting for Stock-BasedCompensation,” requires all share-based payments to employees, including grantsof employee stock options, to be recognized in the income statement based ontheir fair value.  The new standard is effective for interim or annualreporting periods beginning after January 1, 2006.  The implementation of SFAS No. 123(R) isexpected to have no impact on the our financial statements.**

** **

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

 

**3.  Loansand Other Lending Investments**

 

**The aggregate carrying values,allocation by product type and weighted average coupons of our loans and otherlending investments as of September 30, 2005 and December 31, 2004 were asfollows:**
| ** **                                    | ** ** | **Carrying Value ($ in thousands)** | ** ** | **Allocation by  Investment Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average Spread over LIBOR** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------|------------|--------------------------------|------------|-----------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                      | ** ** | **2004**                           | ** ** | **2005**                       | ** ** | **2004**                                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Whole loans, floating rate                    |       | $                                             | 397,271    |                               | $          | 155,215                        |       | 43                                            | %          | 38 | % | — |   | — |   | 309 bps |   | 373 bps |   |
| Whole loans, fixed rate                       |       | 65,836                                        |       | —                             |       | 7                              | %          | —                                        |       | 8.12 | % | — |   | — |   | — |   |
| Subordinate mortgage interests, floating rate |       | 298,026                                       |       | 209,286                            |       | 32                             | %          | 51                                            | %          | — |   | — |   | 575 bps |   | 640 bps |   |
| Subordinate mortgage interests, fixed rate    |       | 36,639                                        |       | 31,216                             |       | 4                              | %          | 8                                             | %          | 9.23 | % | 9.57 | % | — |   | — |   |
| Mezzanine loans, floating rate                |       | 72,540                                        |       | —                             |       | 8                              | %          | —                                        |       | — |   | — |   | 908 bps |   | — |   |
| Mezzanine loans, fixed rate                   |       | 43,323                                        |       | —                             |       | 4                              | %          | —                                        |       | 8.88 | % | — |   | — |   | — |   |
| Preferred equity                              |       | 11,767                                        |       | —                             |       | 1                              | %          | —                                        |       | — |   | — |   | 900 bps |   | — |   |
| Commercial mortgage backed securities         |       | 10,999                                        |       | 10,898                             |       | 1                              | %          | 3                                             | %          | 13.49 | % | 13.49 | % | — |   | — |   |
| Total / Average                               |       | $                                             | 936,401    |                               | $          | 406,615                        |       | 100                                           | %          | 100 | % | 8.97 | % | 10.58 | % | 475 bps |   | 526 bps |   |

** **

**13**

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** **

For the three and nine monthsended September 30, 2005 and the period from April 12, 2004 (formation) throughSeptember 30, 2004 the Company’s investment income from debt investments wasgenerated by the following investment types:

 
| ** **                      | ** ** | **For the Three Months Ended September 30,** | ** ** | **For the Nine Months Ended September 30,** | ** ** | **For the Period April 12, 2004 (formation) through September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                     | ** ** | **2004**                                    | ** ** | **2005**                                                            | ** ** | **2004** | ** ** |
| **Investment Type**             | ** ** | **Investment Income**                        | ** ** | **% of  Total**                             | ** ** | **Investment Income**                                               | ** ** | **% of  Total** | ** ** | **Investment Income** | ** ** | **% of  Total** | ** ** | **Investment Income** | ** ** | **%****of  Total** | ** ** |
| Subordinate mortgage  interests |       | $                                            | 7,529      |                                        | 36         | %                                                                   | $          | 1,047 |   | 85 | % | $ | 19,689 |   | 42 | % | $ | 1,047 |   | 85 | % |
| Whole loans                     |       | 9,410                                        |       | 44                                          | %          | —                                                              |       | — |   | 18,394 |   | 39 | % | — |   | — |   |
| Mezzanine loans                 |       | 3,313                                        |       | 16                                          | %          | —                                                              |       | — |   | 6,682 |   | 14 | % | — |   | — |   |
| Preferred Equity                |       | 421                                          |       | 2                                           | %          | —                                                              |       | — |   | 1,112 |   | 2 | % | — |   | — |   |
| CMBS                            |       | 387                                          |       | 2                                           | %          | 180                                                                 |       | 15 | % | 1,122 |   | 3 | % | 180 |   | 15 | % |
|                            |       | $                                            | 21,060     |                                        | 100        | %                                                                   | $          | 1,227 |   | 100 | % | $ | 46,999 |   | 100 | % | $ | 1,227 |   | 100 | % |
|                                 |            |                                              |            |                                             |            |                                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At September 30, 2005 andDecember 31, 2004, our debt investment portfolio had the following geographicdiversification:

 

| ** ** | ** ** | **2005**            | ** ** | **2004**        | ** ** |
|------------|------------|---------------------|------------|-----------------|------------|
| **Region** | ** ** | **Carrying  Value** | ** ** | **% of  Total** | ** ** | **Carrying  Value** | ** ** | **% of  Total** | ** ** |
| Northeast  |       | $                   | 429,012    |            | 46         | % | $ | 185,081 |   | 46 | % |
| South      |       | 127,973             |       | 14              | %          | 126,493 |   | 31 | % |
| West       |       | 251,853             |       | 27              | %          | 20,804 |   | 5 | % |
| Midwest    |       | 107,563             |       | 11              | %          | 26,284 |   | 6 | % |
| Various    |       | 20,000              |       | 2               | %          | 47,953 |   | 12 | % |
| Total      |       | $                   | 936,401    |            | 100        | % | $ | 406,615 |   | 100 | % |

** **

**In connection with our preferredequity investment we have guaranteed a portion of the outstanding principalbalance of the first mortgage loan, up to approximately $1,400, that is afinancial obligation of the entity in which we have invested in the event of aborrower default under such loan.  Theloan matures in 2032.  This guarantee isconsidered to be an off-balance sheet arrangement.  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. The liability will be amortized over the life ofthe guarantee using the straight-line method and corresponding fee income willbe recorded.  Our maximum exposure underthis guarantee is approximately $1,400 as of September 30, 2005.  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.  Investment in Unconsolidated Joint Venture**

***One Madison Office Fee LLC***

**On April 29, 2005, we closed on a$57,503 initial investment in a joint venture with SL Green to acquire, own andoperate the South Building located at One Madison Avenue, New York, New York,or the Property.  The joint venture isowned 45% by our wholly-owned subsidiary and 55% by a wholly-owned subsidiaryof SL Green.  The joint venture interestsare pari passu.  Also on April 29, 2005,the joint venture completed the acquisition of the Property from MetropolitanLife Insurance Company for the purchase price of approximately $802,800 plusclosing costs, financed in part through a $690,000 first mortgage loan on theProperty.  The first mortgage isnon-recourse to us.  The Propertycomprises approximately 1.2 million square feet and is almost entirely netleased to CSFB pursuant to a lease with a 15-year remaining term.  As of September 30, 2005 the investment has acarrying value of $56,930.  For the threeand nine months ended September 30, 2005, we recorded our pro rata share of netlosses of the joint venture of $510 and $914, respectively.**

** **

**14**

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**5.  Property Acquisition**

***200 FranklinSquare Drive***

On September 6, 2005, weclosed on the acquisition of a 100% fee interest in 200 Franklin Square Drive,located in Somerset, New Jersey. The property is a two hundred thousand squarefoot building which is 100% net leased to Philips Holding USA Inc, awholly-owned subsidiary of Royal Philips Electronics, through December2021.  The property was acquired for apurchase price of $50,250, excluding closing costs, and financed with a$41,000, 10-year, fixed-rate first mortgage loan.

** **

**6.  Junior Subordinated Debentures**

**On May 20, 2005 we completed theissuance of $50,000 in unsecured trust preferred securities through a newlyformed  Delaware statutory trust,Gramercy Capital Trust I, or GCTI, that is a wholly owned subsidiary of theOperating Partnership.  The securitiesbear interest at a fixed rate of 7.57% for the first ten years ending June2015.  Thereafter the rate will floatbased on the three-month LIBOR plus 300 basis points.**

**On August 9, 2005 we completed anadditional issuance of $50,000 in unsecured trust preferred securities througha separate newly formed Delaware statutory trust, Gramercy Capital Trust II, orGCTII, that is also a wholly owned subsidiary of the OperatingPartnership.  The securities bearinterest at a fixed rate of 7.75% for the first ten years ending October2015.  Thereafter the rate will floatbased on the three-month LIBOR plus 300 basis points.**

**Both issuances of trust preferredsecurities require quarterly interest distributions; however, payments may bedeferred while the interest expense is accrued for a period of up to fourconsecutive quarters if the Operating Partnership exercises its right to defersuch payments.  The trust preferredsecurities are redeemable, at the option of the Operating Partnership, in wholeor in part, with no prepayment premium any time after June 30, 2010 for thesecurities issued in May 2005 and October 30, 2010 for the securities issued inAugust 2005.**

**GCTI and GCTII each issued $1,550aggregate liquidation amount of common securities, representing 100% of thevoting common stock of GCTI and GCTII to the Operating Partnership for a totalpurchase price of $3,100.  GCTI and GCTIIused the proceeds from the sale of the trust preferred securities and thecommon securities to purchase the Operating Partnership’s junior subordinatednotes.  The terms of the juniorsubordinated notes match the terms of the trust preferred securities.  The notes are subordinate and junior in rightof payment to all present and future senior indebtedness and certain other ofour financial obligations.  We realizednet proceeds from each offering of approximately $48,956.**

Our interests in GCTI and GCTII are accounted for using the equitymethod and the assets and liabilities of GCTI and GCTII are not consolidatedinto our financial statements.  Intereston the junior subordinated notes is included in interest expense on ourconsolidated income statements while the junior subordinated notes are presentedas a separate item in our consolidated balance sheet.

 

**7.**  **CollateralizedDebt Obligation**

On July 14, 2005, we issued approximately $1,000,000 ofcollateralized debt obligations, or CDO, through two newly-formed indirectsubsidiaries, Gramercy Real Estate CDO 2005-1 Ltd., or the Issuer, andGramercy Real Estate CDO 2005-1 LLC, or the Co-Issuer. The CDO consists of$810,500 of investment grade notes, and $84,500 of non-investment grade notes,which were co-issued by the Issuer and the Co-Issuer, and $105,000 of preferredshares, which were issued by the Issuer. We retained all non-investment grade securities and the preferred sharesin the Issuer.  The Issuer holds assets,consisting primarily of whole loans, subordinate interests in whole loans, mezzanineloans and preferred equity investments, which serve as collateral for the CDO.The investment grade notes were issued with floating rate coupons with acombined weighted average rate of three-month LIBOR plus 0.49%. The CDO may bereplenished pursuant to certain rating agency guidelines relating to creditquality and diversification, with substitute collateral for loans that arerepaid during the first five years of the CDO. Thereafter, the CDO securitieswill be retired in sequential order from senior-most to junior-most as loansare repaid. We incurred approximately $11,580 of issuance costs, which isamortized on a level yield basis over the average life of the CDO.  The Issuer is consolidated in our financialstatements. The investment grade notes are treated as a secured financing, andare non-recourse to us. Proceeds from the sale of the investment grade notesissued were used to repay substantially all outstanding debt under ourrepurchase agreements and to fund additional investments.

** **

**15**

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** **

**8.  Debt Obligations**

#### **Credit Facilities**

**We have three secured creditfacilities: two with Wachovia Capital Markets, LLC or one or more of itsaffiliates and one with Goldman Sachs Mortgage Company.**

The first facility withWachovia Capital Markets, LLC and its affiliates is a $500,000 repurchasefacility.  This facility was increased to$350,000 from $250,000 effective January 3, 2005, and subsequently increased to$500,000 effective April 22, 2005.  Aspart of the April 2005 increase to $500,000, the initial term of the facilitywas modified to reflect staggered maturities in which $250,000 matures inAugust 2007, $150,000 matures in December 2007 and the remaining $100,000matures in June 2008.  Also inconjunction with the April 2005 increase, the $50,000 credit facility wepreviously maintained with Wachovia was consolidated into the $500,000repurchase facility.  The $500,000facility bears interest at spreads of 1.25% to 3.50% over a 30-day LIBOR and,based on our expected investment activities, provides for advance rates thatvary from 50% to 95% based upon the collateral provided under a borrowing basecalculation.  The lender has a consentright to the inclusion of investments in this facility, determines periodicallythe market value of the investments, and has the right to require additionalcollateral if the estimated market value of the included investmentsdeclines.  We had borrowings of $0 and$239 under this facility at September 30, 2005 and December 31, 2004,respectively.  We can utilize the $25,000revolving credit facility described below to fund requirements for additionalcollateral pursuant to the warehouse financing or to fund the acquisition ofassets.

** **

The second facility withWachovia Capital Markets, LLC and its affiliates is a $25,000 revolving creditfacility with a term of two years. Amounts drawn under this facility for liquidity purposes bear interestat a rate equal to a spread over LIBOR of 525 basis points.  Amounts drawn under this facility foracquisition purposes bear interest at a spread over LIBOR of 225 basispoints.  Amounts drawn under thisfacility for liquidity purposes must be repaid within 105 days.  Amounts drawn under this facility generallywill be secured by assets established under a borrowing base calculation unlesscertain financial covenants are satisfied. These covenants are generally more restrictive than those set forthbelow.  At September 30, 2005 andDecember 31, 2004 we had no borrowings 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 expiring in January2008 with one six-month extension option. This facility bears interest at spreads of 1.125% to 2.75% over a 30-dayLIBOR and, based on our expected investment activities, provides for advancerates that vary from 75% to 90% based upon the collateral provided under aborrowing base calculation.  As with theWachovia facility, the lender has a consent right to the inclusion ofinvestments in this facility, determines periodically the market value of theinvestments, and has the right to require additional collateral if theestimated market value of the included investments declines.  At September 30, 2005 we had no borrowingsunder this facility.

 

The terms of both of ourrepurchase facilities and our credit facility include covenants that****(a) limit our maximum total indebtednessto no more than 85% of total assets, (b) require us to maintain minimumliquidity of at least $10,000 for the first two years and $15,000 thereafter,(c) our fixed charge coverage ratio shall at no time be less than 1.50 to 1.00,(d) our minimum interest coverage ratio shall at no time be less than 1.75 to1.00, (e) require us to maintain minimum tangible net worth of not less thanthe greater of (i) $129,750, or (i) plus (ii) 75% of the proceeds of oursubsequent equity 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 we may inany 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 ceasesto be the Manager.

 

The revolving credit facilityand the repurchase facilities require that we pay down borrowings under thesefacilities as principal payments on the loans and investments pledged to thesefacilities are received.

 

#### **Mortgage Loan**

We have one interest-onlymortgage loan of $41,000 that bears interest at a fixed rate of 4.90% and has aterm of ten years, resulting in a balloon payment in 2015.  This mortgage was used to finance ouracquisition of 200 Franklin Square Drive for approximately $50,250, excludingclosing costs, in September 2005.

** **

**16**

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** **

**9. **Operating Partnership Agreement / Manager

** **

At September 30, 2005, weowned all of the Class A limited partnership interests in our OperatingPartnership.  At September 30, 2005, the majorityof the Class B limited partnership interests were owned by our Manager and SLGreen Operating Partnership, L.P. Interests were also held by certain officersand employees of SL Green Realty Corp., including some of whom are ourexecutive officers, which interests are subject to performance thresholds.

 

At September 30, 2005, the majority of theinterests in our Manager were held by SL Green Operating Partnership, L.P.  Interests were also held by certain officersand employees of SL Green Realty Corp., including some of whom are our executiveofficers, which interests are subject to performance thresholds.

 

**10.  Related Party Transactions**

 

In connection with our initialpublic offering, we entered into a management agreement with GKK Manager LLC,which provides for an initial term through December 2007 with automaticone-year extension options and is subject to certain termination rights.  We pay the Manager an annual management feeequal to 1.75% of our gross stockholders equity (as defined in the ManagementAgreement) inclusive of the trust preferred securities issued on May 20, 2005and August 9, 2005.  We paid or hadpayable to the Manager under this agreement an aggregate of approximately$1,678 and $4,208, for the three and nine months ended September 30, 2005,respectively and approximately $547 for the period from April 12, 2004 throughSeptember 30, 2004.

** **

At September 30, 2005, the majorityof the Class B limited partnership interests were owned by our Manager and SLGreen Operating Partnership, L.P. Interests were also held by certain officersand employees of SL Green Realty Corp., including some of whom are ourexecutive officers, which interests are subject to performance thresholds.  To provide an incentive for the Manager toenhance the value of the common stock, the Manager and SL Green OperatingPartnership, L.P. are entitled through their ownership of Class B limitedpartner interests of the Operating Partnership to an incentive return equal to25% of the amount by which funds from operations (as defined in the partnershipagreement of the Operating Partnership) plus certain accounting gains exceedthe product of our weighted average stockholders equity (as defined in thepartnership agreement of the Operating Partnership) multiplied by 9.5% (dividedby 4 to adjust for quarterly calculations). We will record any distributions on the Class B limited partnerinterests as an incentive distribution expense in the period when earned andwhen payments of such amounts have become probable and reasonably estimable inaccordance with the partnership agreement. We incurred approximately $1,038 of incentive distribution expense forthe nine months ended September 30, 2005.

 

We are obligated to reimbursethe Manager for its costs incurred under an Asset Servicing Agreement betweenour Manager and an affiliate of SL Green Operating Partnership, L.P. and aseparate Outsourcing Agreement between our Manager and SL Green OperatingPartnership, L.P.  The Asset ServicingAgreement provides for an annual fee payable by us of 0.15% of the carryingvalue of our investments, excluding certain defined investments for which otherservicing arrangements are executed and further reduced by fees paid directlyto outside servicers by us which have been approved by SL Green OperatingPartnership, L.P.  The OutsourcingAgreement provides a fee payable by us of $1,288 per year, increasing 3%annually over the prior year.  For thethree months ended September 30, 2005, we paid or had payable an aggregate of$319 and $291 to our Manager under the Outsourcing and Asset ServicingAgreements, respectively.  For the ninemonths ended September 30, 2005 and the period from April 12, 2004 throughSeptember 30, 2004, we paid or had payable an aggregate of $944 and $208,respectively, to our Manager under the Outsourcing Agreement.  For the nine months ended September 30, 2005and the period from April 12, 2004 through September 30, 2004, we paid or hadpayable an aggregate of $674 and $31 to our Manager under the Asset ServicingAgreement, respectively.

 

In connection with theclosing of our CDO in July 2005, the Issuer entered into a CollateralManagement Agreement with the Manager. Pursuant to the Collateral ManagementAgreement, the Manager has agreed to provide certain advisory andadministrative services in relation to the collateral debt securities and othereligible investments securing the CDO notes. The Collateral Management Agreement provides for a senior collateralmanagement fee, payable quarterly in accordance with the priority of paymentsas set forth in the indenture, equal to 0.15% per annum of the net outstandingportfolio balance, and an additional subordinate collateral management fee,payable quarterly in accordance with the priority of payments as set forth inthe indenture, equal to 0.25% per annum of the net outstanding portfoliobalance.  Net outstanding portfoliobalance is the sum of the (i) aggregate principal balance of the collateraldebt securities, excluding defaulted securities, (ii) aggregate principalbalance of all principal proceeds held as cash and eligible investments incertain accounts, and (iii) with respect to the defaulted securities, thecalculation amount of such defaulted securities. As compensation for theperformance of its obligations as collateral manager, our Board of Directorshas allocated to the Manager the portion of the subordinate collateralmanagement fee paid on securities not held by us.  The senior collateral management

** **

** **

**17**

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** **

 

feeand balance of the subordinate collateral management fee is allocated tous.  For the three and nine months endedSeptember 30, 2005 we paid or had payable $438 to the Manager under theCollateral Management Agreement.

 

In connection with the5,500,000 shares of common stock that were sold on December 3, 2004 and settledon December 31, 2004 and January 3, 2005 in a private placement, we agreed topay the Manager a fee of $1,000 as compensation for financial advisory,structuring and costs incurred on our behalf.  This fee was recorded as a reduction in the proceeds of the privateplacement.  Apart from legal fees andstock clearing charges totaling $245, no other fees were paid by us to aninvestment bank, broker/dealer or other financial advisor in connection withthe private placement, resulting in total costs of 1.3% of total grossproceeds.

 

**On April 29, 2005, we closed on a$57,503 initial investment in a joint venture with SL Green to acquire, own andoperate the South Building located at One Madison Avenue, New York, New York,or the Property.  The joint venture,which was created 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 paripassu.  Also on April 29, 2005, the jointventure completed the acquisition of the Property from Metropolitan LifeInsurance Company for the purchase price of approximately $802,800 plus closingcosts, financed in part through a $690,000 first mortgage loan on the Property.  The Property comprises approximately 1.2million square feet and is almost entirely net leased to Credit Suisse FirstBoston (USA), Inc., or CSFB, pursuant to a lease with a 15-year remaining term.**

** **

Commencing May1, 2005 we are party to a lease agreement with SLG Graybar Sublease LLC, anaffiliate of SL Green, for our corporate offices at 420 Lexington Avenue, NewYork, New York.  The lease is forapproximately five thousand square feet with an option to lease an additional approximatelytwo thousand square feet and carries a term of ten years with rents on theentire seven thousand square feet of approximately $249 per annum for year onerising to $315 per annum in year ten.

 

**BrightStar Couriers LLC, or Bright Star, provides messenger services to us.  Bright Star is owned by Gary Green, a son ofStephen L. Green.  The aggregate amountof fees paid by us for such services for the three and nine months endedSeptember 30, 2005 was approximately $1 and $2, respectively and less than $1for the three months ended September 30, 2004 and the period from April 12,2004 through September 30, 2004.**

** **

**SL GreenOperating Partnership, L.P. has invested $75,000 and $6,100 in preferred equityinterests that are subordinate to two of our investments with book values of$94,273 and $6,439, respectively, as of September 30, 2005.**

** **

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

** **

**11.  DeferredCosts**

 

Deferredcosts at September 30, 2005 and December 31, 2004 consisted of the following(in thousands):

 

| ** **                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Deferred  financing            |       | $        | 19,909     |     | $          | 2,334 |   |
| Deferred  acquisition          |       | 1,013    |       | 215      |       |
|                           |       | 20,922   |       | 2,549    |       |
| Less  accumulated amortization |       | (2,094   | )          | (316     | )          |
|                           |       | $        | 18,828     |     | $          | 2,233 |   |

 

Deferred financing costs relate to ourexisting repurchase and credit facilities with Wachovia and Goldman Sachs, ourCDO and our mortgage note.  These costsare amortized on a straight-line basis to interest expense based on theremaining term of the related financing.

 

Deferred acquisition costs consist of fees anddirect costs incurred to originate our investments and are amortizedusing the effective yield method over the related term of the investment.

 

18

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** **

**12.  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 CDO, 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 September 30, 2005. Although we are not aware of any factors that would significantly affectthe reasonable fair value amounts, such amounts have not been comprehensivelyrevalued for purposes of these financial statements since that date and currentestimates of fair value may differ significantly from the amounts presentedherein.

 

**13.  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 of commonstock outstanding valued at approximately $200,000.  On August 2, 2004 we completed our initialpublic offering of 12,500,000 shares of common stock resulting in net proceedsof approximately $177,600, which was used to fund investments and commence ouroperations.  As of September 30, 2005,333,000 restricted shares had also been issued under our 2004 Equity IncentivePlan, 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 shareswere sold to SL Green Operating Partnership, L.P. pursuant to its contractualright to maintain a 25% ownership interest in the outstanding 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.

 

OnSeptember 9, 2005 we sold 3,833,333 shares of common stock resulting in netproceeds of approximately $98,100.  Atotal of 2,875,000 shares were sold through public offering and an additional958,333 shares were sold to SL Green Operating Partnership, L.P. pursuant toits contractual right to maintain a 25% ownership interest in our outstandingshares of common stock.  After thisoffering, SL Green Operating Partnership, L.P. owned 5,668,333 shares of ourcommon stock.  Net proceeds were used foracquisitions, repayment of outstanding principal under one of our repurchasefacilities and general corporate purposes.

 

InAugust 2005 our $350,000 shelf registration statement was declared effective bythe Securities and Exchange Commission, or SEC.  This registrationstatement provides us with the ability to issue common and preferred stock,depository shares and warrants.  We currently have $251,100 availableunder the shelf.

 

Asof September 30, 2005, 22,794,309 shares of common stock and no shares ofpreferred stock were issued and outstanding.

 

 

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**Equity Incentive Plan**

As part of our initial public offering we institutedour Equity Incentive Plan.  The EquityIncentive Plan, as amended, authorizes (i) the grant of stock options thatqualify as incentive stock options under Section 422 of the Internal RevenueCode of 1986, as amended, or ISOs, (ii) the grant of stock options that do notqualify, or NQSOs, (iii) the grant of stock options in lieu of cash directors’fees and (iv) grants of shares of restricted and unrestricted commonstock.  The exercise price of stockoptions will be determined by the compensation committee, but may not be lessthan 100% of the fair market value of the shares of common stock on the date ofgrant.  At September 30, 2005, approximately1,091,930 shares of common stock were available for issuance under the EquityIncentive Plan.

** **

Options granted under the Equity Incentive Plan to employees areexercisable at the fair market value on the date of grant and, subject totermination of employment, expire ten years from the date of grant, are nottransferable other than on death, and are exercisable in three to four annualinstallments commencing one year from the date of grant.  In some instances, options may be grantedunder the Equity Incentive Plan to persons who provide significant services tous or our affilliates, but are not considered employees because compensationfor their services is not covered by our Management Agreement or OutsourcingAgreement.  Options granted to non-employeeshave the same terms as those issued to employees except as it relates to anyperformance-based provisions within the grant. To the extent there are performance provisions associated with a grantto a non-employee, an estimated expense related to these options is recognizedover the vesting period and the final expense is reconciled at the pointperformance has been met, or the measurement date.  If no performance based provision exists, thefair value of the options is calculated on a quarterly basis and the relatedexpense is recognized over the vesting period.

 

A summary of the status of our stock options as of September 30, 2005and December 31, 2004 are presented below:

** **

| ** **                   | ** ** | **2005**                 | ** ** | **2004**                               | ** ** |
|------------------------------|------------|--------------------------|------------|----------------------------------------|------------|
| ** **                   | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Balance at beginning of year |       | 640,500                  |       | $                                      | 15.05      |   | — |   | $ | — |   |
| Granted                      |       | 224,000                  |       | $                                      | 19.47      |   | 640,500 |   | $ | 15.05 |   |
| Exercised                    |       | (127,916                 | )          | $                                      | 15.01      |   | — |   | $ | — |   |
| Lapsed or cancelled          |       | (10,000                  | )          | $                                      | 18.73      |   | — |   | $ | — |   |
| Balance at end of period     |       | 726,584                  |       | $                                      | 16.39      |   | 640,500 |   | $ | 15.05 |   |

** **

All options were granted withina price range of $15.00 to $24.66.  Theremaining weighted average contractual life of the options was 9.06 years.  Of the options granted 22% have vested.  Compensation expense of $46 and $13 wasrecorded during the three months ended September 30, 2005 and 2004,respectively, and $105 and $13 was recorded for the nine months ended September30, 2005 and the period from April 12, 2004 through September 30, 2004,respectively, related to the issuance of stock options.

 

As of September 30, 2005,333,000 restricted shares had been issued under the Equity Incentive Plan, ofwhich 32% have vested.  The unvestedshares are not currently entitled to receive distributions declared by us onour common stock until such time as the shares have vested.  Unvested shares may be entitled to receivedividends at the discretion of the Compensation Committee of our Board ofDirectors.  Holders of restricted sharesare prohibited from selling such shares until they vest but are provided theability to vote such shares beginning on the date of grant.  Compensation expense of $274 and $142 wasrecorded during the three months ended September 30, 2005 and 2004,respectively, and $926 and $142 was recorded for the nine months endedSeptember 30, 2005 and the period from April 12, 2004 through September 30,2004, respectively, related to the issuance of restricted shares.

 

 

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**OutperformancePlan**

On June 15, 2005, theCompensation Committee of our Board of Directors approved the 2005Outperformance Plan, a long-term incentive compensation program.

 

Under the 2005Outperformance Plan, award recipients will share in a “performance pool” if ourtotal return to stockholders for the period from June 1, 2005 through May 31,2008 exceeds a cumulative total return to stockholders of 30%.  The size of the pool will be 10% of theoutperformance amount in excess of the 30% benchmark, subject to a maximumlimit equal to the lesser of 4% of our outstanding shares or 1,200,000shares.  If our total return tostockholders from June 1, 2005 to any subsequent date exceeds 80% and remains atthat level or higher for 30 consecutive days, then a minimum performance poolwill be established.  In the event thepotential outperformance pool reaches the maximum dilution cap before May 31,2008 and remains at that level or higher for 30 consecutive days, theperformance period will end early and the pool will be formed at such earlierdate.

 

Each officer’s awardunder the 2005 Outperformance Plan is designated as a specified percentage ofthe aggregate performance award pool. Assuming that the 30% benchmark is achieved, the pool will be allocatedamong our senior officers in accordance with the percentage specified in eachofficer’s participation agreement. Individual awards under the 2005 Outperformance Plan will be made in theform of partnership units, or LTIP Units, that are convertible into shares ofour common stock or cash, at our election. LTIP Units will be granted prior to the determination of the performancepool; however, they will only vest upon satisfaction of performance and otherthresholds, and will not be entitled to distributions until after theperformance pool, or minimum performance pool, is established.  Distributions on LTIP Units will equal thedividends paid on our common stock on a per unit basis.  The 2005 Outperformance Plan provides that ifa pool is established, each officer will also be entitled to the distributionsthat would have been paid by us had the LTIP Units been issued on the date the2005 Outperformance Plan was approved. Those distributions will be paid in the form of additional LTIPUnits.  Once a performance pool has beenestablished, distributions will commence with respect to any LTIP Units thatare a part of the performance pool.

 

Although the amount ofthe awards will be determined on the measurement date, none of the awards vestat that time.  Instead, 50% of the awardsvest in May 2009 and the balance vest one year later based on continuedemployment.

 

Inthe event of a change in control of us prior to the establishment of the pool,the performance period will be shortened to end on a date immediately prior tosuch event and the cumulative shareholder return benchmark will be adjusted ona pro rata basis.  The pool will beformed as described above if the adjusted benchmark target is achieved andfully vested awards will be issued.  Alldeterminations, interpretations and assumptions relating to the vesting andcalculation of the performance awards will be made by the CompensationCommittee.  We will record the expense ofthe restricted stock award in accordance with SFAS 123. Compensationexpense of $881 was recorded for the nine months ended September 30, 2005related to the 2005 Outperformance Plan.

 

**Deferred StockCompensation Plan for Directors**

 

Under our Independent Director’sDeferral Program, which commenced April 2005, our non-employee directorsmay elect to defer up to 100% of their annual retainer fee, chairman fees andmeeting fees.  Unless otherwise elected by a participant, fees deferredunder the program shall be credited in the form of phantom stock units. The phantom stock units are convertible into an equal number of shares of commonstock upon such directors’ termination of service from the Board of Directorsor a change in control by us, as defined by the program.  Phantom stockunits are credited to each non-employee director quarterly using the closingprice of our common stock on the applicable dividend record date for therespective quarter.  Each participating non-employee director who electsto receive fees in the form of phantom stock units has the option to have theiraccount credited for an equivalent amount of phantom stock units based on thedividend rate for each quarter or have dividends paid in cash.

 

During the three months endedSeptember 30, 2005, 665 phantom stock units were earned.  As of September 30, 2005 there wereapproximately 1,498 phantom stock units outstanding.

 

**Earnings per Share**

** **

Earningsper share for the three and nine months ended September 30, 2005 and the threemonths ended September 30, 2004 and the period from April 12, 2004 (formation)through September 30, 2004 is computed as follows:

 

 

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| ** **                                  | ** ** | **Three  months ended  September 30,** | ** ** | **For the  Nine  Months Ended  September 30,** | ** ** | **For the  Period  April 12, 2004  (formation)  through  September 30,** | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                               | ** ** | **2004**                                       | ** ** | **2005**                                                                 | ** ** | **2004** | ** ** |
| **Numerator (Income)**                      |       |                                   |       |                                           |       |                                                                     |       |   |   |
| Basic  Earnings:                            |       |                                   |       |                                           |       |                                                                     |       |   |   |
| Net income available to common stockholders |       | $                                      | 8,577      |                                           | $          | 11                                                                       |       | $ | 20,599 |   | $ | 11 |   |
| Effect of  dilutive securities              |       | —                                 |       | —                                         |       | —                                                                   |       | — |   |
| Diluted  Earnings:                          |       |                                   |       |                                           |       |                                                                     |       |   |   |
| Net income available to common stockholders |       | $                                      | 8,577      |                                           | $          | 11                                                                       |       | $ | 20,599 |   | $ | 11 |   |
|                                        |       |                                   |       |                                           |       |                                                                     |       |   |   |
| **Denominator  (Weighted Average Shares)**  |       |                                   |       |                                           |       |                                                                     |       |   |   |
| Basic                                       |       |                                   |       |                                           |       |                                                                     |       |   |   |
| Shares available to common stockholders     |       | 19,603                                 |       | 13,313                                         |       | 19,093                                                                   |       | 13,313 |   |
| Effect of  Diluted Securities:              |       |                                   |       |                                           |       |                                                                     |       |   |   |
| Stock-based compensation plans              |       | 1,184                                  |       | 8                                              |       | 524                                                                      |       | 8 |   |
| Phantom stock units                         |       | 1                                      |       | —                                         |       | 1                                                                        |       | — |   |
| Diluted  Shares                             |       | 20,788                                 |       | 13,321                                         |       | 19,618                                                                   |       | 13,321 |   |

 

**14.  Minority Interest**

** **

At September 30, 2005, we ownedall of the Class A limited partnership interests in our OperatingPartnership.  At September 30, 2005, the majorityof the Class B limited partnership interests were owned by our Manager and SLGreen Operating Partnership, L.P. Interests were also held by certain officersand employees of SL Green Realty Corp., including some of whom are ourexecutive officers, which interests are subject to performance thresholds.

 

**15.  Benefit Plans**

** **

**We do not maintain a definedbenefit pension plan, post-retirement health and welfare plan, 401(K) plan orother benefits plans as we do not have any employees.  These benefits are provided to its employeesby our Manager, a majority-owned subsidiary of SL Green.**

** **

**16. **Commitmentsand 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, New York are subject to an operatinglease agreement with SLG Graybar Sublease LLC, an affiliate of SL Green,effective May 1, 2005.  The lease is forapproximately five thousand square feet with an option to lease an additionalapproximately two thousand square feet and carries a term of ten years withrents on the entire seven thousand square feet of approximately $249 per annumfor year one rising to $315 per annum in year ten.

 

 

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The followingis a schedule of future minimum lease payments under our operating lease as ofSeptember 30, 2005.

 

| ** **                   | ** ** | **Operating Leases** | ** ** |
|------------------------------|------------|----------------------|------------|
| 2005                         |       | $                    | 62         |   |
| 2006                         |       | 252                  |       |
| 2007                         |       | 256                  |       |
| 2008                         |       | 261                  |       |
| 2009                         |       | 265                  |       |
| Thereafter                   |       | 1,633                |       |
| Total minimum lease payments |       | $                    | 2,729      |   |

 

**17.**        Financial Instruments: Derivatives andHedging

** **

FASB No. 133, orSFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” whichbecame effective January 1, 2001, requires Gramercy to recognize allderivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value throughincome.  If a derivative is a hedge,depending on the nature of the hedge, changes in the fair value of thederivative will either be offset against the change in fair value of the hedgedasset, liability, or firm commitment through earnings, or recognized in othercomprehensive income until the hedged item is recognized in earnings.  The ineffective portion of a derivative’schange in fair value will be immediately recognized in earnings.  SFAS 133 may increase or decrease reportednet income and stockholders’ equity prospectively, depending on future levelsof LIBOR interest rates and other variables affecting the fair values ofderivative instruments and hedged items, but will have no effect on cash flows,provided the contract is carried through to full term.

 

The followingtable summarizes the notional and fair value of our derivative financialinstrument at September 30, 2005.  Allderivative instruments have been designated as cash flow hedges.  The notional value is an indication of theextent of our involvement in this instrument at that time, but does notrepresent exposure to credit, interest rate or market risks (in thousands):

 
| ** **          | ** ** | **Notional  Value** | ** ** | **Strike  Rate** | ** ** | **Effective  Date** | ** ** | **Expiration  Date** | ** ** | **Fair  Value** | ** ** |
|---------------------|------------|---------------------|------------|------------------|------------|---------------------|------------|----------------------|------------|-----------------|------------|
| Interest  Rate Swap |       | $                   | 10,729     |             | 3.360      | %                   | 8/2004     |                 | 12/2007    |            | $          | 255 |   |
| Interest  Rate Swap |       | $                   | 31,686     |             | 3.855      | %                   | 4/2005     |                 | 11/2009    |            | 773        |   |
| Interest  Rate Swap |       | $                   | 3,465      |             | 3.300      | %(1)                | 2/2005     | (1)                  | 2/2006     | (1)             | 41         |   |
| Interest  Rate Swap |       | $                   | 19,800     |             | 3.625      | %                   | 5/2005     |                 | 2/2006     |            | 32         |   |
| Interest  Rate Swap |       | $                   | 26,235     |             | 4.188      | %                   | 6/2005     |                 | 6/2010     |            | 363        |   |
| Interest  Rate Swap |       | $                   | 20,048     |             | 4.348      | %                   | 6/2005     |                 | 6/2015     |            | 457        |   |
| Interest  Rate Swap |       | $                   | 40,000     |             | 4.420      | %                   | 7/2005     |                 | 2/2014     |            | 496        |   |
|                     |            |                     |            |                  |            |                     |            |                      |            |                 |            |  |  |

 

(1)          This swap has a step-upcomponent with a strike rate of 4.28%, an effective date of February 2006 andan expiration of December 2009.  Thetotal fair value of the initial swap and the step-up provisions are reflectedin the fair value.

 

OnSeptember 30, 2005, the derivative instruments were reported as an assetat their fair value of $2,417. Offsetting adjustments are represented as deferred losses and are acomponent of Accumulated Other Comprehensive Income of $2,506.  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.

 

Weare hedging exposure to variability in future interest payments on our debtfacilities except in the case of TROR swaps we may enter into from time totime, which are intended to hedge our exposure to variability in the rate ofreturn in excess of anticipated future interest payments on that portion of ourdebt facilities used to fund fixed rate mortgage loan assets held as availablefor sale.

 

 

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**18.  Income Taxes**

 

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

 

During the three and ninemonths ended September 30, 2005, we recorded $500 and $1,000 of income taxexpense, respectively, for income attributable to GKK Trading Corp., our whollyowned taxable REIT subsidiary. We have assumed an effective tax rate for theyear ended December 31, 2005 of 40% taking into consideration the anticipatedapplicable U.S. federal statutory tax rate at December 31, 2005 of 34% andstate and local taxes, net of federal tax benefit.

 

**19.**       Environmental Matters

** **

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

** **

**20.**       Segment Reporting

** **

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

** **

**21.**       SupplementalDisclosure of Non-Cash Investing and Financing Activities

 

The following table represents non-cashinvesting and financing activities (in thousands):

 

| ** **                            | ** ** | **2005** | ** ** |
|---------------------------------------|------------|----------|------------|
| Derivative  instruments at fair value |       | $        | 2,417      |   |
|                                       |            |          |            |  |

** **

** **

**24**

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** **

**ITEM 2****: Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

** **

**Overview**

We are a national commercialreal estate 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, primarily in theUnited States.  We also make equityinvestments in commercial real estate properties net leased to tenants,primarily for the recurring earnings, tax benefits and long-term residualbenefits these transactions often hold. We conduct substantially all of our operations through our operatingpartnership, GKK Capital LP.  We areexternally managed and advised by GKK Manager LLC, or the Manager, amajority-owned subsidiary 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 transactionwe undertake, we seek to control as much of the capital structure as possiblein order to be able to identify and retain that portion that provides the bestrisk adjusted returns.  This is generallyachieved through the direct origination of whole loans, the ownership of whichpermits a wide variety of syndication and securitization executions to achieveexcess returns.  By providing a singlesource of financing for developers and sponsors, we intend to streamline thelending process, provide greater certainty for borrowers and retain the highyield debt instruments that we manufacture. By creating, rather than buying whole loans, subordinate mortgageparticipations, mezzanine debt and preferred equity, we strive to deliversuperior returns to our shareholders.

 

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

 

Because of the high relativevaluation of debt instruments in the current market and a generally increasingrate environment, we have carefully managed our exposure to interest ratechanges that could affect our liquidity. We generally match our assets and liabilities in terms of base interestrate (generally 30-day LIBOR) and expected duration.  We raised $95.0 million of additional equityin December 2004 and January 2005 to reduce our outstanding indebtedness andmaintain sufficient liquidity for our investment portfolio.  We sold a total of $100.0 million of trust preferredsecurities in two $50.0 million issuances in May 2005 and August 2005 throughwholly-owned subsidiaries of the Operating Partnership with 30 year termsexpiring in June 2035 and October 2035, respectively.  The securities issued in May bear interest ata fixed rate of 7.57% for the first ten years ending June 2015 while thesecurities issued in August bear interest at a fixed rate of 7.75% for thefirst ten years ending October 2015. After the first ten years, both issuances bear interest at three monthLIBOR plus 300 basis points.  Theproceeds from the issuances of the trust preferred securities were used to fundexisting and future investment opportunities. In July 2005 we closed on a $1.0 billion collateralized debt obligation,or CDO, which will serve to extend the term of our liabilities and lower ouroverall cost of funds from approximately 200 basis points over LIBOR toapproximately 49 basis points over LIBOR, excluding transaction costs.  The proceeds of the CDO were used torefinance our warehouse facilities and to fund additional investmentactivities.  In September 2005 we sold3,833,333 shares of common stock resulting in net proceeds of approximately$98.1 million which were used to fund acquisitions, repay outstanding principalamounts under our warehouse facilities and for general corporate purposes.

 

 

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As of September 30, 2005, weheld loans and other lending investments of approximately $936,401 million netof fees, discounts, repayments, asset sales and unfunded commitments.  As of September 30, 2005 we also held a$56,930 investment in an unconsolidated joint venture that acquired the SouthBuilding located at One Madison Avenue in New York, New York, which is almostentirely net leased to Credit Suisse First Boston (USA), Inc., or CSFB, under anet lease with a 15 year remaining term and a $51,259 investment in a 200,000square foot building in Somerset, New Jersey which is 100% net leased toPhilips Holding USA Inc, a wholly-owned subsidiary of Royal PhilipsElectronics, through December 2021.

 

The aggregate carryingvalues, allocation by product type and weighted average coupons of our loansand other lending investments as of September 30, 2005 and December 31, 2004were as follows:

** **
| ** **                                     | ** ** | **Carrying Value ($ in thousands)** | ** ** | **Allocation by  Investment Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average Spread over  LIBOR** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------|------------|--------------------------------|------------|------------------------------------------------|------------|
| ** **                                     | ** ** | **2005**                                      | ** ** | **2004**                           | ** ** | **2005**                       | ** ** | **2004**                                       | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Whole loans,  floating rate                    |       | $                                             | 397,271    |                               | $          | 155,215                        |       | 43                                             | %          | 38 | % | — |   | — |   | 309 bps |   | 373 bps |   |
| Whole loans,  fixed rate                       |       | 65,836                                        |       | —                             |       | 7                              | %          | —                                         |       | 8.12 | % | — |   | — |   | — |   |
| Subordinate  mortgage interests, floating rate |       | 298,026                                       |       | 209,286                            |       | 32                             | %          | 51                                             | %          | — |   | — |   | 575 bps |   | 640 bps |   |
| Subordinate  mortgage interests, fixed rate    |       | 36,639                                        |       | 31,216                             |       | 4                              | %          | 8                                              | %          | 9.23 | % | 9.57 | % | — |   | — |   |
| Mezzanine loans,  floating rate                |       | 72,540                                        |       | —                             |       | 8                              | %          | —                                         |       | — |   | — |   | 908 bps |   | — |   |
| Mezzanine loans,  fixed rate                   |       | 43,323                                        |       | —                             |       | 4                              | %          | —                                         |       | 8.88 | % | — |   | — |   | — |   |
| Preferred equity                               |       | 11,767                                        |       | —                             |       | 1                              | %          | —                                         |       | — |   | — |   | 900 bps |   | — |   |
| Commercial  mortgage backed securities         |       | 10,999                                        |       | 10,898                             |       | 1                              | %          | 3                                              | %          | 13.49 | % | 13.49 | % | — |   | — |   |
| Total / Average                                |       | $                                             | 936,401    |                               | $          | 406,615                        |       | 100                                            | %          | 100 | % | 8.97 | % | 10.58 | % | 475 bps |   | 526 bps |   |

** **

The following discussionrelating to our consolidated financial statements should be read in conjunctionwith the financial statements appearing in Item 8 of the Annual Report on Form10-K and Item 1 of this form 10-Q.

 

**Critical Accounting Policies**

Our discussion and analysis of financialcondition and results of operations is based on our financial statements, whichhave been prepared in accordance with accounting principles generally acceptedin the United States, known as GAAP. These accounting principles require us tomake some complex and subjective decisions and assessments.  Our most critical accounting policies involvedecisions and assessments, which could significantly affect our reportedassets, liabilities and contingencies, as well as our reported revenues andexpenses.  We believe that all of thedecisions and assessments upon which our financial statements are based werereasonable at the time made based upon information available to us at thattime.  We evaluate these decisions andassessments on an ongoing basis.  Actualresults may differ from these estimates under different assumptions orconditions.  We have identified our mostcritical accounting policies to be the following:

 

**Loans and Investments and LoansHeld for Sale**

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. Loans held for sale are carried at the lower of cost or market valueusing available market information obtained through consultation with dealersor other originators of such investments. We may originate or acquire preferred equity interests that allow us toparticipate in a percentage of the underlying property’s cash flows fromoperations and proceeds from a sale or refinancing.  Should we make such a preferred equityinvestment, we must determine whether that investment should be accounted foras a loan, joint venture or as an interest in real estate.  Our current preferred equity investment doesnot entitle us to a percentage of the underlying property’s cash flows fromoperations or proceeds from a sale or refinancing and is, therefore, accountedfor as a loan.

 

Specific valuationallowances are established for impaired loans based on the fair value ofcollateral on an individual loan basis. The fair value of the collateral is determined by an evaluation ofoperating cash flow from the property during the projected holding period, andthe estimated sales value of the collateral computed by applying an expectedcapitalization rate to the stabilized net operating income of the specificproperty, less selling costs, all of which are discounted at market discountrates.

 

 

26

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If upon completion of thevaluation, the fair value of the underlying collateral securing the impairedloan is less than the net carrying value of the loan, an allowance is createdwith a corresponding charge to the provision for loan losses.  The allowance for each loan is maintained ata level we believe is adequate to absorb probable losses.  At September 30, 2005 we maintained a reserveof $955.

 

Our Manager evaluates ourassets on a regular basis to determine if they continue to satisfy our investmentcriteria. Subject to certain restrictions applicable to REITs, our Manager maycause us to sell our investments opportunistically and use the proceeds of anysuch sale for debt reduction, additional acquisitions or working capitalpurposes.

#### ** **

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

Mortgage-backedsecurities, or MBS, are classified as available-for-sale securities.  As a result, changes in fair value will berecorded as a balance sheet adjustment to accumulated other comprehensiveincome, which is a component of stockholders equity, rather than through ourstatement of operations.  Ifavailable-for-sale securities were classified as trading securities, therecould be substantially greater volatility in earnings from period-to-period asthese investments would be marked to market and any reduction in the value ofthe securities versus the previous carrying value would be considered anexpense on our statement of operations. We had no investments as of September30, 2005 that were accounted for as trading securities.

** **

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

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

 

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

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

 

In accordancewith FASB No. 144, or SFAS 144, “Accounting for the Impairment of Disposal ofLong-Lived Assets,” a property to be disposed of is reported at the lower ofits carrying amount or its estimated fair value, less its cost to sell.  Once an asset is held for sale, depreciationexpense and straight-line rent adjustments are no longer recorded and historicresults are reclassified as Discontinued Operations.

 

In accordance with FASB No.141, or SFAS 141, “Business Combinations,” we allocate the purchase price ofreal estate to land and building and, if determined to be material,intangibles, such as the value of above, below and at-market leases andorigination costs associated with the in-place leases.  We depreciate theamount allocated to building and other intangible assets over their estimateduseful lives, which generally range from three to 40 years.  The values ofthe above and below market leases are amortized and recorded as either anincrease (in the case of below market leases) or a decrease (in the case ofabove market leases) to rental income over the remaining term of the associatedlease.  The value associated with in-place leases and tenant relationshipsare amortized over the expected term of the relationship, which includes anestimated probability of the lease renewal, and its estimated term.  If atenant vacates its space prior to the contractual termination of the lease andno rental payments are being made on the lease, any unamortized

 

 

27

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balance of the relatedintangible will be written off.  The tenant improvements and originationcosts are amortized as an expense over the remaining life of the lease (orcharged against earnings if the lease is terminated prior to its contractualexpiration date).  We assess fair value of the leases based on estimatedcash flow projections that utilize appropriate discount and capitalizationrates and available market information.  Estimates of future cash flowsare based on a number of factors including the historical operating results,known trends, and market/economic conditions that may affect the property.

 

As a result of our evaluationunder SFAS No. 141 of our acquisition of 200 Franklin Square Drive, werecognized an increase of approximately $4 in rental revenue for the three andnine months ended September 30, 2005 for the amortization of below marketleases and lease origination costs, resulting from the reallocation of thepurchase price of the property.

 

 At September 30, 2005 we held two CTLinvestments totaling $108,189 comprised of a $56,930 investment in the jointventure that acquired the South Building located at One Madison Avenue in NewYork, New York, and a $51,259 investment in 200 Franklin Square Drive inSomerset, New Jersey.

 

**Investment inUnconsolidated Joint Ventures**

#### **We account for our investment in anunconsolidated joint venture under the equity method of accounting since weexercise significant influence, but do not unilaterally control, the entity andare not considered to be the primary beneficiary under FIN 46.  In thejoint venture, the rights of the other investor are protective andparticipating. These rights preclude us from consolidating theinvestment.  The investment is recorded initially at cost, as aninvestment in an unconsolidated joint venture, and subsequently adjusted for equityin net income (loss) and cash contributions and distributions.  Anydifference between the carrying amount of the investments on our balance sheetand the underlying equity in net assets is amortized as an adjustment to equityin net income (loss) of unconsolidated joint ventures over the lesser of thejoint venture term or 40 years.  None of the joint venture debt isrecourse to us.**

 

#### **RevenueRecognition**

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.

** **

Income recognition is generallysuspended for debt investments at the earlier of the date at which paymentsbecome 90 days past due or when, in our opinion, a full recovery of income andprincipal becomes doubtful.  Incomerecognition is resumed when the loan becomes contractually current andperformance 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 and Servicing ofFinancial Assets and Extinguishments of Liabilities,” criteria is met, underwhich control of the asset that is sold is surrendered making it a “true sale,”a gain on the sale will be recorded through earnings as other income.

** **

Rental revenue is recognized ona straight-line basis over the term of the lease. The excess of rentsrecognized over amounts contractually due pursuant to the underlying leases isincluded in other assets on the accompanying balance sheets. We may establish,on a current basis, an allowance against this account for future potentialtenant credit losses, which may occur. The balance reflected on the balancesheet will be net of such allowance.

 

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

 

#### **Reservefor Possible Credit Losses**

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

** **

** **

**28**

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** **

Where impairment is indicated,a valuation write-down or write-off is measured based upon the excess of therecorded investment amount over the net fair value of the collateral, asreduced by selling costs.  Any deficiencybetween the carrying amount of an asset and the net sales price of repossessedcollateral is charged to the allowance for credit losses.  At September 30, 2005 we maintained a reservefor possible credit losses of $955.

 

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

The Class B limitedpartner interests are entitled to receive an incentive return equal to 25% ofthe amount by which funds from operations (as defined in the partnershipagreement of the Operating Partnership) plus certain accounting gains exceedthe product of our weighted average stockholders equity (as defined in thepartnership agreement of the Operating Partnership) multiplied by 9.5% (dividedby 4 to adjust for quarterly calculations). We will record any distributions on the Class B limited partner interestsas an incentive distribution expense in the period when earned and when paymentof such amounts has become probable and reasonably estimable in accordance withthe partnership agreement.  These cashdistributions will reduce the amount of cash available for distribution to ourcommon unitholders in our Operating Partnership and to commonstockholders.  We incurred approximately$1,038 with respect to such Class B limited partner interests for the ninemonths ended September 30, 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 ofbusiness, we are exposed to the effect of interest rate changes and limit theserisks by following established risk management policies and proceduresincluding the use of derivatives.  Toaddress exposure to interest rates, we use derivatives primarily to hedge themark-to-market risk of our liabilities with respect 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 also use total rate of return swaps, orTROR swaps, which are tied to the Lehman Brothers CMBS index. We expresslyprohibit the use of unconventional derivative instruments and using derivativeinstruments for trading or speculative purposes.  Further, we have a policy of only enteringinto contracts with major financial institutions based upon their creditratings and other factors.

** **

**FASB No. 133, or SFAS 133, “Accountingfor Derivative Instruments and Hedging Activities,” which became effectiveJanuary 1, 2001, as amended by FASB No. 149, requires us to recognize allderivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value throughincome.  If a derivative is a hedge,depending on the nature of the hedge, changes in the fair value of thederivative will either be offset against the change in fair value of the hedgedasset, liability, or firm commitment through earnings, or recognized in othercomprehensive income until the hedged item is recognized in earnings.  The ineffective portion of a derivative’schange in fair value will be immediately recognized in earnings.  SFAS 133 may increase or decrease reportednet income and stockholders’ equity prospectively, depending on future levelsof LIBOR, swap spreads and other variables affecting the fair values ofderivative instruments and hedged items, but will have no effect on cash flows,provided the contract is carried through to full term.**

 

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

 

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

 

 

29

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**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 Internal RevenueService grants us relief under certain statutory provisions.  Such an event could materially adverselyaffect our net income and net cash available for distributions to stockholders.  However, we believe that we will be organizedand operate in such a manner as to qualify for treatment as a REIT and weintend to operate in the foreseeable future in such a manner so that we willqualify as a REIT for federal income tax purposes.  We may, however, be subject to certain stateand local taxes.

** **

**Our wholly owned taxable REITsubsidiaries, individually referred to as a TRS, are subject to federal, stateand local taxes.**

 

# **Results of Operations**

 

***Comparison of the three monthsended September 30, 2005 to the three months ended September 30, 2004 (dollarsin thousands)***

 

***Revenues*                              **

** **

| ** **                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **$ Change** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|-------------------|------------|
| Investment  income                                  |       | $        | 21,060     |     | $          | 1,227             |       | $ | 19,833 |   |
| Rental  revenue                                     |       | 314      |       | —   |       | 314               |       |
| Other income                                        |       | 5,218    |       | 245      |       | 4,973             |       |
| Total revenues                                      |       | $        | 26,592     |     | $          | 1,472             |       | $ | 25,120 |   |
|                                                |       |     |       |     |       |              |       |
| Equity in  net loss of unconsolidated joint venture |       | $        | (510       | )        | $          | —            |       | $ | (510 | ) |
|                                                     |            |          |            |          |            |                   |            |  |  |  |  |  |

 

Investment income isgenerated on our whole loans, senior mortgage interests, subordinate mortgageinterests, mezzanine loans, preferred equity interests and CMBSinvestments.  For the three months endedSeptember 30, 2005 $3,409 was earned on fixed rate investments while theremaining $17,651 was earned on floating rate investments.  The increase over the prior year is due to asignificantly higher number of investments in 2005 versus 2004 and the effectof a full three months of operations in 2005.

** **

**Rental revenue of $314 in 2005was earned on 200 Franklin Square Drive, which was acquired in September2005.  This amount includes the effect ofadjustments for straight-line rent and FASB 141 adjustments for below marketleases.  We did not hold any real estateinvestments during 2004.**

 

Other income of $5,218for the three months ended September 30, 2005 is comprised primarily of incomerecorded on the sale of whole loans of $3,184, interest on restricted cash balancesin the CDO, which was not in place in 2004 of approximately $1,212 and aone-time break-up fee paid by a potential borrower of $604.  For the three months ended September 30,2004, other income of $245 was comprised only of interest income on cash balances.

** **

**The loss on investment inunconsolidated joint venture of $510 in 2005 represents our proportionate shareof the losses generated by the joint venture that owns the South Building atOne Madison Avenue.  We did not maintainany joint venture investments during 2004.**

** **

***Expenses***

*** ***

| ** **                             | ** ** | **2005** | ** ** | **2004** | ** ** | **$ Change** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|-------------------|------------|
| Interest  expense                      |       | $        | 11,250     |     | $          | 63                |       | $ | 11,187 |   |
| Management  fees                       |       | 2,726    |       | 786      |       | 1,940             |       |
| Incentive  fee                         |       | 1,038    |       | —   |       | 1,038             |       |
| Depreciation  and amortization         |       | 105      |       | 5        |       | 100               |       |
| Marketing,  general and administrative |       | 1,456    |       | 332      |       | 1,124             |       |
| Provision  for loan loss               |       | 430      |       | —   |       | 430               |       |
| Provision  for taxes                   |       | 500      |       | —   |       | 500               |       |
| GKK  formation costs                   |       | —   |       | 275      |       | (275              | )          |
| Total expenses                         |       | $        | 17,505     |     | $          | 1,461             |       | $ | 16,044 |   |
|                                        |            |          |            |          |            |                   |            |  |  |  |  |

 

 

30

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Interest expense was $11,250for the three months ended September 30, 2005 versus $63 for the three monthsended September 30, 2004.  The increasein 2005 is due primarily to $7,659 of interest on the investment grade tranchesof our CDO, which was not in place in 2004, which are not held by us, $1,824 ofinterest on borrowings on our master repurchase facilities with WachoviaCapital Markets, LLC and Goldman Sachs Mortgage Company and $1,527 of interestexpense accrued against our two $50,000 issuances of trust preferredsecurities.  The $63 of interest expensefor the three months ended September 30, 2004 was comprised of the amortizationof deferred financing costs and interest on one swap agreement.

 

Management fees increased$1,940 for the three months ended September 30, 2005 versus same period in 2004due primarily to higher fees of $1,131 paid or payable to the Manager under ourmanagement agreement resulting from an increase in our stockholder’s equity,the issuance of trust preferred securities and a full three months ofoperations in 2005.  The remainingincrease is comprised of $438 payable to the Manager under the CDO collateralmanagement agreement which was not in place in 2004, and higher fees paid or payableto SL Green Operating Partnership, L.P. of $111 and $260 under our outsourcingand servicing agreements, respectively, due to a full three months ofoperations in 2005 and a larger asset base on which to calculate the servicingfee.  These fees and the relationshipbetween us, the Manager and SL Green Operating Partnership, L.P. are discussedfurther in “Related Party Transactions.”

 

We recorded an incentive feeexpense of $1,038 during the three months ended September 30, 2005 inaccordance with requirements of the partnership agreement of the OperatingPartnership which entitles owners of Class B limited partner interests in theOperating Partnership to an incentive return equal to 25% of the amount bywhich 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).  This thresholdwas not reached during 2004 and, consequently, no expense was recorded.  This fee and the relationship between us, theManager and SL Green Operating Partnership, L.P. are discussed further in “RelatedParty Transactions.”

 

The increase in marketing,general and administrative expenses of $1,124 for the three months endedSeptember 30, 2005 versus the same period in 2004 reflects a full three monthsof operations in 2005 and a corresponding increase in professional fees,stock-based compensation, insurance and general overhead costs.

 

Stock-based compensationexpense included in marketing, general and administrative expenses was $455 forthe three months ended September 30, 2005 representing a ratable portion of theexpense for the issuance of restricted stock, options or other equity awardsover their respective vesting periods.

 

***Comparison of the nine monthsended September 30, 2005 to the period from April 12, 2004 (formation) throughSeptember 30, 2004 (dollars in thousands)***

 

***Revenues***

 

| ** **                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **$ Change** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|-------------------|------------|
| Investment  income                                  |       | $        | 46,999     |     | $          | 1,227             |       | $ | 45,772 |   |
| Rental  revenue                                     |       | 314      |       | —   |       | 314               |       |
| Other income                                        |       | 8,727    |       | 245      |       | 8,482             |       |
| Total revenues                                      |       | $        | 56,040     |     | $          | 1,472             |       | $ | 54,568 |   |
|                                                |       |     |       |     |       |              |       |
| Equity in  net loss of unconsolidated joint venture |       | $        | (914       | )        | $          | —            |       | $ | (914 | ) |
|                                                     |            |          |            |          |            |                   |            |  |  |  |  |  |

 

For the nine months endedSeptember 30, 2005 $6,716 was earned on fixed rate investments while theremaining $40,283 was earned on floating rate investments.  The increase over the prior year is due to asignificantly higher number of investments in 2005 versus 2004 and the effectof a full nine months of operations in 2005.

** **

**Rental revenue of $314 in 2005was earned on 200 Franklin Square Drive which was acquired in September2005.  This amount reflects the effect ofadjustments for straight-line rent and FASB 141.  We did not hold any real estate investmentsduring 2004.**

 

Other income of $8,727for the nine months ended September 30, 2005 is comprised primarily of incomerecorded on the sale of whole loans of $6,565, interest on restricted cashbalances in the CDO of approximately $1,212 and a one-time break-up fee paid bya potential borrower of $604.  For theperiod from April 12, 2004 through September 30, 2004, other income of $245 wascomprised only of interest income on cash balances.

** **

** **

**31**

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** **

** **

**The loss on investment inunconsolidated joint venture of $914 in 2005 represents our proportionate shareof the losses generated by the joint venture that owns the South Building atOne Madison Avenue.  We did not maintainany joint venture investments during 2004.**

 

***Expenses***

*** ***

| ** **                             | ** ** | **2005** | ** ** | **2004** | ** ** | **$ Change** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|-------------------|------------|
| Interest  expense                      |       | $        | 20,316     |     | $          | 63                |       | $ | 20,253 |   |
| Management  fees                       |       | 6,264    |       | 786      |       | 5,478             |       |
| Incentive  fee                         |       | 1,038    |       | —   |       | 1,038             |       |
| Depreciation  and amortization         |       | 232      |       | 5        |       | 227               |       |
| Marketing,  general and administrative |       | 4,722    |       | 332      |       | 4,390             |       |
| Provision  for loan loss               |       | 955      |       | —   |       | 955               |       |
| Provision  for taxes                   |       | 1,000    |       | —   |       | 1,000             |       |
| GKK  formation costs                   |       | —   |       | 275      |       | (275              | )          |
| Total expenses                         |       | $        | 34,527     |     | $          | 1,461             |       | $ | 33,066 |   |
|                                        |            |          |            |          |            |                   |            |  |  |  |  |

 

Interest expense was $20,316for the nine months ended September 30, 2005 versus $63 for the period fromApril 12, 2004 through September 30, 2004. This increase is due primarily to $7,659 of interest on the investmentgrade tranches of our CDO, which did not exist in 2004, which are not held byus, $10,480 of interest on borrowings on our master repurchase facilities withWachovia Capital Markets, LLC and Goldman Sachs Mortgage Company and $1,937 ofinterest expense accrued against our two $50,000 issuances of trust preferredsecurities.  The $63 of interest expensein 2004 was comprised of the amortization of deferred financing costs andinterest on one swap agreement.

 

Management fees increased$5,478 in 2005 due primarily to higher fees of $3,661 paid or payable to theManager under our management agreement resulting from an increase in ourstockholder’s equity, the issuance of trust preferred securities and a fullnine months of operations in 2005.  Theremaining increase is comprised of $438 payable to the Manager under the CDOcollateral management agreement which was not in place in 2004, and higher feespaid or payable to SL Green Operating Partnership, L.P. of $736 and $643 underour outsourcing and servicing agreements, respectively, due to a full ninemonths of operations in 2005 and a larger asset base on which to calculate theservicing fee.  These fees and therelationship between us, the Manager and SL Green Operating Partnership, L.P.are discussed further in “Related Party Transactions.”

 

We recorded an incentive feeexpense of $1,038 during the nine months ended September 30, 2005 in accordancewith requirements of the partnership agreement of the Operating Partnership asoutlined above.  This threshold was notreached during 2004 and, consequently, no expense was recorded.  This fee and the relationship between us, theManager and SL Green Operating Partnership, L.P. are discussed further in “RelatedParty Transactions.”

 

The increase in marketing,general and administrative expenses of $4,390 for the nine months endedSeptember 30, 2005 versus the period from April 12, 2004 through September 30,2004 reflects a full nine months of operations in 2005 and a correspondingincrease in professional fees, stock-based compensation, insurance and generaloverhead costs.

 

Stock-based compensationexpense included in marketing, general and administrative expenses was $1,912for the nine months ended September 30, 2005 representing a ratable portion ofthe expense for the issuance of restricted stock, options or other equityawards over their respective vesting periods.

 

**Liquidity and Capital Resources**

 

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

** **

Our ability to meet ourlong-term liquidity and capital resource requirements will be subject toobtaining additional debt financing and equity capital.  If we are unable to renew, replace or expandour sources of financing on substantially similar terms, it may have an

 

 

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

 

To maintain our status as aREIT under the Internal Revenue Code, we must distribute annually at least 90%of our taxable income.  Thesedistribution requirements limit our ability to retain earnings and therebyreplenish or increase capital for operations. However, we believe that our significant capital resources and access tofinancing will provide us with financial flexibility at levels sufficient tomeet current and anticipated capital requirements, including funding newlending and investment opportunities.

 

**Collateralized Debt Obligation**

On July 14, 2005, we issued approximately $1,000,000 ofcollateralized debt obligations, or CDO, through two newly-formed indirectsubsidiaries, Gramercy Real Estate CDO 2005-1 Ltd., or the Issuer, andGramercy Real Estate CDO 2005-1 LLC, or the Co-Issuer. The CDO consists of$810,500 of investment grade notes, and $84,500 of non-investment grade notes,which were co-issued by the Issuer and the Co-Issuer, and $105,000 of preferredshares, which were issued by the Issuer. We retained all non-investment grade securities and the preferred sharesin the Issuer.  The Issuer holds assets,consisting primarily of whole loans, subordinate interests in whole loans,mezzanine loans and preferred equity investments, which serve as collateral forthe CDO. The investment grade notes were issued with floating rate coupons witha combined weighted average rate of three-month LIBOR plus 0.49%. The CDO maybe replenished pursuant to certain rating agency guidelines relating to creditquality and diversification, with substitute collateral for loans that arerepaid during the first five years of the CDO. Thereafter, the CDO securitieswill be retired in sequential order from senior-most to junior-most as loansare repaid. We incurred approximately $11,580 of issuance costs, which will beamortized on a level yield basis over the average life of the CDO. The Issueris consolidated in our financial statements. The investment grade notes aretreated as a secured financing, and are non-recourse to us.

Proceeds from the sale of the investment grade notes issued were usedto repay substantially all outstanding debt under our repurchase agreements andfund additional investments.

 

**JuniorSubordinated Debentures**

On May 20, 2005 we completedthe issuance of $50,000 in unsecured trust preferred securities through a newlyformed  Delaware statutory trust,Gramercy Capital Trust I, or GCTI, that is a wholly owned subsidiary of theOperating Partnership.  The securitiesbear interest at a fixed rate of 7.57% for the first ten years ending June 2015.  Thereafter the rate will float based on thethree-month LIBOR plus 300 basis points.

 

On August 9, 2005 we completedan additional issuance of $50,000 in unsecured trust preferred securitiesthrough a separate newly formed Delaware statutory trust, Gramercy CapitalTrust II, or GCTII, that is also a wholly owned subsidiary of the OperatingPartnership.  The securities bearinterest at a fixed rate of 7.75% for the first ten years ending October2015.  Thereafter the rate will floatbased on the three-month LIBOR plus 300 basis points.

 

Both issuances of trustpreferred securities require quarterly interest distributions, however paymentsmay be deferred while the interest expense is accrued for a period of up tofour consecutive quarters if the Operating Partnership exercises its right to defersuch payments.  The trust preferredsecurities are redeemable, at the option of the Operating Partnership, in wholeor in part, with no prepayment premium any time after June 30, 2010 for thesecurities issued in May 2005 and October 30, 2010 for the securities issued inAugust 2005.

 

GCTI and GCTII each issued$1,550 aggregate liquidation amount of common securities, representing 100% ofthe voting common stock of GCTI and GCTII to the Operating Partnership for atotal purchase price of $3,100.  GCTI andGCTII used the proceeds from the sale of the trust preferred securities and thecommon securities to purchase the Operating Partnership’s junior subordinatednotes.  The terms of

** **

**33**

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** **

**the junior subordinated notesmatch the terms of the trust preferred securities.  The notes are subordinate and junior in rightof payment to all present and future senior indebtedness and certain other ofour financial obligations.  We realizednet proceeds from each offering of approximately $48,956.**

Our interests in GCTI and GCTII are accounted for using the equitymethod and the assets and liabilities of GCTI and GCTII are not consolidatedinto our financial statements.  Intereston the junior subordinated notes is included in interest expense on ourconsolidated income statements while the junior subordinated notes arepresented as a separate item in our consolidated balance sheet.

** **

**Indebtedness**

** **

**The table below summarizesborrowings under our Wachovia and Goldman repurchase facilities and any termloans at September 30, 2005 and December 31, 2004, respectively (dollars inthousands).**

** **

| ** **                                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-------------------|------------|------------------|------------|
| **Debt Summary:**                            | ** ** | **2005**          | ** ** | **2004**         | ** ** |
| **Balance**                                  |       |              |       |             |       |
| Fixed rate                                   |       | $                 | 41,000     |             | $          | — |   |
| Variable  rate                               |       | —            |       | 238,885          |       |
| Total                                        |       | $                 | 41,000     |             | $          | 238,885 |   |
|                                         |       |              |       |             |       |
| **Effective  interest rate for the period:** |       |              |       |             |       |
| Fixed rate                                   |       | 4.90              | %          | —           |       |
| Variable  rate                               |       | —            |       | LIBOR + 1.99     | %          |

** **

**RepurchaseFacilities**

** **

Wehave two repurchase facilities with an aggregate of $700 million of total debtcapacity.  In August 2004 we closed on a$250 million 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 April22, 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, $150million matures in December 2007 and the remaining $100 million matures in June2008.  Also in conjunction with the April2005 upsize, the $50 million credit facility we previously maintained withWachovia was consolidated into the $500 million repurchase facility.  The$500 million facility bears interest at spreads of 1.25% to 3.50% over 30-dayLIBOR and, based on our investment activities, provides for advance rate thatvary from 50% to 95% based upon the collateral provided under a borrowing basecalculation.  The lender has a consentright with respect to the inclusion of investments in this facility, determinesperiodically the market value of the investments, and has the right to requireadditional collateral if the estimated market value of the included investmentsdeclines. We did not have any borrowings under this facility atSeptember 30, 2005.  $239 was outstandingat December 31, 2004.  We can utilize the$25,000 revolving credit facility described below to fund requirements foradditional collateral pursuant to the warehouse financing or to fund theacquisition of assets.

 

On January 3, 2005 weclosed an additional repurchase facility of $200 million with Goldman SachsMortgage Company, an affiliate of Goldman Sachs & Co.  This facility has an initial term of threeyears expiring in January 2008 with one six-month extension option.  This facility bears interest at spreads of1.125% to 2.75% over a 30-day LIBOR and, based on our 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 investmentsdeclines.  At September 30, 2005 we hadno borrowings under this facility.

** **

The repurchase facilitiesrequire that we pay down borrowings under these facilities as principalpayments on the loans and investments pledged to these facilities 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.

** **

** **

**34**

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** **

**CreditFacility**

** **

We have one $25 millioncredit facility with Wachovia CapitalMarkets, LLC. with a term of two years. Amounts drawn under this facility for liquidity purposes bear interestat a spread over LIBOR of 525 basis points. Amounts drawn under this facility for acquisition purposes bear interestat a spread over LIBOR of 225 basis points. Amounts drawn under this facility for liquidity purposes must be repaidwithin 105 days.  Amounts drawn underthis facility generally will be secured by assets established under a borrowingbase calculation unless certain financial covenants are satisfied.  These covenants are generally morerestrictive than those set forth below. At September 30, 2005 and December 31, 2004 we had no borrowings underthis facility.

** **

**The credit facility requires thatwe pay down borrowings under this facility as principal payments on our loansand investments pledged to this facility are received.**

** **

**RestrictiveCovenants**

** **

**The terms of both of ourrepurchase facilities and our credit facility include covenants that (a) limitour maximum total indebtedness to no more than 85% of our total assets, (b)require us to maintain minimum liquidity of at least $10 million for the firsttwo years and $15 million thereafter, (c) our fixed charge coverage ratio shallat no time 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 maintain minimumtangible net worth of not less than the greater of (i) $129.75 million, or (i)plus (ii) 75% of the proceeds of our subsequent equity issuances and (f)restrict the maximum amount of our total indebtedness.  The covenants also restrict us from makingdistributions in excess of a maximum of 103% of our funds from operations (asdefined by the National Association of Real Estate Investment Trusts) throughJuly 2005 and 100% thereafter, except that we may in any case pay distributionsnecessary to maintain our REIT status.  Underour facilities with Wachovia Capital Markets, LLC, an event of default will betriggered if GKK Manager LLC ceases to be the Manager.  As of September 30, 2005, we were incompliance with all such covenants.**

 

To maintain our status as aREIT under the Internal Revenue Code, we must distribute annually at least 90%of our taxable income.  Thesedistribution requirements limit our ability to retain earnings and therebyreplenish or increase capital for operations. However, we believe that our significant capital resources and access tofinancing will provide us with financial flexibility at levels sufficient tomeet current and anticipated capital requirements, including funding newlending and investment opportunities.

 

#### **Mortgage Loan**

 

We have one interest-onlymortgage loan of $41,000 that bears interest at a fixed rate of 4.90% and has aterm of ten years, resulting in a balloon payment in 2015.  This mortgage was used to finance ouracquisition of 200 Franklin Square Drive for approximately $50,250, excludingclosing costs, in September 2005.

** **

**Capitalization**

** **

As of September 30, 2005, wehad 22,794,309 shares of common stock outstanding.

 

**Market Capitalization**

 

At September 30, 2005, ourcollateralized debt obligation and borrowings under our repurchase facilities,revolving credit facility and mortgage loan represented 61% of our consolidatedmarket capitalization of $1.5 billion (based on a common stock price of $23.96per share, the closing price of our common stock on the New York Stock Exchangeon September 30, 2005).  Marketcapitalization includes our consolidated debt and common stock.

 

35

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**Contractual Obligations**

 

Combinedaggregate principal maturities of our CDO, repurchase facilities, trust preferredsecurities, mortgage note payable, revolving credit facility and ourobligations under our operating lease as of September 30, 2005 are as follows(in thousands):

 
| ** ** | ** ** | **Collateralized Debt  Obligation** | ** ** | **Repurchase Facilities** | ** ** | **Trust Preferred Securities** | ** ** | **Mortgage Note Payable** | ** ** | **Revolving  Credit  Facility** | ** ** | **Operating Leases** | ** ** | **Total** | ** ** |
|------------|------------|-------------------------------------|------------|---------------------------|------------|--------------------------------|------------|---------------------------|------------|---------------------------------|------------|----------------------|------------|-----------|------------|
| 2005       |       | $                                   | —     |                      | $          | —                         |       | $                         | —     |                            | $          | —               |       | $         | —     |   | $ | 62 |   | $ | 62 |   |
| 2006       |       | —                              |       | —                    |       | —                         |       | —                    |       | —                          |       | 252                  |       | 252       |       |
| 2007       |       | —                              |       | —                    |       | —                         |       | —                    |       | —                          |       | 256                  |       | 256       |       |
| 2008       |       | —                              |       | —                    |       | —                         |       | —                    |       | —                          |       | 261                  |       | 261       |       |
| 2009       |       | —                              |       | —                    |       | —                         |       | —                    |       | —                          |       | 265                  |       | 265       |       |
| Thereafter |       | 810,500                             |       | —                    |       | 100,000                        |       | 41,000                    |       | —                          |       | 1,633                |       | 953,133   |       |
|       |       | $                                   | 810,500    |                      | $          | —                         |       | $                         | 100,000    |                            | $          | 41,000               |       | —    |       | $ | 2,729 |   | $ | 954,229 |   |
|            |            |                                     |            |                           |            |                                |            |                           |            |                                 |            |                      |            |           |            |  |  |  |  |  |  |  |  |  |  |  |

 

**Dividends**

 

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

 

**Related Party Transactions**

 

In connection withour initial public offering, we entered into a management agreement with GKKManager LLC, or Manager, which provides for an initial term through December2007 with automatic one-year extension options and is subject to certaintermination rights.  We pay the Manageran annual management fee equal to 1.75% of our gross stockholders equity (asdefined in the management agreement) inclusive of the trust preferredsecurities issued on May 20, 2005 and August 9, 2005.  We paid or had payable to the Manager underthis agreement an aggregate of approximately $1,678 and $4,208, for the threeand nine months ended September 30, 2005, respectively and approximately $547for the period from April 12, 2004 through September 30, 2004.

** **

At September 30, 2005, the majorityof the Class B limited partnership interests were owned by our Manager and SLGreen Operating Partnership, L.P. Interests were also held by certain officersand employees of SL Green Realty Corp., including some of whom are ourexecutive officers, which interests are subject to performance thresholds.  To provide an incentive for the Manager toenhance the value of the common stock, the Manager and SL Green OperatingPartnership, L.P. are entitled through their ownership of Class B limitedpartner interests of the Operating Partnership to an incentive return equal to25% of the amount by which funds from operations (as defined in the partnershipagreement of the Operating Partnership) plus certain accounting gains exceedthe product of our weighted average stockholders equity (as defined in thepartnership agreement of the Operating Partnership) multiplied by 9.5% (dividedby 4 to adjust for quarterly calculations). We will record any distributions on the Class B limited partnerinterests as an incentive distribution expense in the period when earned andwhen payments of such amounts have become probable and reasonably estimable inaccordance with the partnership agreement. We incurred approximately $1,038 of incentive distribution expense forthe nine months ended September 30, 2005.

 

We are obligated to reimbursethe Manager for its costs incurred under an Asset Servicing Agreement betweenour Manager and an affiliate of SL Green Operating Partnership, L.P. and aseparate Outsourcing Agreement between our Manager and SL Green OperatingPartnership, L.P.  The Asset ServicingAgreement provides for an annual fee payable by us of 0.15% of the carryingvalue of our investments, excluding certain defined investments for which otherservicing arrangements are executed and further reduced by fees paid directlyto outside servicers by us which have been approved by SL Green OperatingPartnership, L.P.  The OutsourcingAgreement provides a fee payable by us of $1,288 per year, increasing 3%annually over the prior year.  For thethree months ended September 30, 2005, we paid or had payable an aggregate of$319 and $291 to our Manager under the Outsourcing and Asset ServicingAgreements, respectively.  For the ninemonths ended September 30, 2005 and the period from April 12, 2004 throughSeptember 30, 2004, we paid or had payable an aggregate of $944 and $208,respectively, to our Manager under the Outsourcing Agreement.  For the nine months ended September 30, 2005and the period from April 12, 2004 through September 30, 2004, we paid or hadpayable an aggregate of $674 and $31 to our Manager under the Asset ServicingAgreement, respectively.

 

 

36

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In connection with theclosing of our CDO in July 2005, the Issuer entered into a CollateralManagement Agreement with the Manager. Pursuant to the Collateral ManagementAgreement, the Manager has agreed to provide certain advisory andadministrative services in relation to the collateral debt securities and othereligible investments securing the CDO notes. The Collateral Management Agreement provides for a senior collateralmanagement fee, payable quarterly in accordance with the priority of paymentsas set forth in the indenture, equal to 0.15% per annum of the net outstandingportfolio balance, and an additional subordinate collateral management fee,payable quarterly in accordance with the priority of payments as set forth inthe indenture, equal to 0.25% per annum of the net outstanding portfoliobalance.  Net outstanding portfoliobalance is the sum of the (i) aggregate principal balance of the collateraldebt securities, excluding defaulted securities, (ii) aggregate principalbalance of all principal proceeds held as cash and eligible investments incertain accounts, and (iii) with respect to the defaulted securities, thecalculation amount of such defaulted securities. As compensation for theperformance of its obligations as collateral manager, our Board of Directorshas allocated to the Manager the portion of the subordinate collateralmanagement fee paid on securities not held by us.  The senior collateral management fee and balance of the subordinatecollateral management fee is allocated to us. For the three and nine months ended September 30, 2005 we paid or hadpayable $438 to the Manager under the Collateral Management Agreement.

** **

In connection with the5,500,000 shares of common stock that were sold on December 3, 2004 and settledon December 31, 2004 and January 3, 2005 in a private placement, we agreed topay the Manager a fee of $1,000 as compensation for financial advisory,structuring and costs incurred on our behalf.  This fee was recorded as a reduction in the proceeds of the privateplacement.  Apart from legal fees andstock clearing charges totaling $245, no other fees were paid by us to aninvestment bank, broker/dealer or other financial advisor in connection withthe private placement, resulting in total costs of 1.3% of total grossproceeds.

 

**On April 29, 2005, we closed on a$57,503 initial investment in a joint venture with SL Green to acquire, own andoperate the South Building located at One Madison Avenue, New York, New York,or the Property.  The joint venture,which was created to acquire, own and operate the Property, is owned 45% by awholly-owned subsidiary of us and 55% by a wholly-owned subsidiary of SLGreen.  The joint venture interests arepari passu.  Also on April 29, 2005, thejoint venture completed the acquisition of the Property from Metropolitan LifeInsurance Company for the purchase price of approximately $802,800 plus closingcosts, financed in part through a $690,000 first mortgage loan on the Property.  The Property comprises approximately 1.2million square feet and is almost entirely net leased to Credit Suisse FirstBoston (USA), Inc., or CSFB, pursuant to a lease with a 15-year remaining term.**

** **

Commencing May1, 2005 we are party to a lease agreement with SLG Graybar Sublease LLC, anaffiliate of SL Green, for our corporate offices at 420 Lexington Avenue, NewYork, New York.  The lease is forapproximately five thousand square feet with an option to lease an additionalapproximately two thousand square feet and carries a term of ten years withrents on the entire seven thousand square feet of approximately $249 per annumfor year one rising to $315 per annum in year ten.

 

**BrightStar Couriers LLC, or Bright Star, provides messenger services to us.  Bright Star is owned by Gary Green, a son ofStephen L. Green.  The aggregate amountof fees paid by us for such services for the three and nine months endedSeptember 30, 2005 was approximately $1 and $2, respectively and less than $1for the three months ended September 30, 2004 and the period from April 12,2004 through September 30, 2004.**

** **

**SL GreenOperating Partnership, L.P. has invested $75,000 and $6,100 in preferred equityinterests that are subordinate to two of our investments with book values of$94,273 and $6,439, respectively, as of September 30, 2005.**

** **

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

** **

**Funds from Operations**

FFO is a widely recognized measure of REIT performance.  We compute FFO in accordance with standardsestablished by the National Association of Real Estate Investment Trusts, orNAREIT, which may not be comparable to FFO reported by other REITs that do notcompute FFO in accordance with the NAREIT definition, or that interpret theNAREIT definition differently than we do. The revised White Paper on FFO approved by the Board of Governors ofNAREIT in April 2002 defines FFO as net income (loss) (computed in accordancewith GAAP), excluding gains (or losses) from debt restructuring and sales ofproperties, plus real estate related depreciation and amortization and afteradjustments for unconsolidated partnerships and joint ventures.  We present FFO because we consider it animportant supplemental measure of our operating performance and believe that itis frequently used by

 

37

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securities analysts, investors and other interested parties in theevaluation of REITS.  We also use FFO asone of several criteria to determine performance-based bonuses for members ofour senior management.  FFO is intendedto exclude GAAP historical cost depreciation and amortization of real estateand related assets, which assumes that the value of real estate assetsdiminishes ratably over time. Historically, however, real estate values have risen or fallen withmarket conditions.  Because FFO excludesdepreciation and amortization unique to real estate, gains and losses fromproperty dispositions and extraordinary items, it provides a performancemeasure that, when compared year over year, reflects the impact to operationsfrom trends in occupancy rates, rental rates, operating costs, interest costs,providing perspective not immediately apparent from net income.  FFO does not represent cash generated fromoperating activities in accordance with GAAP and should not be considered as analternative to net income (determined in accordance with GAAP), as anindication of our financial performance or to cash flow from operatingactivities (determined in accordance with GAAP) as a measure of our liquidity,nor is it indicative of funds available to fund our cash needs, including ourability to make cash distributions.

 

Funds from Operations for the three and nine months ended September 30,2005, the three months ended September 30, 2004 and the period from April 12,2004 (formation) through September 30, 2004 is as follows (in thousands):

 
| ** **                                       | ** ** | **For the Three  Months Ended  September 30,  2005** | ** ** | **For the Three  Months Ended  September 30,  2004** | ** ** | **For the Nine  Months Ended  September 30,  2005** | ** ** | **For the Period  April 12, 2004  (formation)  through  September 30,  2004** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| Net income available to common stockholders      |       | $                                                    | 8,577      |                                                 | $          | 11                                                  |       | $                                                                             | 20,599     |   | $ | 11 |   |
| Add:                                             |       |                                                 |       |                                                 |       |                                                |       |                                                                          |       |
| Depreciation and amortization                    |       | 1,012                                                |       | 46                                                   |       | 1,966                                               |       | 46                                                                            |       |
| FFO adjustment for unconsolidated joint  venture |       | 1,784                                                |       | —                                               |       | 2,984                                               |       | —                                                                        |       |
| Less:                                            |       |                                                 |       |                                                 |       |                                                |       |                                                                          |       |
| Non real estate depreciation and  amortization   |       | 926                                                  |       | 46                                                   |       | 1,880                                               |       | 46                                                                            |       |
| Funds from operations                            |       | $                                                    | 10,447     |                                                 | $          | 11                                                  |       | $                                                                             | 23,669     |   | $ | 11 |   |
|                                             |       |                                                 |       |                                                 |       |                                                |       |                                                                          |       |
| Funds from operations per share - basic          |       | $                                                    | 0.53       |                                                 | $          | 0.00                                                |       | $                                                                             | 1.24       |   | $ | 0.00 |   |
| Funds from operations per share - diluted        |       | $                                                    | 0.50       |                                                 | $          | 0.00                                                |       | $                                                                             | 1.21       |   | $ | 0.00 |   |

 

**Cautionary Note Regarding Forward-Looking Statements**

 

This report contains “forward-looking statements” within the meaning ofSection 27A of the Securities Act of 1933, as amended, or the Act, and Section21E of the Securities Exchange Act of 1934, as amended, or the ExchangeAct.  You can identify forward-lookingstatements by the use of forward-looking expressions such as “may,” “will,” “should,”“expect,” “anticipate,” “estimate,” “believe,” “intend,” “plan,” “project,” “continue,”or any negative or other variations on such expressions.  Forward-looking statements includeinformation concerning possible or assumed future results of our operations,including any forecasts, projections, plans and objectives for futureoperations.  Although we believe that ourplans, intentions and expectations as reflected in or suggested by thoseforward-looking statements are reasonable, we can give no assurance that theplans, intentions or expectations will be achieved.  We have listed below some important risks,uncertainties and contingencies which could cause our actual results,performance or achievements to be materially different from the forward-lookingstatements we make in this report.  Theserisks, uncertainties and contingencies include, but are not limited to, the following:

 

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

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

•                    theperformance and financial condition of borrowers and corporate customers;

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

•                    the cost ofour capital, 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;

•                    availabilityof qualified personnel;

•                    availabilityof investment opportunities on real estate related and other securities;

 

 

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•                    the adequacyof our cash reserves and working capital;

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

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

•                    risks ofstructured finance investments;

•                    GKK ManagerLLC remaining as our Manager;

•                    environmentaland/or safety requirements;

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

•                    competitionwith other companies;

•                    our ability tosatisfy complex rules in order for us to qualify as a REIT for federal income taxpurposes, our operating partnership’s ability to satisfy the rules in order forit to qualify as a partnership for federal income tax purposes, the ability ofcertain of our subsidiaries to qualify as REITs, and the ability of certain ofour subsidiaries to qualify as taxable REIT subsidiaries for federal income taxpurposes, and our ability and the ability of our subsidiaries to operateeffectively within the limitations imposed by these rules;

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

•                    legislativeand regulatory changes (including changes to laws governing the taxation ofREITs), and other factors, many of which are beyond our control.

 

We undertake no obligation to publicly update or revise anyforward-looking statements, whether as a result of future events, newinformation 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.

** **

** **

**39**

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** **

**ITEM3.  Quantitative and QualitativeDisclosure 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.

 

#### **RealEstate Risk**

 

Commercial and multi-familyproperty values and net operating income derived from such properties aresubject to volatility and may be affected adversely by a number of factors,including, but not limited to, national, regional and local economic conditionswhich may be adversely affected by industry slowdowns and other factors), localreal estate conditions (such as an oversupply of retail, industrial, office orother commercial or multi-family space), changes or continued weakness inspecific industry segments, construction quality, age and design, demographicfactors, retroactive changes to building or similar codes, and increases inoperating expenses (such as energy costs). In the event net operating income decreases, a borrower may havedifficulty repaying our loans, which could result in losses to us.  In addition, decreases in property valuesreduce the value of the collateral and the potential proceeds available to aborrower to repay our loans, which could also cause us to suffer losses.  Even when a property’s net operating incomeis sufficient to cover the property’s debt service, at the time a loan is made,there can be no assurance that this will continue in the future.

###### ** **

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

 

Interest rate risk is highlysensitive to many factors, including governmental monetary and tax policies,domestic and international economic and political considerations and otherfactors beyond our control.  Ahypothetical 100 basis point increase in interest rates along the entireinterest rate curve for the nine months ended September 30, 2005 would haveincreased our interest cost by approximately $2,026, offset by an increase inour investment income of approximately $2,313.

 

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 our mark-to-marketdebt to hedge against this risk.  Some ofour 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 a significant rising interest rate environment and/oreconomic downturn, delinquencies and defaults could increase and result incredit losses to us, which could adversely affect our liquidity and operatingresults.  Further, such delinquencies ordefaults could have an adverse effect on the spreads between interest-earningassets and interest-bearing liabilities

 

**ITEM4.  Controls and Procedures**

** **

**Evaluation of Disclosure Controls and Procedures**

** **

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

 

** **

**40**

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** **

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

 

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

** **

**Changes in Internal Controls over Financial Reporting**

** **

**There were no changes in ourinternal controls over financial reporting identified in connection with theevaluation of such internal controls that occurred during Gramercy’s lastfiscal quarter that have materially affected, or are reasonably likely tomaterially**affect, Gramercy’s internal controls overfinancial reporting.

 

 

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** **
| **PART  II** | ** **                                            | **OTHER****INFORMATION**                                         |
|--------------|-------------------------------------------------------|------------------------------------------------------------------|
|         |                                                  |                                                             |
| **ITEM 1.**  | ** **                                            | **LEGAL  PROCEEDINGS**                                           |
|         |                                                  |                                                             |
|         | See Note 16 to the Consolidated Financial  Statements |
|         |                                                  |                                                             |
| **ITEM  2.** | ** **                                            | **UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS** |
|         |                                                  |                                                             |
|         | None                                                  |
|         |                                                  |                                                             |
| **ITEM 3.**  | ** **                                            | **DEFAULTS UPON SENIOR  SECURITIES**                             |
|         |                                                  |                                                             |
|         | None                                                  |
|         |                                                  |                                                             |
| **ITEM 4.**  | ** **                                            | **SUBMISSION OF MATTERS  TO A VOTE OF SECURITY HOLDERS**         |
|         |                                                  |                                                             |
|         | None                                                  |
|         |                                                  |                                                             |
| **ITEM  5.** | ** **                                            | **OTHER INFORMATION**                                            |
|         |                                                  |                                                             |
|         | None                                                  |
|         |                                                  |                                                             |
| **ITEM 6.**  | ** **                                            | **EXHIBITS**                                                     |

 

(a)          Exhibits:

 

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

** **

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

** **

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

** **

**10.1 Form of Management Agreementby and between the Company and GKK Manager LLC, incorporated by reference tothe Company’s Registration Statement on Form S-11 (No. 333-114673), declaredeffective by the Commission on July 27, 2004.**

** **

**10.2 Form of OriginationAgreement by and between the Company and SL Green Realty Corp., incorporated byreference to the Company’s Registration Statement on Form S-11 (No.333-114673), declared effective by the Commission on July 27, 2004.**

** **

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

** **

**10.4 Form of Asset ServicingAgreement by and between GKK Manager LLC and SLG Gramercy Services LLC,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.**

** **

**10.5 Form of Outsource Agreementby and between GKK Manager LLC and SLG Operating Partnership, L.P.,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.**

** **

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

** **

** **

**42**

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** **

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

** **

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

** **

**10.9 Form of Credit Agreement,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.**

** **

**10.10 Form of Master RepurchaseAgreement dated as of January 3, 2005, incorporated by reference to the Company’sAnnual Report on Form 10-K for the fiscal year ended December 31, 2004.**

** **

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

** **

**10.12 Form of EmploymentAgreement by and between Hugh Hall and GKK Manager LLC, incorporated byreference to the Company’s Annual Report on Form 10-K for the fiscal year endedDecember 31, 2004.**

** **

**10.13 Form of EmploymentAgreement by and between Robert R. Foley and GKK Manager LLC, incorporated byreference to the Company’s Annual Report on Form 10-K for the fiscal year endedDecember 31, 2004.**

** **

**10.14 Form of Registration RightsAgreement, by and between various holders of the Company’s common stock and theCompany, incorporated by reference to the Company’s Form 8-K, dated December 9,2004, filed with the Commission on December 9, 2004.**

** **

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

** **

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

** **

**10.17 Form of LLC Agreement, byand between GKK Madison Investment LLC, a wholly owned subsidiary of theCompany, and SLG Madison Investment LLC, a wholly owned subsidiary of SL Green RealtyCorp, incorporated by reference to the Company's Quarterly Report onForm 10-Q for the fiscal quarter ended March 31, 2005.**

** **

**10.18 Form of Second Amended andRestated Master Repurchase Agreement, by and between the Company and WachoviaCapital Markets, LLC, incorporated by reference to the Company's QuarterlyReport on Form 10-Q for the fiscal quarter ended March 31, 2005.**

** **

**10.19 Form of Indenture by andamong Gramercy Real Estate CDO 2005-1, Ltd., as issuer, Gramercy Real EstateCDO 2005-1 LLC, as co-issuer, GKK Liquidity LLC, as advancing agent and WellsFargo Bank, National Association, as trustee, paying agent, calculation agent,transfer agent, custodial securities intermediary, backup advancing agent,notes registrar, incorporated by reference to the Company’s Quarterly Report onForm 10-Q for the fiscal quarter ended June 30, 2005.**

** **

**10.20 Form of CollateralManagement Agreement by and between Gramercy Real Estate CDO 2005-1, Ltd., asissuer and GKK Manager LLC, as collateral manager, incorporated by reference tothe Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended June30, 2005.**

** **

**10.21 Form of Amended andRestated Trust Agreement by and among GKK Capital LP, as depositor, JPMorganChase Bank, National Association, as property trustee, Chase Bank USA, NationalAssociation, as Delaware trustee, and the administrative trustees named therein,incorporated by reference to the Company’s Quarterly Report on Form 10-Q forthe fiscal quarter ended June 30, 2005.**

** **

**10.22 Form of Junior SubordinatedIndenture between GKK Capital LP and JPMorgan Chase Bank, National Association,as trustee, incorporated by reference to the Company’s Quarterly Report on Form10-Q for the fiscal quarter ended June 30, 2005.**

 

10.23 Form of Amended and Restated TrustAgreement among GKK Capital LP, as depositor, JPMorgan Chase Bank, NationalAssociation, as property trustee, Chase Bank USA, National Association, asDelaware trustee, and the administrative trustees named therein, dated August9, 2005.

 

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10.24 Form of Junior Subordinated Indenturebetween GKK Capital LP and JPMorgan Chase Bank, National Association, astrustee, dated August 9, 2005.

 

20.25 Form of Gramercy Capital Corp. Director’sDeferral Program, incorporated by reference to the Company’s Quarterly Reporton Form 10-Q/A for the fiscal quarter ended June 30, 2005.

 

20.26 Form of Underwriting Agreement amongGramercy Capital Corp., GKK Capital LP and Wachovia Capital Markets, LLC, asunderwriter, dated September 8, 2005, incorporated by reference to the Company’sForm 8-K, dated September 7, 2005.

 

31.1 Certification by theChief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of2002 filed herewith.

 

31.2 Certification by theChief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of2002 filed herewith.

 

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

 

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

 

 

44

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**SIGNATURES**

 

 

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|   |   |   |   |   |   |   | GRAMERCY CAPITAL CORP. |                    |
|--------|--------|--------|--------|--------|--------|--------|------------------------|-------------------------|
|   |   |   |   |   |   |   |                   |                    |
|   |   |   |   |   |   |   |                   |                    |
|   |   |   |   |   |   |   |                   |                    |
|   |   |   |   |   |   |   |                   |                    |
|   |   |   |   |   |   |   | By:                    | /s/ Robert R. Foley     |
|   |   |   |   |   |   |   |                   | Robert R. Foley         |
|   |   |   |   |   |   |   |                   | Chief Financial Officer |
|        |        |        |        |        |        |        |                        |                         |  |

 

 

 

 

Date:       November 9, 2005

 

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