**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM10-K**

 

**ý****  ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe fiscal year ended December 31, 2005**

 

**or**

 

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

 

**Forthe transition period from             to              .**

 

**CommissionFile No. 1-32248**

 

**GRAMERCYCAPITAL CORP.**

(Exact name ofregistrant as specified in its charter)

 

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

 

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

 

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

 

SECURITIESREGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 
| **Title  of Each Class**       |   | **Name  of Each Exchange on Which Registered** |
|--------------------------------|--------|------------------------------------------------|
|                           |   |                                           |
| Common Stock,  $.001 Par Value |   | New York Stock  Exchange                       |

 

SECURITIESREGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: **None**

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act. Yes o  No ý.

 

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act. Yes o  No ý.

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý  No o.

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer. See definition of “accelerated filer” and “non-accelerated filer” in Rule 12b-2 of theExchange Act.

Largeaccelerated filer  o  AcceleratedFiler  ý  Non-accelerated filer  o

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act). Yes o  No ý.

 

As of March 13, 2006,there were 22,805,642 shares of the Registrant’s common stock outstanding. Theaggregate market value of common stock held by non-affiliates of the registrant(16,379,809 shares) at September 14, 2005, was $422,762,870. The aggregatemarket value was calculated by using the price at which our common stock waslast sold, which was $25.81 per share on September 14, 2005.

 

DOCUMENTSINCORPORATED BY REFERENCE

 

Portions of theregistrant’s Proxy Statement for the 2006 Annual Stockholders’ Meeting to beheld May 17, 2006 and to be filed within 120 days after the close of theRegistrant’s fiscal year are incorporated by reference into Part III of thisAnnual Report on Form 10-K.

 

 

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**GRAMERCYCAPITAL CORP.****FORM 10-K****TABLE OF CONTENTS**

 

**10-K PART AND ITEM NO.**

 
| **PART I**   | ** **                                                                                  |
|--------------|---------------------------------------------------------------------------------------------|
| ** **   | ** **                                                                                  | ** ** |
| 1.           | Business                                                                                    |   |
|         |                                                                                        |   |
| 1A,          | Risk Factors                                                                                |   |
|         |                                                                                        |   |
| 1B.          | Unresolved  Staff Comments                                                                  |   |
|         |                                                                                        |   |
| 2.           | Properties                                                                                  |   |
|         |                                                                                        |   |
| 3.           | Legal Proceedings                                                                           |   |
|         |                                                                                        |   |
| 4.           | Submission  of Matters to a Vote of Security Holders                                        |   |
|         |                                                                                        |   |
| **PART II**  |                                                                                        |
|         |                                                                                        |   |
| 5.           | Market for  Registrant’s Common Equity and Related Stockholders Matters                |   |
|         |                                                                                        |   |
| 6.           | Selected Financial  Data                                                                    |   |
|         |                                                                                        |   |
| 7.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|         |                                                                                        |   |
| 7A.          | Quantitative  and Qualitative Disclosures about Market Risk                                 |   |
|         |                                                                                        |   |
| 8.           | Financial Statements and Supplemental  Data                                                 |   |
|         |                                                                                        |   |
| 9.           | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure       |   |
|         |                                                                                        |   |
| 9A.          | Controls and  Procedures                                                                    |   |
|         |                                                                                        |   |
| 9B.          | Other Information                                                                           |   |
|         |                                                                                        |   |
| **PART III** |                                                                                        |
|         |                                                                                        |   |
| 10.          | Directors  and Executive Officers of the Registrant                                         |   |
|         |                                                                                        |   |
| 11.          | Executive  Compensation                                                                     |   |
|         |                                                                                        |   |
| 12.          | Security  Ownership of Certain Beneficial Owners and Management                             |   |
|         |                                                                                        |   |
| 13.          | Certain  Relationships and Related Transactions                                             |   |
|         |                                                                                        |   |
| 14.          | Principal  Accounting Fees and Services                                                     |   |
|         |                                                                                        |   |
| **PART IV**  |                                                                                        |
|         |                                                                                        |   |
| 15.          | Exhibits,  Financial Statements, Schedules and Reports on Form 8-K                          |   |
|         |                                                                                        |   |
|         | SIGNATURES                                                                                  |   |

 

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**PART I**

 

**ITEM 1.          BUSINESS**

 

**General**

 

Gramercy Capital Corp.(the “Company” or “Gramercy”) is a national commercial real estate specialtyfinance company that specializes in the direct origination and acquisition ofwhole loans, subordinate interests in whole loans, mezzanine loans, preferredequity, and net lease investments involving commercial properties throughoutthe United States. When evaluating transactions, we assess our risk-adjustedreturn and target transactions with yields that ensure an equitable balancebetween risks and return. We invest in assets with the potential forappreciation, in addition to providing current income. We have elected to betaxed as a real estate investment trust, or REIT, under the Internal RevenueCode and generally will not be subject to federal income taxes to the extent wedistribute our income to our stockholders.

 

Gramercy was formed in April 2004 and we completed our initial publicoffering in August 2004. Substantially all of Gramercy’s operations areconducted through GKK Capital LP, a Delaware limited partnership, or theOperating Partnership. Gramercy, as the sole general partner of, and holder of100% of the common units of, the Operating Partnership, has responsibility anddiscretion in the management and control of the Operating Partnership, and thelimited partners of the Operating Partnership, in such capacity, have noauthority to transact business for, or participate in the management activitiesof, the Operating Partnership. Accordingly, we consolidate the accounts of theOperating Partnership.

 

Weare externally managed and advised by GKK Manager LLC, or the Manager, amajority-owned subsidiary of SL Green Realty Corp. (NYSE: SLG), or SL Green. AtDecember 31, 2005, SL Green also owned approximately 25% of the outstandingshares of our common stock.

 

Asof December 31, 2005, we held loans and other lending investments of $1.2billion net of fees, discounts, repayments, asset sales and unfundedcommitments with an average spread to the London Inter-Bank Offered Rate, orLIBOR, of 417 basis points for our floating rate investments and an averageyield of 9.92% for our fixed rate investments. As of December 31, 2005, we alsoheld interests in three net lease investments totaling $109.2 million comprisedof the $51.2 million carrying value of 200 Franklin Square Drive, 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 and $58.0 million in joint ventureinvestments.

 

Ourcorporate offices are located in midtown Manhattan at 420 Lexington Avenue, NewYork, New York 10170. We do not currently have any employees, nor do weanticipate hiring any employees in the near term. Our executive officers areall employed by our Manager or SL Green. We can be contacted at (212)297-1000. We maintain a website at *www.gramercycapitalcorp.com*.On our website, you can obtain, free of charge, a copy of our annual report onForm 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, andamendments to those reports filed or furnished pursuant to Section 13(a)or 15(d) of the Securities Exchange Act of 1934, as amended, as soon aspracticable after we file such material electronically with, or furnish it to,the Securities and Exchange Commission. We have also made available on ourwebsite our audit committee charter, compensation committee charter, nominatingand corporate governance committee charter, code of business conduct and ethicsand corporate governance principles.

 

Unless the contextrequires otherwise, all references to “we,” “our,” and “us” in this annualreport means Gramercy Capital Corp., a Maryland corporation, and one or more ofits subsidiaries, including GKK Capital LP, a Delaware limited partnership.

 

**Corporate Structure**

 

Substantially all of ourassets are held by, and all of our operations are conducted through, ourOperating Partnership. We are the sole general partner and sole owner of theClass A limited partner interests of the Operating Partnership. At December 31,2005, the majority of the Class B limited partnership interests were owned byour Manager and SL Green Operating Partnership, L.P. Interests were also heldby certain officers and employees of SL Green Realty Corp., including some ofwhom are among our executive officers, which interests are subject toperformance thresholds. To provide an incentive for the Manager to enhance thevalue of the common stock, the holders of the Class B limited partner interestsof the Operating Partnership are entitled to an incentive return equal to 25%of the amount by which funds from operations (as defined in the partnershipagreement of the Operating Partnership) plus certain accounting gains exceedthe product of the weighted average stockholders equity (as defined in thepartnership agreement of the Operating Partnership) multiplied by 9.5% (dividedby 4 to adjust

 

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for quarterlycalculations).

 

Asof December 31, 2005, the majority of the interests in our Manager were held bySL Green Operating Partnership, L.P. Interests were also held by certainofficers and employees of SL Green Realty Corp., including some of whom areamong our executive officers, which interests are subject to performancethresholds. We pay to the Manager a base management fee equal to one andthree-quarters of one percent (1.75%) of our stockholders’ equity (as definedin the management agreement with the Manager) inclusive of the trust preferredsecurities issued on May 20, 2005 and August 9, 2005. In addition, we areobligated to reimburse the Manager for its costs incurred under an assetservicing agreement and a separate outsource agreement between the Manager andSL Green Operating Partnership, L.P. The asset servicing agreement provides foran annual fee payable to SL Green Operating Partnership, L.P. by us of 0.15% ofthe book value of our investments, which amount SL Green Operating Partnership,L.P. has agreed to reduce for certain investments, and which fee may be furtherreduced by SL Green Operating Partnership, L.P. for fees paid directly tooutside servicers by us. The outsourcing agreement currently provides for anannual fee payable by us of $1.28 million per year, increasing 3% annually overthe prior year, for management services outlined in the agreement. The assetservicing and outsourcing agreements allow us to leverage the experience,resources and relationships SL Green has established while maintaining amoderate level of corporate overhead expenses.

 

Ourcollateralized debt obligation, or CDO, which was closed in July 2005, wasissued through two indirect subsidiaries, Gramercy Real Estate CDO 2005-1Ltd., or the Issuer, and Gramercy Real Estate CDO 2005-1 LLC, or the Co-Issuer.The Issuer and Co-Issuer are subsidiaries of our private REIT, GramercyInvestment Trust. Our Operating Partnership holds all shares of common stockand controls all of the management and operations of the private REIT. AtDecember 31, 2005, the private REIT and all subsidiaries of the private REITwere consolidated into our financial results.

 

Inconnection with the closing of our CDO, the Issuer entered into a collateralmanagement agreement with the Manager. Pursuant to the collateral managementagreement, the Manager has agreed to provide certain advisory andadministrative services in relation to the collateral debt securities and othereligible investments securing the CDO notes. The collateral managementagreement provides for a senior collateral management fee, payable quarterly inaccordance with the priority of payments as set forth in the indenture, equalto 0.15% per annum of the net outstanding portfolio balance in lieu of the 0.15%fee otherwise payable on our investments under our servicing agreement with SLGreen Operating Partnership, L.P., and an additional subordinate collateralmanagement fee, payable quarterly in accordance with the priority of paymentsas set forth in the indenture, equal to 0.25% per annum of the net outstandingportfolio balance. Net outstanding portfolio balance is the sum of the (i)aggregate principal balance of the collateral debt securities, excludingdefaulted securities, (ii) aggregate principal balance of all principalproceeds held as cash and eligible investments in certain accounts, and (iii)with respect to the defaulted securities, the calculation amount of suchdefaulted securities. As compensation for the performance of its obligations ascollateral manager, our Board of Directors has allocated to the Manager theportion of the subordinate collateral management fee paid on securities notheld by us. The senior collateral management fee and balance of thesubordinate collateral management fee is allocated to us.

 

**Business and Growth Strategies**

 

We invest in adiversified portfolio of domestic real estate loans and securities, includingwhole loans, bridge loans, subordinate interests in whole loans, distresseddebt, mortgage-backed securities, mezzanine loans, preferred equity, and net lease investments involving commercial propertiesthroughout the United States. We believe these investments offer attractive risk-adjustedreturns with long-term principal protection under a variety of default and lossscenarios. We actively manage our assets with a goal of generating cashavailable for distribution, facilitating capital appreciation and generatingattractive returns to our stockholders.

 

Wegenerate income principally from the spread between the yields on our assetsand the cost of our borrowing and hedging activities. We leverage ourinvestments to enhance returns to shareholders equity. We finance, or intend tofinance, assets through a variety of techniques, including repurchaseagreements, secured and unsecured credit facilities, issuances of commercialmortgage-backed securities, or CMBS, CDOs, unsecured junior subordinatedcorporate debt and other structured financings. In addition, we matchfund interest rates with like-kind debt (i.e., fixed-rate assets are financedwith fixed-rate debt, and floating rate assets are financed with floating ratedebt), through the use of hedges such as interest rate swaps, caps, or througha combination of these strategies. This allows us to reduce the impact ofchanging interest rates on our cash flow and earnings. We actively manage our positions, using our credit,structuring and asset management skills to enhance returns. We intend to grow our businessusing prudent levels of debt financing, syndication of loan interests andstructured financing when feasible, rather than relying solely on equitycapital, in order to increase earnings per share.

 

Our ability to managethe real estate risk underwritten by our Manager and us is a critical componentof our success. We actively manage and maintain the credit quality of ourportfolio by using our management team’s expertise in structuring andrepositioning investments to improve the quality and yield on managedinvestments. When investing in higher leverage transactions, we use

 

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guidelines and standardsdeveloped and employed by senior management of the Manager and SL Green,including rigorous underwriting of collateral performance and valuation, areview of the creditworthiness of the equity investors, additional forms ofcollateral and strategies to effect repayment. If defaults occur, we willemploy SL Green’s strong asset management skills to mitigate the severityof any losses and seek to optimize the recovery from assets in the event thatwe foreclose upon them. In New York, Washington, D.C. and elsewhere asappropriate, SL Green will manage these assets and has the right topurchase properties in metropolitan New York and Washington, D.C. that we acquirein foreclosure. In other geographic markets, we often use long-standingrelationships of senior management or SL Green with local operators orinvestors to enhance our ability to underwrite transactions or mitigatedefaults when making or managing investments.

 

We seek to structure thedebt transactions in which we invest, which enhances our ability to mitigateour losses, by having the benefit of loan documents that afford us appropriaterights and control over our collateral, and having the right to control thedebt that is senior to our position. We believe that this level of controlallows us to achieve attractive risk-adjusted returns within a real estate debtcapital structure. We generally avoid investments where we cannot secureadequate control rights, unless we believe the default risk is very low. Ourflexibility to invest in all or any part of a debt capital structure enables usto participate in many transactions and to retain only the investments thatmeet our investment parameters.

 

We believe that ourability to provide a wide range of financing products and our ability tocustomize financing structures to meet borrowers’ needs differentiates us fromour competitors. We are a one-stop shop for real estate financing solutionscapable of financing the most senior capital positions through subordinateinterests to equity participations. Our senior management team has substantialexperience in responding to unique borrower needs by crafting financialproducts that are tailored to meet the business plan of a property owner.

 

Wefocus on certain types of investments where we believe we have a competitiveadvantage and that offer appropriate risk adjusted returns. For properties thatwe believe have stable values or where we have specific asset management capabilitiesto mitigate losses, we will target higher leverage investments. If we concludethat a property to be financed will have a more volatile value under a varietyof market conditions, we target a less leveraged investment. In suchtransactions we may seek a second loss position. We also target the originationof larger components of financings, including whole loans, to afford us theopportunity to syndicate and securitize our investments to create retainedinstruments with above-market returns. We originate investments in directtransactions with borrowers, we co-originate with or acquire existing assetsfrom third parties, primarily financial institutions, and we occasionallyco-invest with SL Green and its affiliates.

 

Our targeted investmentsinclude the following:

 

***Whole Loans****—*We originate fixed-ratewhole loans with terms of up to 15 years. We may separate certain of theseloans into tranches, which can be securitized and resold. If we do so, we wouldexpect to retain a subordinate interest, mezzanine loan or preferred equitycreated in connection with such whole loan origination, where we see the mostadvantageous risk-adjusted returns. We expect the stated maturity of our wholeloan investments to range from five years to 15 years. We may sell theseinvestments prior to maturity.

 

***Bridge Loans***—We offer floating ratewhole loans to borrowers who are seeking debt capital with a final term tomaturity of not more than five years to be used in the acquisition,construction or redevelopment of a property. Typically, the borrower hasidentified a property in a favorable market that it believes to be poorlymanaged or undervalued. Bridge financing enables the borrower to secureshort-term financing while improving the operating performance and physicalaspects of the property and avoid burdening it with restrictive long-term debt.The bridge loans we originate are predominantly secured by first mortgage lienson the property and are expected to provide interest rates ranging from 225 to400 basis points over applicable index rate indexes. We expect the statedmaturity of our bridge loans to range from two years to five years, and weexpect to hold these investments to maturity.

 

We believe our bridge loanswill lead to additional financing opportunities in the future, as bridgefacilities are often a first step toward permanent financing or a sale. We haveexperienced that many major financial institutions have largely avoided thistype of lending because it does not lead to significant trading profits fromsubsequent securitizations. However, we intend to use securitization as afinancing rather than a trading activity. We intend to use these transactionsto pool together smaller bridge loans and retain the resulting non-investmentgrade interests and interest-only certificates (perhaps in a single bondstructure). To increase our volume, enhance financing efficiencies and create anational presence, we may seek joint ventures, mergers or other arrangementswith regional or product specific originators.

 

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***Subordinate Interests in Whole Loans***—Wepurchase from third parties, and may retain from whole loans we originate andco-originate and securitize or sell, subordinate interests in whole loans.Subordinate interests are loans secured by a whole loan and subordinated to asenior interest. The subordination is generally evidenced by a co-lender orparticipation agreement between the holders of the related senior interest andthe subordinate interest. In some instances, the subordinate interest lendermay additionally require a security interest in the stock or partnershipinterests of the borrower as part of the transaction. We originate subordinateinterests in whole loans directly or acquire them in negotiated transactionswith originators of the whole loan. When we originate whole loans, we maydivide them, securitizing or selling the senior interest and keeping asubordinate interest for investment. We believe the subordinate interest marketwill continue to grow with the expansion of the commercial mortgagesecuritization market.

 

Subordinate interests in whole loans typically bearinterest at a rate of 200 to 600 basis points over the applicable interest rateindex and have loan-to-value ratios between 65% and 75%. Subordinate interestlenders have the same obligations, collateral and borrower as the seniorinterest lender, but typically are subordinated in recovery upon a default.Subordinate interests in whole loans share certain credit characteristics withsecond mortgages, in that both are subject to greater credit risk with respectto the underlying mortgage collateral than the corresponding senior interest.

 

Subordinate interests created from bridge loansgenerally will have terms matching those of the whole loan of which they are apart, typically two to five years. Subordinate interests created from wholeloans generally will have terms of five years to fifteen years. We expect tohold subordinate interests in whole loans to their maturity.

 

When we acquire subordinateinterests in whole loans from third parties, we may earn income on theinvestment, in addition to the interest payable on the subordinate piece, in the form of fees charged to the borrowerunder that note (currently approximately 0.25% to 1% of the note amount) or byreceiving principal payments in excess of the discounted price (below parvalue) we paid to acquire the note. When we originate subordinate interests outof whole loans and then sell the senior interest, we allocate our basis in thewhole loan among the two (or more) components to reflect the fair market valueof the new instruments. We may realize a profit on sale if our allocated valueis below the sale price. Our ownership of a subordinate interest with controlling class rights, whichtypically means we have the unilateral ability to determine when, and in whatmanner, to exercise the rights and remedies afforded the holder of the seniorinterest, may, in the event the financing fails to perform according to itsterms, cause us to elect to pursue our remedies as owner of the subordinateinterest, which may include foreclosure on, or modification of, the note. Insome cases, usually restricted to situations in which the current market valueof the underlying commercial property securing the loan has declined below theaggregate unpaid principal balance of secured debt senior to our investment,the owner of the senior interest may be able to foreclose or modify the noteagainst our wishes as holder of the subordinate interest. As a result, oureconomic and business interests may diverge from the interests of the holdersof the senior interest. These divergent interests among the holders of eachinvestment may result in conflicts of interest.

 

***Distressed Debt***—We may also invest indistressed debt, most often sub- and non-performing real estate loans acquiredfrom financial institutions. We will make these investments when we believe ourunderwriting, credit, financing and asset management experience will enable usto generate above-average risk-adjusted returns by resolving these distressedloans expeditiously through refinancings, negotiated repayments with borrowersor foreclosure and subsequent sale of the underlying property. A sub-performingloan is a loan with a very high loan-to-value ratio, with a low debt servicecoverage ratio, and which is likely to default at maturity because the propertysecuring the loan cannot support a refinancing of the loan’s entire unpaidprincipal balance. A non-performing loan is a loan that is in default of itscovenants, is past due in interest payments, or is past its final maturity dateand has not been repaid. Sub- and non-performing loans are typically purchasedat a discount to the note balance. Our investment return results from a combinationof current cash flow from the note or underlying property, plus any eventualrecovery of loan principal.

 

We expect the maturity of ourdistressed debt investments to range from several months to up to ten years.Such investments will usually be held until resolution, which may entail abankruptcy and foreclosure process, which can require months or years.

 

***Mortgage-Backed Securities****—*We acquire mortgage-backed securities,or MBS, that are created when commercial or residential loans are pooled and securitized.These securities may be issued by government sponsored agencies or otherentities and may or may not be rated investment grade by rating agencies. Wemay also originate MBS from pools of commercial loans we assemble, in whichevent we expect to retain the more junior interests.

 

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CMBS are secured by orevidenced by ownership interests in a single commercial mortgage loan or a poolof mortgage loans secured by commercial properties. Residential mortgage-backedsecurities, or RMBS, are backed by pools of home mortgages. We expect amajority of our mortgage-backed securities investments to be rated by at leastone rating agency.

 

CMBS are generallypass-through certificates that represent beneficial ownership interests incommon law trusts whose assets consist of defined portfolios of one or morecommercial mortgage loans. They are typically issued in multiple trancheswhereby the more senior classes are entitled to priority distributions from thetrust’s income to make specified interest and principal payments on suchtranches. Losses and other shortfalls from expected amounts to be received onthe mortgage pool are borne by the most subordinate classes, whichreceive payments only after the more senior classes have received all principaland/or interest to which they are entitled.

 

The credit quality of MBSdepends on the credit quality of the underlying mortgage loans, which is afunction of factors such as:

 

•                                          theprincipal amount of loans relative to the value of the related properties;

•                                          themortgage loan terms (e.g. amortization);

•                                          marketassessment and geographic location;

•                                          constructionquality of the property; and

•                                          thecreditworthiness of the borrowers.

 

We focus not on new issues butrather on “Story Securities” available in the secondary market where we areable to analyze and underwrite the underlying assets. “Story Securities” areseasoned securities with identifiable credit risks (such as large defaulted orsub-performing loans or a negative development with respect to the sponsor of alarge loan) that we believe may require complex financial analysis to fullyunderstand the issues and which fixed income money managers cannot efficientlyunderwrite, or which make them unattractive to a significant number of fixedincome investors. We seek capital appreciation, in addition to interest income,by buying these securities at a discount to par value.

 

We expect the stated maturityof our MBS investments to range from several months to up to 15 years for CMBSand up to 40 years for RMBS. Such securities do not have stated maturitiesbut rather receive principal payments from the underlying investments. Weexpect to hold CMBS to maturity and may sell RMBS prior to maturity.

 

***Mezzanine Loans***—We originatemezzanine loans that are senior to the borrower’s equity in, and subordinate toa whole loan on, a property. These loans are secured by pledges of ownershipinterests, typically in whole but occasionally in part (but usually witheffective sole control over all the ownership interests), in entities thatdirectly or indirectly own the real property. In addition, we may require othercollateral to secure mezzanine loans, including letters of credit, personalguarantees, or collateral unrelated to the property.

 

We typically structure our mezzanine loans to receivea stated coupon (benchmarked usually against LIBOR, or occasionally against aTreasury index or a swap index). We may in certain, select instances structureour mezzanine loans to receive a stated coupon plus a percentage of grossrevenues and a percentage of the increase in the fair market value of theproperty securing the loan, payable upon maturity, refinancing or sale of theproperty. Mezzanine loans may also have prepayment lockouts, penalties, minimumprofit hurdles and other mechanisms to protect and enhance returns in the eventof premature repayment.

 

These investments typically range in size from $10 to$50 million, have terms from two to ten years and typically bearinterest at a rate of 400 to 1000 basis points over the applicable interestrate index. Some transactions entail the issuance of more than one tranche orclass of mezzanine debt. Mezzanine loans usually have loan-to-value ratiosbetween 75% and 90%. Mezzanine loans frequently have maturities that match thematurity of the related mortgage loan but may have shorter or longer terms. Weexpect to hold these investments to maturity.

 

***Preferred Equity***—We originatepreferred equity investments in entities that directly or indirectly owncommercial real estate. Preferred equity is not secured, but holders havepriority relative to common equity holders on cash flow distributions andproceeds from capital events. In addition, preferred holders can often enhancetheir position and protect their equity position with covenants that limit theentity’s activities and grant us the exclusive right to control the propertyafter an event of

 

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default. Occasionally, the first mortgage on a propertyprohibits additional liens and a preferred equity structure provides anattractive financing alternative. With preferred equity investments, we maybecome a special limited partner or member in the ownership entity and may beentitled to take certain actions, or cause a liquidation, upon a default.Preferred equity typically is more highly leveraged, with loan-to-value ratiosof 85% to more than 90%. We expect our preferred equity to have mandatoryredemption dates (that is, maturity dates) that range from three years to fiveyears, and we expect to hold these investments to maturity.

 

***Other Real Estate-Related Investments—***Wemay also make investments in other types of commercial or multi-family realestate assets. These may include acquisitions of real property and debt issuedby REITs or other real estate companies. We have authority to issue our commonstock or other equity or debt securities in exchange for property. Subject togross income and asset tests necessary for REIT qualification, we may alsoinvest in securities of other REITs, or other entities engaged in real estateactivities or securities of other issuers, including for the purpose ofexercising control over such entities.

 

Some of these investments maybe equity interests in properties with no stated maturity or redemption date,or long-term leasehold interests with expiration dates as long as 40 yearsbeyond the date of our investment. We expect to hold these investments forbetween several months and up to ten years, depending upon the risk profile ofthe investment and our investment rationale. The timing of our sale of theseinvestments, or of their repayment, will frequently be tied to certain eventsinvolving the underlying property, such as new tenants or superior financing.

 

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

 
| ** **                                           | ** ** | **Carrying Value (1)  ($ in thousands)** | ** ** | **Allocation by  Investment Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average Spread over  LIBOR (2)** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                                     | ** ** | **2004**                                     | ** ** | **2005**                                 | ** ** | **2004**                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | ** ** | **2004** | ** ** |
| Whole loans,  floating rate                          |       | $ 561,388                                               |       | $ 155,215                               |       | 46                                       | %          | 38                                                                     | %          | — |   | — |   | 325 | bps |   | 373 | bps |
| Whole loans,  fixed rate                             |       | 94,448                                                       |       | —                                       |       | 8                                        | %          | —                                                                 |       | 10.64 | % | — |   | — |   |   | — |   |
| Subordinate  interests in whole loans, floating rate |       | 362,983                                                      |       | 209,286                                      |       | 30                                       | %          | 51                                                                     | %          | — |   | — |   | 443 | bps |   | 640 | bps |
| Subordinate  interests in whole loans, fixed rate    |       | 37,104                                                       |       | 31,216                                       |       | 3                                        | %          | 8                                                                      | %          | 9.19 | % | 9.57 | % | — |   |   | — |   |
| Mezzanine loans,  floating rate                      |       | 82,793                                                       |       | —                                       |       | 7                                        | %          | —                                                                 |       | — |   | — |   | 858 | bps |   | — |   |
| Mezzanine loans,  fixed rate                         |       | 43,352                                                       |       | —                                       |       | 4                                        | %          | —                                                                 |       | 8.88 | % | — |   | — |   |   | — |   |
| Preferred  equity, floating rate                     |       | 11,795                                                       |       | —                                       |       | 1                                        | %          | —                                                                 |       | — |   | — |   | 900 | bps |   | — |   |
| Preferred  equity, fixed rate                        |       | 11,882                                                       |       | —                                       |       | 1                                        | %          | —                                                                 |       | 10.28 | % | — |   | — |   |   | — |   |
| Commercial  mortgage backed securities               |       | —                                                       |       | 10,898                                       |       | —                                   |       | 3                                                                      | %          | — |   | 13.49 | % | — |   |   | — |   |
| Total / Average                                      |       | $ 1,205,745                                             |       | $ 406,615                               |       | 100                                      | %          | 100                                                                    | %          | 9.92 | % | 10.58 | % | 417 | bps |   | 526 | bps |

 

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**(1)**          Debtinvestments are presented after scheduled amortization payments andprepayments, and are net of unamortized fees, discounts, asset sales andunfunded commitments.

** **

**(2)**          Spreadsover an index other than LIBOR have been adjusted to a LIBOR based equivalent.

 

Wemonitor our portfolio periodically and prior to each acquisition to confirmthat we continue to qualify for the exemption from registration provided bySection 3(c)(5)(C) and 3(c)(6) of the Investment Company Act of 1940, asamended, or the Investment Company Act. Qualifying for the Section 3(c)(5)(C)exemption requires that at least 55% of our portfolio is comprised of “qualifyingassets,” and a total of at least 80% of our portfolio is comprised of “realestate-related assets,” a category that includes qualifying assets.

 

Wegenerally expect whole loans, bridge loans, whole pool MBS, our credit tenantlease investments, or CTLs, and certain distressed debt securities to bequalifying real estate assets. The treatment of distressed debt securities asqualifying real estate assets is based on the characteristics of the particulartype of loan, including its foreclosure rights. Junior (first loss) interestsin mortgage-backed securities pools may constitute qualifying real estateassets under Section 3(c)(5)(C) provided that we have the unilateral rightto foreclose, directly or indirectly, on the mortgages in the pool and that wemay act as the controlling class or directing

 

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holderof the pool. Similarly, subordinate interests in whole loans may constitutequalifying real estate assets under Section 3(c)(5)(C) providedthat we have the unilateral right to foreclose, directly or indirectly, on themortgage and that we may act as the controlling class or directing holder ofthe note.  We generally do not treatmezzanine loans and preferred equity investments as qualifying real estateassets.  In addition to makinginvestments of qualifying real estate assets, we also makeinvestments so that at least 80% of our portfolio is comprised of realestate-related assets. We expect that all of these classes of investments willbe considered real estate-related assets under the Investment Company Act forpurposes of the 80% investment threshold. Qualification for the 3(c)(5)(C) and 3(c)(6) exemptions will limit our ability to makecertain investments.

 

On occasion, we utilizea special servicer, which in some instances may be an affiliate of us or may bethe rated special servicer affiliate of SL Green, to manage, modify andresolve loans and other investments that fail to perform under the terms of theloan agreement, note, indenture, or other governing documents. We willtypically negotiate for the right to appoint a special servicer as part of theorigination or purchase of an investment. Special servicers are most frequentlyemployed in connection with whole loans, subordinate interests in whole loansand first-loss classes of CMBS. The rights of the special servicer, which aretypically subject to a servicing standard that requires the special servicer topursue remedies that maximize the recovery of investment principal, typicallyinclude, among other things, the right to foreclose upon the loan collateralafter an event of default.

 

Our rights, includingforeclosure rights we hold, are found in the agreements among the lenders orholders of notes, such as intercreditor or participation agreements. Where wehold unilateral foreclosure rights, those rights generally become exercisableupon the occurrence of an event of default, such as nonpayment of the debt. Incertain circumstances we may lose our foreclosure rights. For example, wherethe appraised value of the collateral for the debt falls below agreed levelsrelative to the total outstanding debt, we may lose our foreclosure rights,which are then exercisable by the holder of more senior debt. Generally, we donot expect SL Green or its affiliates to hold these types of senior debt wherewe hold a more junior instrument. If we were to lose our foreclosure rights,the Investment Company Act status of the particular investment could change.

 

While we intend to holdour investments to maturity, in all instances we may sell an investment priorto its stated maturity for reasons of risk management, liquidity, changinginvestment objectives, or regulatory requirements.

 

**Financing Strategy**

 

We use debt financing invarious forms in an effort to increase the size of our portfolio and potentialreturns to our stockholders. Access to low-cost capital is crucial to ourbusiness, since we earn income based on the spread between the yield on ourinvestments and the cost of our borrowings.

 

Our financing strategyfocuses on the use of match-funded financing structures. This means that weseek to match the maturities of our financial obligations with the maturitiesof our investments to minimize the risk that we have to refinance ourliabilities prior to the maturities of our assets, and to reduce the impact ofchanging interest rates on our cash flow and earnings. In addition, we matchfund interest rates with like-kind debt (i.e., fixed-rate assets are financedwith fixed-rate debt, and floating rate assets are financed with floating ratedebt), through the use of hedges such as interest rate swaps, caps, or througha combination of these strategies. This allows us to reduce the impact on ourcash flow and earnings of changing interest rates. At December 31, 2005,approximately 85% of our investments, when measured by carrying value, werefloating rate instruments based on LIBOR. The remaining 15% of our investmentscarried fixed rates of interest, although we have entered into swap contractsthat convert substantially all of the floating rate financing expenses againstthese assets to fixed rate expenses to eliminate basis risk. Our investmentshad a weighted average remaining term to initial maturity of 2.3 years.

 

Weuse short-term financing in the form of our repurchase agreements, revolvingcredit facilities and bridge financings prior to the implementation oflonger-term match-funded financing. At December 31, 2005, we had approximately$117.4 million outstanding under our repurchase facilities with WachoviaCapital Markets, LLC, or Wachovia, and Goldman Sachs Mortgage Company, orGoldman Sachs. Under our facility with Wachovia, an event of defaultwill be triggered if GKK Manager LLC ceases to be the Manager.

 

For longer-term funding, we utilize securitizationstructures, including CDOs, as well as other match-funded financing structures.CDOs are multiple class debt securities, or bonds, secured by pools of assets,such as mortgage-backed securities, subordinate interests in whole loans,mezzanine loans and REIT debt. Like typical securitization structures, in a CDOthe assets are pledged to a trustee for the benefit of the holders of thebonds. The bonds may be rated by one or more rating agencies. One or moreclasses of the bonds are marketed to a wide variety of fixed income investors,which enables the CDO sponsor to achieve a relatively low cost of long-termfinancing. We believe that CDOs are a suitable long-term financing vehicle forour investments because they will enable us to maintain our strategy of fundingsubstantially all of our assets and related liabilities using the same LIBORbenchmark, lock-in a long-term cost of funds tied to LIBOR, and reduce the riskthat we have to refinance our liabilities prior to the maturities of ourinvestments. On July 14, 2005, we issued approximately $1.0 billion ofCDOs, through two newly-formed indirect subsidiaries, Gramercy Real Estate

 

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CDO 2005-1 Ltd., or the Issuer, and Gramercy RealEstate CDO 2005-1 LLC, or the Co-Issuer. The CDO consists of $810.5 million ofinvestment grade notes, and $84.5 million of non-investment grade notes, whichwere co-issued by the Issuer and the Co-Issuer, and $105 million of preferredshares, which were issued by the Issuer. We retained all non-investment gradesecurities, the preferred shares and the common shares in the Issuer.

 

We use different levelsof leverage depending on the specific risk-return characteristics of eachinvestment type. For example, we generally use more leverage with whole loansthan mezzanine loans. We anticipate our overall leverage will be 70% to 80% ofthe carrying value of our assets; but our actual leverage depends on our mix ofassets. As of December 31, 2005, our leverage as a percentage of total assetvalue was 66%, excluding the trust preferred securities, which are discussed inmore detail below. The average advance rate against investment assets pledgedunder our repurchase facilities with Wachovia and Goldman Sachs was 70%.

 

Our charter and bylawsdo not limit the amount of indebtedness we can incur. Our leverage policypermits us to leverage up to 80% of the carrying value of our assets. Our boardof directors has discretion to deviate from or change our indebtedness policyat any time. However, we seek to maintain an adequate capital base to protectagainst various business environments in which our financing and hedging costsmight exceed the interest income from our investments. These conditions couldoccur, for example, due to credit losses or when, due to interest ratefluctuations, interest income on our investment lags behind interest rateincreases on our borrowings, which are predominantly variable rate. We use leveragefor the sole purpose of financing our portfolio and not for the purpose ofspeculating on changes in interest rates.

 

In addition, wecontinuously evaluate other sources of long-term debt and hybrid debt/equitycapital, including perpetual preferred equity and trust preferred equity, whichmay be available to us on competitive market pricing and terms.

 

**Origination, Underwriting and Asset Management**

 

Our Manager andSL Green provide all of our critical investment selection, assetmanagement, servicing and portfolio management and reporting functions fromloan origination to disposition. Our origination and underwriting is based oncareful review and preparation, and generally proceeds as follows:

 

•                                          Allinvestments are analyzed for consistency with investment parameters developedby our Manager and adopted by our board of directors;

•                                          Alltransactions considered for funding are presented at a weekly pipeline meetingattended by our Manager’s senior executive officers; and

•                                          Allfinancing applications, conditional commitments and submissions to the creditcommittee must be approved by a managing director of our Manager.

 

The affirmative vote of all members of a creditcommittee consisting of all senior officers of our Manager plus our chiefexecutive officer is necessary to approve all transactions over$3 million. Our chief investment officer may approve investments of lessthan $3 million. The investment committee of our board of directors mustunanimously approve all transactions involving investments of (i) $35 millionor more with respect to whole loans, (ii) $30 million or more withrespect to subordinate interests in whole loans, (iii) $20 million orover with respect to mezzanine loans, (iv) $20 million or more withrespect to preferred equity, and (v) $20 million or more with respectto commercial real estate properties net leased to tenants. The full board ofdirectors must approve investments (i) over $75 million with respectto whole loans, (ii) over $65 million with respect to subordinateinterests in whole loans, (iii) over $55 million with respect tomezzanine loans, (iv) over $50 million with respect to preferredequity and (v) over $50 million with respect to commercial realestate properties net leased to tenants. Our Manager will have full discretionto make investments on our behalf under (i) $35 million with respectto whole loans, (ii) $30 million with respect to subordinateinterests in whole loans, (iii) $20 million with respect to mezzanineloans, (iv) $20 million with respect to preferred equity and(v) $20 million with respect to commercial real estate properties netleased to tenants. Approval limits are based on the investment amount less anyorigination fees, discounts or other up-front fees we receive in connectionwith the investment.

 

The stages of the investmentprocess are described in more detail below.

 

***Origination***

 

OurManager is primarily responsible for originating all of our assets. In additionto SL Green’s existing customer base, our Manager utilizes an extensivenational network of relationships with property owners, developers, mortgageloan brokers, commercial and investment banks and institutional investors. Thisnetwork has been developed by the senior managers of the Manager and senior

 

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executivesof SL Green over more than 15 years. We originate investments in directtransactions with borrowers, we co-originate with or acquire existing assetsfrom third parties, primarily financial institutions, and we may occasionallyco-invest with SL Green and its affiliates. We have been growing ourplatform on a national scale through the creation of strategic partnerships andhiring additional originators who are responsible for generating new financingopportunities. As of December 31, 2005, approximately 68% of our investmentswere directly originated by us while the remaining 32% were co-originated withthird parties. Once potential investment opportunities have beenidentified, our Manager determines which financing products best meet theborrower’s needs. Our Manager works to optimize pricing and structure andcreate a favorable transaction for us while meeting our borrower’s needs. Afteridentifying a suitable structure, our Manager works with the borrower toprepare a loan application and an initial review of the investment beforecommitting underwriting resources. Once a loan is identified as suitable, it isunderwritten by our Manager’s team of experienced underwriters.

 

***Underwriting***

 

Once a potentialinvestment has been identified, our Manager’s underwriters performcomprehensive financial, structural, operational and legal due diligence toassess the risks of the investment. Our Manager’s underwriters analyze the loanapplication package and conduct follow-up due diligence on each borrower aspart of the underwriting process. The Manager’s underwriters generally reviewthe following criteria as part of the underwriting process:

 

•                                          thehistoric, in-place and projected property revenues and expenses;

 

•                                          thepotential for near-term revenue growth and opportunity for expense reductionand increased operating efficiencies;

 

•                                          onhigher leverage loans secured by leased properties, accountants may be engagedto audit operating expense recovery income;

 

•                                          theproperty’s location and its attributes;

 

•                                          thevaluation of the property based upon financial projections prepared by ourManager’s underwriters and confirmed by an independent “as is” and/or “asstabilized” appraisal;

 

•                                          marketassessment, including, review of tenant lease files, surveys of property salesand leasing comparables based on conversations with local property owners,leasing brokers, investment sales brokers and other local market participants,and an analysis of area economic and demographic trends, and a review of anacceptable mortgagee’s title policy;

 

•                                          marketrents, and in the case of certain high-leverage loans, leasing projections formajor vacant spaces and near-term vacancies, to be provided by a leasing brokerwith local knowledge;

 

•                                          structuraland environmental review of the property, including review of engineering andenvironmental reports and a site inspection, to determine future maintenanceand capital expenditure requirements;

 

•                                          therequirements for any reserves, including those for immediate repairs orrehabilitation, replacement reserves, tenant improvement and leasing commissioncosts, real estate taxes and property, casualty and liability insurance;

 

•                                          the“Underwritten Net Cash Flow” for a property, which is a set of calculations andadjustments prepared for the underwriting process to assist in evaluating aproperty’s cash flows. The Underwritten Net Cash Flow is generally theestimated stabilized annual revenue derived from the use and operation of theproperty (consisting primarily of rental income and reimbursement of expenseswhere applicable) after an allowance for vacancies, concessions and creditlosses, less estimated stabilized annual expenses;

 

•                                          creditquality of the borrower through background checks and review of financialstrength and real estate operating experience; and

 

•                                          theloan documents, to ensure that we have the necessary protections, rights andremedies.

 

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Key factors that areconsidered in credit decisions include, but are not limited to, debt servicecoverage, loan-to-value ratios and property and financial and operatingperformance. Consideration is also given to other factors such as theexperience, financial strength, reputation, and investment track record of theborrower, additional forms of collateral and identified likely strategies toeffect repayment. Our Manager will continue to refine its underwriting criteriabased upon actual loan portfolio experience and as market conditions andinvestor requirements evolve. Once diligence is completed and our Manager hasreviewed the Underwritten Net Cash Flow, sponsorship and the deal structure,our Manager determines the level in the capital structure at which aninvestment will be made and the required legal and structural protections.

 

***Servicing and Asset Management***

 

SL Green servicessubstantially all of our assets through a sub-contract with our Manager. Theloan servicing platform is designed to provide timely, responsive customerservice as well as accurate and timely information for account follow-up,financial reporting and management review. In addition, the servicingoperations include enforcement of the loan documents and standard assetmanagement functions, including monitoring of property performance and conditionand market analysis. The asset management group monitors the investments toidentify any potential underperformance of the asset and work with the borrowerto remedy the situation in an expeditious manner in order to mitigate anyeffects of underperformance. The asset manager is responsible for understandingthe borrower’s business plan with respect to each collateral property andmonitoring performance measured against that plan. We differentiate ourselvesby leveraging our Manager’s real estate knowledge and proactive approach toasset management by providing approvals and processing requests on a moretimely and efficient basis. We believe that asset management is a vitalcomponent of the borrower and lender relationship because it leaves a lastingpositive impression, and our ability to gain mutual respect with our borrowersand quickly respond to their needs will help us to develop strong andmeaningful relationships that will lead to repeat business.

 

**Operating Policies**

 

***Investment and Borrowing Guidelines***

 

We operate pursuant tothe following general guidelines for our investments and borrowings:

 

•                                          noinvestments are made that would cause us to fail to qualify as a REIT;

•                                          noinvestments are made that would cause us to be regulated as an investment companyunder the Investment Company Act;

•                                          substantiallyall assets are financed through securitization, syndication and securedborrowings, and assets intended for inclusion in traditional securitizationtransactions will be hedged against movements in the applicable swap yieldthrough customary techniques;

•                                          hedgingis generally done through the bank providing the related repurchase facility onmarket terms, or through other dealers. We engage an outside advisory firm toassist in monitoring hedges and advising management on the appropriateness ofsuch hedges;

•                                          ourleverage generally will not exceed 80% of the carrying value of our assets; and

•                                          wewill not co-invest with SL Green or any of its affiliates unless the termsof such transaction are approved by a majority of our independent directors.

 

These investmentguidelines may be changed by our board of directors without the approval of ourstockholders.

 

**Origination Agreement**

 

We have an originationagreement with SL Green pursuant to which SL Green will notoriginate, acquire or participate in fixed income investments in the UnitedStates, subject to certain conditions and exclusions described below. Fixedincome investments include debt obligations or interests in debt obligationsbearing a fixed-rate of return and collateralized by real property or interestsin real property.

 

SL Green has alsoagreed not to acquire, originate or participate in preferred equity investmentswhich bear a fixed rate of return in the United States, unless we havedetermined not to pursue that opportunity.

 

Under the agreement,SL Green has the following rights:

 

(a)          toretain any fixed income investments and/or preferred equity investments itowned or committed to own on the date of our initial public offering;

 

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(b)         tooriginate fixed income investments or acquire interests in fixed incomeinvestments and/or preferred equity investments in connection with the sale ofany real estate or real estate-related assets or fixed income investments itcurrently owns or owns at any future time, in part or whole, directly orindirectly;

 

(c)          tooriginate or acquire fixed income and/or preferred equity investments thatprovide a rate of return tied to the cash flow, appreciation or both of theunderlying real property or interests in real property;

 

(d)         tomodify or refinance any portion of the investments in item (a), (b) or(c) above including, but not limited to, changes in principal, rate ofreturn, maturity or redemption date, lien priority, return priority and/orborrower; and

 

(e)          tooriginate, acquire or participate in any distressed debt, where there is apayment default, an acceleration, bankruptcy or foreclosure, when a default ishighly likely because the loan-to-value ratio is over 100% or when the debtservice exceeds the available cash flow from the property on both a current andprojected basis.

 

Wewill agree that we will not:

 

•                                          acquire real property in metropolitan New York andWashington, D.C. (except by foreclosure or similar conveyance) resulting from afixed income investment;

•                                          originateor acquire investments described in (c) above or distressed debt, in eachcase located in metropolitan New York or Washington, D.C.; and

•                                          originateor acquire participations in any investments described in item (b) or(d) above.

 

We will also agree that,when we acquire direct or indirect ownership interests in property inmetropolitan New York or Washington D.C. by foreclosure or similar conveyance,SL Green will have the right to purchase the property at a price equal toour unpaid asset balance on the date we foreclosed or acquired the asset, plusinterest at the last stated contract (non-default) rate and, to the extentpayable by the borrower under the initial documentation evidencing theproperty, legal costs incurred by us directly related to the conveyance and thefee, if any, due upon the repayment or prepayment of the investment which iscommonly referred to as an “exit fee” (but not including default interest, latecharges, prepayment penalties, extension fees or other premiums of any kind)through the date of SL Green’s purchase. We refer to this amount as “ParValue”. If we seek to sell the asset and receive a bona fide third party offerto acquire the asset for cash that we desire to accept, SL Green maypurchase the asset at the lower of the Par Value or the third party’s offerprice. If the asset is not sold within one year, SL Green has the right topurchase the property at its appraised value. The appraised value will bedetermined as follows: we will select an appraiser and SL Green willselect an appraiser, who will each appraise the property. These two appraisersjointly will select a third appraiser, who will then choose one of the twoappraisals as the final appraised value. These rights may make it moredifficult to sell such assets because third parties may not want to incur theexpense and effort to bid on assets when they perceive that SL Green mayacquire them at the lower of the same terms proposed by the third party or ParValue. As a result, we may not receive the same value on the sale of suchassets as we might receive from an independent third party submitting an offerthrough a competitive bidding process.

 

SL Green has aright of first offer to acquire any distressed debt which we decide to sell.

 

**In the event the Management Agreement is terminated for cause by us or ifneither SL Green nor any of its affiliates shall be the managing member of ourManager, then the non-compete provisions in the origination agreement willsurvive such termination for a period of one year with respect only topotential investments by us as to which our Manager has commenced duediligence.**

** **

***Hedging Activities***

 

We use derivativeinstruments, including forwards, futures, swaps and options, in our riskmanagement strategy to limit the effects of changes in interest rates on ouroperations. Our primary hedging strategy consists of entering into interestrate swap contracts. Additionally, we may in certain select instances choose tohedge our exposure to fluctuations in CMBS credit spreads by purchasing swapswritten against a broad-based CMBS index. The value of our forwards, futuresand swaps may fluctuate over time in response to changing market conditions,and will tend to change inversely with the value of the risk in our liabilitiesthat we intend to hedge. Hedges are sometimes ineffective because thecorrelation between changes in value of the underlying investment and thederivative instrument is less than was expected when the hedging transactionwas undertaken. Since most of our hedging activity covers the period betweenorigination or purchase of loans and their eventual sale or securitization,unmatched losses in our hedging program will tend to occur when the plannedsecuritization fails to occur, or if the hedge proves to be ineffective. Wecontinuously monitor the effectiveness of our hedging strategies and adjust ourstrategies as appropriate. These transactions may include interest rate swaps,the

 

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purchase or sale ofinterest rate collars, caps or floors, options, other hedging instruments andsuch other hedging instruments as may be developed in the future and which wedetermine are suitable to achieve our hedging objectives.

 

We have retained theservices of an outside financial services firm with expertise in the use ofderivative instruments to advise us on our overall hedging strategy, to effecthedging trades, and to provide the appropriate designation and accounting ofall hedging activities from a GAAP and tax accounting and reportingperspective.

 

These instruments areused to hedge as much of the interest rate risk as our Manager determines is inthe best interest of our stockholders, given the cost of such hedges and theneed to maintain our status as a REIT. To the extent that we enter into ahedging contract to reduce interest rate risk on indebtedness incurred toacquire or carry real estate assets, any income that we derive from thecontract is qualifying income for purposes of the REIT 95% gross income test,but not for the 75% gross income test. Our Manager can elect to have us bear alevel of interest rate risk that could otherwise be hedged when it believes,based on all relevant facts, that bearing such risk is advisable.

 

***Disposition Policies***

 

Our Manager evaluatesour assets 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.

 

***Equity Capital Policies***

 

Subject to applicablelaw, our board of directors has the authority, without further stockholderapproval, to issue additional authorized common stock and preferred stock orotherwise raise capital, including through the issuance of senior securities,in any manner and on the terms and for the consideration it deems appropriate.

 

We may, under certaincircumstances, repurchase our common stock in private transactions with ourstockholders if those purchases are approved by our board of directors. Ourboard of directors has no present intention of causing us to repurchase anyshares, and any action would only be taken in conformity with applicablefederal and state laws and the applicable requirements for qualifying as aREIT, for so long as our board of directors concludes that we should remain aREIT.

 

***Other Policies***

 

We operate in a mannerthat will not subject us to regulation under the Investment Company Act. We mayinvest in the securities of other issuers for the purpose of exercising controlover such issuers. We do not underwrite the securities of other issuers.

 

***Future Revisions in Policies and Strategies***

 

Our board of directorshas the power to modify or waive our investment guidelines, policies andstrategies. Among other factors, developments in the market that either affectthe policies and strategies mentioned herein or that change our assessment ofthe market may cause our board of directors to revise our investmentguidelines, policies and strategies. However, if such modification or waiverinvolves the relationship of, or any transaction between, us and our Manager orany affiliate of our Manager, the approval of a majority of our independentdirectors is also required. We may not, however, amend our charter to changethe requirement that a majority of our board of directors consist ofindependent directors or the requirement that a majority of our independentdirectors approve related party transactions without the approval of two-thirdsof the votes entitled to be cast by our stockholders.

 

**Competition**

 

Our net income depends,in large part, on our ability to originate investments with spreads over ourborrowing cost. In originating these investments, we compete with othermortgage REITs, specialty finance companies, savings and loan associations,banks, mortgage bankers, insurance companies, mutual funds, institutionalinvestors, investment banking firms, other lenders, governmental bodies andother entities, many of which have greater financial resources and lower costsof capital available to them than we have. In addition, there are numerousmortgage REITs with asset acquisition objectives similar to ours, and othersmay be organized in the future, which may increase competition for theavailable investments suitable for us. Competitive variables include marketpresence and visibility, size of loans offered and underwriting standards.

 

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To the extent that acompetitor is willing to risk larger amounts of capital in a particulartransaction or to employ more liberal underwriting standards when evaluatingpotential loans than we are, our origination volume and profit margins for ourinvestment portfolio could be adversely affected. Our competitors may also bewilling to accept lower returns on their investments and may succeed inoriginating or acquiring the assets that we have targeted for origination oracquisition. Although we believe that we are well positioned to competeeffectively in each facet of our business, there is considerable competition inour market sector and there can be no assurance that we will competeeffectively or that we will not encounter further increased competition in thefuture that could limit our ability to conduct our business effectively.

 

**Industry Segments**

 

**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. Weare a REIT focused primarily on originating and acquiring loans and securitiesrelated to real estate and currently operate in only one segment.**

** **

**Employees**

 

Wedo not currently have any employees, nor do we anticipate hiring any employeesin the near term. Our executive officers and other staff are all employed byour Manager or SL Green and leased by us pursuant to the managementagreement with our Manager and the outsourcing agreement with SL Green.

 

**EnvironmentalMatters**

 

Under various federal,state and local environmental laws, ordinances and regulations, a current orprevious owner of real estate (including, in certain circumstances, a securedlender that succeeds to ownership or control of a property) may become liablefor the costs of removal or remediation of certain hazardous or toxicsubstances at, on, under or in its property. Those laws typically imposecleanup responsibility and liability without regard to whether the owner orcontrol party knew of or was responsible for the release or presence of suchhazardous or toxic substances. The costs of investigation, remediation orremoval of those substances may be substantial. The owner or control party of asite may be subject to common law claims by third parties based on damages andcosts resulting from environmental contamination emanating from a site. Certainenvironmental laws also impose liability in connection with the handling of orexposure to asbestos-containing materials, pursuant to which third parties mayseek recovery from owners of real properties for personal injuries associatedwith asbestos-containing materials. Absent succeeding to ownership or controlof real property, a secured lender is not likely to be subject to any of theseforms of environmental liability. We are not currently aware of anyenvironmental issues which could materially affect the Company.

 

**ITEM1A.       RISK FACTORS**

 

**Risks Related to Our Management and Our Relationship with SLGreen**

 

***We are dependent on our Manager and its keyemployees and may not find a suitable replacement if our Manager terminates themanagement agreement or the key personnel are no longer available to us.***

 

We have no directemployees. We are completely reliant on our Manager, which has significantdiscretion as to the implementation of our operating policies and strategies.We have entered into a management agreement with the Manager, that terminatesin December 2007, subject to automatic, one-year renewals. We are subjectto the risk that our Manager will terminate the management agreement and thatno suitable replacement will be found to manage us. We believe that our successdepends to a significant extent upon the experience of our Manager’s executiveofficers, whose continued service is not guaranteed. If our Manager terminatesthe management agreement, we may not be able to execute our business plan.

 

***There are conflicts of interest in ourrelationship with our Manager, which could result in decisions that are not inthe best interest of holders of our securities.***

 

We are subject topotential conflicts of interest arising out of our relationship with SL Greenand our Manager. Several of SL Green’s executive officers are also directorsand executive officers of our Manager and us. Specifically, our chairman andeach of our executive officers also serve as officers of our Manager or SLGreen. As a result, the management agreement was not negotiated at arm’s-lengthand its terms, including fees payable, may not be as favorable to us as if ithad been negotiated with an unaffiliated third party.

 

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In addition, our Managerand our executives may have conflicts between their duties to us and their dutiesto, and interests in, SL Green and/or our Manager. Our Manager is not requiredto devote a specific amount of time to our operations. There may also beconflicts in allocating investments which are suitable both for us and SLGreen. SL Green has agreed generally that it will not acquire fixed income orpreferred equity investments during the term of the management agreement.However, there are several exceptions, including debt instruments with equitycharacteristics, distressed debt and refinancings of existing SL Green debtinvestments. As a result, SL Green may compete with us with respect to certaininvestments which we may want to acquire, and as a result we may either not bepresented with the opportunity or have to compete with SL Green to acquirethese investments. Our Manager and our executive officers may choose toallocate favorable investments to SL Green instead of to us.

 

Wepay our Manager substantial base management fees regardless of the performanceof our portfolio. SL Green, our Manager and certain other parties, includingcertain of our officers, also own Class B limited partner interests in ouroperating partnership, which entitles them to receive quarterly distributionsbased on financial performance. In evaluating investments and other managementstrategies, this may lead our Manager to place emphasis on the maximization ofrevenues at the expense of other criteria, such as preservation ofcapital. Investments with higher yield potential are generally riskier or morespeculative. This could result in increased risk to the value of our investedportfolio.

 

Termination of orfailure to renew the management agreement without cause requires us to paysubstantial amounts of termination fees and redeem the Class B limitedpartner interests. If the management agreement is terminated or not renewedother than for cause, we will be required to pay a termination fee equal to twotimes the higher of the total annual fees paid under the management and assetservicing agreements in either of the two calendar years prior to thetermination, unless we become self-managed, in which event this amount will bereduced by 50%. We are also required to redeem the Class B limited partnerinterests upon termination of the management agreement. These provisions mayincrease the effective cost to us of terminating or failing to renew themanagement agreement, thereby adversely affecting our ability to terminate ornot renew the management agreement without cause.

 

***Our assets that may become foreclosed orowned by similar conveyance may be subject to purchase rights or rights offirst offer in favor of SL Green, which could reduce their marketability orvalue.***

 

Pursuant to ourorigination agreement with SL Green, we have granted SL Green rights of firstoffer with respect to the acquisition or origination of certain of our assets.SL Green has the right to purchase ownership interests in real propertieslocated in metropolitan New York or Washington, D.C. relating to properties weacquire in foreclosure of our debt investments and, to purchase distresseddebts located in metropolitan New York or Washington, D.C. acquired by usrelating to properties at a price equal to our unpaid asset balance on the datewe foreclosed on or acquired the asset, plus interest through the date of SLGreen’s purchase. If we seek to sell the asset and receive a bona fide offer toacquire the asset for cash that we desire to accept, SL Green may purchase theasset at the lower of the unpaid asset balance or the third party’s offerprice.

 

Similarly, our jointventure agreement with SL Green contains a buy-sell provision that can betriggered by us in the event we and SL Green are unable to agree upon a majordecision that would materially impair the value of the South Building locatedat One Madison. Such major decisions involve the sale or refinancing of theSouth Building located at One Madison Avenue, any extensions or modificationsto the net lease with the tenant therein or any material capital expenditure.

 

These rights may make itmore difficult to sell such assets because third parties may not want to incurthe expense and effort to bid on assets when they perceive that SL Green mayacquire them at the lower of the same terms proposed by the third party or parvalue. As a result, we may not receive the same value on the sale of suchassets as we might receive from an independent third party submitting an offerthrough a competitive bidding process.

 

***Our financial condition and results ofoperations depend on our ability to manage future growth effectively.***

 

Our ability to achieveour investment objective depends on our ability to grow, which depends, inturn, on our Manager’s ability to identify and invest in debt investments orother securities that meet our investment criteria. Accomplishing this resulton a cost-effective basis is largely a function of our Manager’s structuring ofthe investment process, its ability to provide competent, attentive andefficient services to us and our access to financing on acceptable terms. Thesenior management team of our Manager has substantial responsibilities underthe management agreement. We can offer no assurance that the senior managementteam of our Manager or any of the other employees of the Manager willcontribute to our growth. Any failure to manage our future growth effectivelycould have a material adverse effect on our business, financial condition andresults of operations.

 

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***Our board of directors has approved verybroad investment guidelines for our Manager and does not approve eachinvestment decision made by our Manager.***

 

Our Manager isauthorized to follow very broad investment guidelines. Our directors review ourinvestment guidelines and our investment portfolio annually and as often asthey deem necessary. However, our board of directors does not review eachproposed investment. The investment committee of our board of directors mustunanimously approve all transactions involving investments of(i) $35 million or more with respect to whole loans,(ii) $30 million or more with respect to subordinate interests inwhole loans, (iii) $20 million or over with respect to mezzanineloans, (iv) $20 million or more with respect to preferred equity, and(v) $20 million or more with respect to commercial real estateproperties net leased to tenants. The full board of directors must approveinvestments (i) over $75 million with respect to whole loans,(ii) over $65 million with respect to subordinate interests in whole loans,(iii) over $55 million with respect to mezzanine loans,(iv) over $50 million with respect to preferred equity and(v) over $50 million with respect to commercial real estateproperties net leased to tenants. Our Manager will have full discretion to makeinvestments on our behalf under (i) $35 million with respect to wholeloans, (ii) $30 million with respect to subordinate interests inwhole loans, (iii) $20 million with respect to mezzanine loans,(iv) $20 million with respect to preferred equity and(v) $20 million with respect to commercial real estate properties netleased to tenants. Our chief investment officer may approve investments of lessthan $3 million. Approval limits are based on the investment amount lessany origination fees, discounts or other up-front fees we receive in connectionwith the investment. In addition, in conducting periodic reviews, the directorsrely primarily on information provided to them by our Manager. Our Manager hasgreat latitude within the broad parameters of our investment guidelines indetermining the types of assets it may decide are proper investments for us.Decisions made and investments entered into by our Manager may not fullyreflect the stockholder’s best interests.

 

***We may change our investment andoperational policies without stockholder consent.***

 

We may change ourinvestment and operational policies, including our policies with respect toinvestments, acquisitions, growth, operations, indebtedness, capitalization anddistributions, at any time without the consent of our stockholders, which couldresult in our making investments that are different from, and possibly riskierthan, the types of investments described in this filing. A change in ourinvestment strategy may increase our exposure to interest rate risk, default riskand real estate market fluctuations, all of which could adversely affect ourability to make distributions.

 

**Risks Related to Our Business**

 

***Maintenance of our Investment Company Actexemption imposes limits on our operations.***

 

We have conducted ouroperations and intend to continue to conduct our operations so as not to becomeregulated as an investment company under the Investment Company Act. We believethat there are a number of exemptions under the Investment Company Act that maybe applicable to us. For example, Section 3(c)(5)(C) exempts from thedefinition of “investment company” any person who is “primarily engaged in thebusiness of purchasing or otherwise acquiring mortgages and other liens on andinterests in real estate.” Additionally, Section 3(c)(6) exempts from thedefinition of “investment company” any company primarily engaged, directly orthrough majority-owned subsidiaries, in the business of purchasing or otherwiseacquiring mortgages and other liens on and interests in real estate. Further,Rule 3a-1 under the Investment Company Act exempts from the definition of “investmentcompany” a company if no more than 45% of the value of its assets (exclusive ofU.S. Government securities and cash items) consists of, and no more than 45% ofits net income after taxes for the past four quarters is derived from,securities other than U.S. Government securities, securities issued byemployees’ securities companies, securities issued by certain majority-ownedsubsidiaries of such company and securities issued by certain companies thatare controlled primarily by such company, provided, that certain otherrequirements are met. The assets that we have acquired and may acquire in thefuture, therefore, are limited by the provisions of the Investment Company Actand the exemptions on which we rely. In addition, we could, among other things,be required either (a) to change the manner in which we conduct ouroperations to avoid being required to register as an investment company or(b) to register as an investment company, either of which could have anadverse effect on our business and our ability to pay dividends.

 

To maintain ourqualification for an exemption from registration under the Investment CompanyAct pursuant to Section 3(c)(5)(C) and3(c)(6)at least 55% of our portfolio, or the assets of our majority-ownedsubsidiaries, must be comprised of qualifying realestate assetsunder Section 3(c)(5)(C) of the Investment Company Act, and 80% of ourportfolio, or the assets of our majority-owned subsidiaries, must be comprisedof qualifying real estate assets and real estate-relatedassets under Section 3(c)(5)(C) of the Investment Company Act. Inaddition, we may not issue redeemable securities. To comply with theseregulations, we may from time to time buy RMBS and other qualifying real estate assets. We generally expect that whole loans, bridge loans,whole pool MBS, CTLs and certain distressed debt securities to be qualifying real estate assets under the Section 3(c)(5)(C) and 3(c)(6) exemptions from the Investment Company Act. The treatment ofdistressed debt securities as qualifying realestate assetsis, and will be, based on the characteristics of the particular type of loan,including its foreclosure rights. Junior (first loss) interests in MBS poolsmay constitute qualifying real

 

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estateassets under Section 3(c)(5)(C) provided that we have theunilateral right to foreclose, directly or indirectly, on the mortgages in thepool and that we may act as the controlling class or directing holder of thepool. Similarly, subordinate interests in whole loans may constitute qualifyingreal estate assets underSection 3(c)(5)(C) provided that we have the unilateral right toforeclose, directly or indirectly, on the mortgage and that we may act as thecontrolling class or directing holder of the note. We generally do not treatmezzanine loans and preferred equity investments as qualifying real real estateassets.  Although we monitor ourportfolio periodically and prior to each origination or acquisition of a newasset or disposition of an existing asset, there can be no assurance that wewill be able to maintain this exemption from registration. Further, we may notbe able to invest in sufficient qualifying and/or real estate-related assetsand future revisions or interpretations of the Investment Company Act may causeus to lose our exemption or force us to re-evaluate our portfolio and ourbusiness strategy. Such changes may prevent us from operating our businesssuccessfully.

 

As part of its dutiesunder the management agreement, our Manager periodically evaluates our assets,and also evaluates prior to an acquisition or origination the structure of eachprospective investment, to determine whether the investment will be aqualifying asset for purposes of maintaining our exemption from registrationunder the Investment Company Act, and we consult with counsel to verify suchdetermination. If we are obligated to register as an investment company, wewould have to comply with a variety of substantive requirements under theInvestment Company Act, including limitations on capital structure,restrictions on specified investments; prohibitions on transactions withaffiliates, changes in the composition of the board of directors and compliancewith reporting, record keeping, voting, proxy disclosure and other rules andregulations that would significantly change our operations. In addition, theterms of our management agreement would need to be substantially revised orsuch agreement would need to be terminated. If the management agreement isterminated, we will, among other things, be in default under our repurchasefacilities and financial institutions will have the right to terminate thosefacilities and their obligation to advance funds to us to finance our futureinvestments. In addition, we may not be able to identify a replacement manageron favorable terms or at all.

 

***We utilize a significant amount of debt tofinance our portfolio, which may subject us to an increased risk of loss,adversely affecting the return on our investments and reducing cash availablefor distribution.***

 

We utilize a significantamount of debt to finance our operations, which can compound losses and reducethe cash available for distributions to our stockholders. We generally leverageour portfolio through the use of bank credit facilities, repurchase agreements,securitizations, including the issuance of CDOs and other borrowings. Theleverage we employ varies depending on our ability to obtain repurchasefacilities, the loan-to-value and debt service coverage ratios of our assets,the yield on our assets, the targeted leveraged return we expect from ourportfolio and our ability to meet ongoing covenants related to our asset mixand financial performance. Substantially all of our assets are pledged ascollateral for our borrowings. Our return on our investments and cash availablefor distribution to our stockholders may be reduced to the extent that changesin market conditions cause the cost of our financing to increase relative tothe income that we can derive from the assets we acquire. For example, we havepurchased and expect to purchase in the future, subordinate classes of bonds inour CDOs, which represent leveraged investments in the collateral debtsecurities and other underlying assets. The use of leverage through such CDOscreate the risk for the holders of the subordinate classes of bonds ofincreased exposure to losses on a leveraged basis as a result of defaults withrespect to such collateral debt securities. As a result, the occurrence ofdefaults with respect to only a small portion of the collateral debt securitiescould result in the complete loss of the investment of the holders of thesubordinate classes of bonds.

 

Our debt servicepayments, including payments in connection with any CDOs, reduce the net incomeavailable for distributions. Moreover, we may not be able to meet our debtservice obligations and, to the extent that we cannot, we risk the loss of someor all of our assets to foreclosure or sale to satisfy our debt obligations.Under our repurchase agreements, our lenders take title to our assets and mayhave an ability to liquidate our assets through an expedited process.Currently, neither our charter nor our bylaws impose any limitations on theextent to which we may leverage our assets.

 

***If GKK Manager LLC ceases to be our managerpursuant to the management agreement, financial institutions providing ourrepurchase facilities may not provide future financing to us.***

 

One of the financialinstitutions that finance our investments pursuant to certain of our creditfacilities and repurchase agreements require that GKK Manager LLC remain ourManager pursuant to the management agreement. If GKK Manager LLC ceases to beour Manager, it is an event of default and the applicable financial institutionunder these facilities has the right to terminate its facility and itsobligation to advance funds to us to finance our future investments. If GKKManager LLC ceases to be our Manager for any reason and we are unable to obtainfinancing under these or replacement credit and repurchase facilities, ourgrowth may be limited.

 

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***Our repurchase agreements and our CDOfinancing agreements may limit our ability to make investments.***

 

In order to borrow moneyto make investments under our repurchase agreements, our lenders, Wachovia andGoldman Sachs have the right to review the potential investment for which weare seeking financing. We may be unable to obtain the consent of our lenders tomake investments that we believe are favorable to our company. In the eventthat Wachovia or Goldman Sachs do not consent to the inclusion of the potentialasset in the repurchase facility, we may be unable to obtain alternatefinancing for that investment. Our lender’s consent rights with respect to ourrepurchase agreements may limit our ability to execute our business plan.

 

Each CDO financing thatwe engage in will contain certain eligibility criteria with respect to thecollateral that we seek to acquire and sell to the CDO issuer. If thecollateral does not meet the eligibility criteria for eligible collateral asset forth in the transaction documents of such CDO transaction, we may not beable to acquire and sell such collateral to the CDO issuer. The inability ofthe collateral to meet eligibility requirements with respect to our CDOs maylimit our ability to execute our business plan.

 

***We may not be able to issue CDO securitieson attractive terms, which may require us to seek more costly financing for ourinvestments or to liquidate assets.***

 

Conditions in thecapital markets may make the issuance of a CDO less attractive to us even ininstances when we have a sufficient pool of eligible collateral. If we areunable to issue a CDO to finance these assets, or if doing so is noteconomical, we may be required to seek other forms of potentially lessattractive financing or otherwise to liquidate the collateral.

 

***We may not be able to access financingsources on favorable terms, or at all, which could adversely affect our abilityto execute our business plan and our ability to distribute dividends.***

 

We finance our assetsover the long-term through a variety of means, including repurchase agreements,credit facilities, CDOs and other structured financings. We have also financedour acquisitions through the issuance of $100 million of trust preferredsecurities in 2005. Our ability to execute this strategy depends on variousconditions in the markets for financing in this manner which are beyond ourcontrol, including lack of liquidity and greater credit spreads. We cannot beassured that these markets will remain an efficient source of long-termfinancing for our assets. If our strategy is not viable, we will have to findalternative forms of long-term financing for our assets, as secured revolvingcredit facilities and repurchase facilities may not accommodate long-termfinancing. This could subject us to more recourse indebtedness and the riskthat debt service on less efficient forms of financing would require a largerportion of our cash flows, thereby reducing cash available for distribution toour stockholders, funds available for operations as well as for future businessopportunities.

 

In addition, we dependupon the availability of adequate financing sources and capital for ouroperations. As a REIT, we are required to distribute at least 90% of our REITtaxable income, determined without regard to the deduction for dividends paidand excluding net capital gain, to our stockholders and are therefore not ableto retain our earnings for new investments. However, our taxable REITsubsidiaries are able to retain (and likely will retain) earnings forinvestment in new capital, subject to maintaining our qualification as a REIT.We cannot be assured that any, or sufficient, funding or capital will beavailable to us in the future on terms that are acceptable to us.

 

Furthermore, if theminimum dividend distribution required to maintain our REIT qualificationbecomes large relative to our cash flow due to our taxable income exceeding ourcash flow from operations, then we could be forced to borrow funds, sell assetsor raise capital on unfavorable terms, if we are able to at all, in order tomaintain our REIT qualification. In the event that we cannot obtain sufficientfunding on acceptable terms, there may be a negative impact on the market priceof our common shares and our ability to distribute dividends.

 

***Lack of diversification in number ofinvestments increases our dependence on individual investments.***

 

If we acquire largerloans or property interests, our portfolio will be concentrated in a smallernumber of assets, increasing the risk of loss to stockholders if a default orother problem arises.

 

***Interest rate fluctuations could reduce ourability to generate income on our investments.***

 

The yield on ourinvestments in real estate securities and loans is sensitive to changes inprevailing interest rates and changes in prepayment rates. Changes in interestrates can affect our net interest income, which is the difference between theinterest income we earn on our interest-earning investments and the interestexpense we incur in financing these investments. We tend to price loans at a

 

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spread to either UnitedStates Treasury obligations, swaps or LIBOR. A decrease in these indexes willlower the yield on our investments. Conversely, if these indexes risematerially, borrowers may be unable to borrow the higher-leverage loans that wetarget.

 

***In a period of rising interest rates, ourinterest expense could increase while the interest we earn on our fixed-rateassets would not change, which would adversely affect our profitability.***

 

Our operating resultsdepend in large part on differences between the income from our assets, net ofcredit losses, and financing costs. In most cases, for any period during whichour assets are not match-funded, the income from such assets will respond moreslowly to interest rate fluctuations than the cost of our borrowings.Consequently, changes in interest rates, particularly short-term interestrates, may significantly influence our net income. Increases in these rateswill tend to decrease our net income and market value of our assets. Interestrate fluctuations resulting in our interest expense exceeding our interestincome would result in operating losses for us and may limit or eliminate ourability to make distributions to our stockholders.

 

***If credit spreads widen before we obtainlong-term financing for our assets, the value of our assets may suffer.***

 

We price our assetsbased on our assumptions about future credit spreads for financing of thoseassets. We have obtained and will obtain in the future longer term financingfor our assets using structured financing techniques. Such issuances entailinterest rates set at a spread over a certain benchmark, such as the yield onUnited States Treasury obligations, swaps or LIBOR. If the spread thatinvestors are paying on our current structured finance vehicle and will pay onfuture structured finance vehicles we may engage in over the benchmark widensand the rates we are charging or will charge on our securitized assets are notincreased accordingly, this may reduce our income or cause losses.

 

***The repurchase agreements and creditfacilities that we use to finance our investments may require us to provideadditional collateral.***

 

We use credit facilitiesand repurchase agreements to finance some of our debt investments, primarily onan interim basis. If the market value of the loans pledged or sold by us to afunding source decline in value, we may be required by the lending institutionto provide additional collateral or pay down a portion of the funds advanced.We may not have the funds available to pay down our debt, which could result indefaults. Posting additional collateral to support our repurchase and creditfacilities will reduce our liquidity and limit our ability to leverage ourassets. In the event we do not have sufficient liquidity to meet suchrequirements, lending institutions can accelerate our indebtedness, increaseinterest rates and terminate our ability to borrow. Such a situation wouldlikely result in a rapid deterioration of our financial condition and possibly necessitatea filing for protection under the United States Bankruptcy Code.

 

Further, facilityproviders may require us to maintain a certain amount of cash uninvested or setaside unlevered assets sufficient to maintain a specified liquidity positionwhich would allow us to satisfy our collateral obligations. As a result, we maynot be able to leverage our assets as fully as we would choose, which couldreduce our return on assets. In the event that we are unable to meet thesecollateral obligations, our financial condition could deteriorate rapidly.

 

***Lenders may require us to enter intorestrictive covenants relating to our operations.***

 

When we obtainfinancing, lenders impose restrictions on us that affect our ability to incuradditional debt, our capability to make distributions to stockholders and ourflexibility to determine our operating policies. Loan documents we executecontain negative covenants that limit, among other things, our ability torepurchase stock, distribute more than a certain amount of our funds fromoperations, and employ leverage beyond certain amounts.

 

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

 

We have purchased, andexpect to purchase in the future, subordinate classes of bonds in our CDOfinancings. The terms of the CDO securities issued by us include and willinclude coverage tests, including over-collateralization tests, used primarilyto determine whether and to what extent principal and interest proceeds on theunderlying collateral debt securities and other assets may be used to payprincipal of and interest on the subordinate classes of bonds in the CDO. Inthe event the coverage tests are not satisfied, interest and principal thatwould otherwise be payable on the subordinate classes may be re-directed to payprincipal on the senior bond classes. Therefore, failure to satisfy thecoverage tests could adversely affect our operating results and cash flows.Although these coverage tests are currently being met, we cannot be assured thatthe coverage tests will continue to be satisfied in the future.

 

Certain coverage tests(based on delinquency levels or other criteria) may also restrict our abilityto receive net income from assets pledged to secure the CDOs. We cannot beassured in advance of completing negotiations with the rating agencies or otherkey

 

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transaction parties onany future CDOs, the actual terms of the delinquency tests,over-collateralization terms, cash flow release mechanisms or other significantfactors regarding the calculation of net income to us. Failure to obtainfavorable terms with regard to these matters may materially and adverselyaffect the availability of net income to us. If our assets fail to perform asanticipated, our over-collateralization or other credit enhancement expenseassociated with our CDOs will increase.

 

***We may not be able to renew the totalreturn swaps that we enter into, which could adversely impact our leveragingstrategy.***

 

Subject to maintainingour qualification as a REIT, we leverage certain of our investments through theuse of total return swaps. We may wish to renew many of the swaps, which arefor specified terms, as they mature. However, there is a limited number ofproviders of such swaps, and there is no assurance the initial swap providerswill choose to renew the swaps, and—if they do not renew—that we would be ableto obtain suitable replacement providers. Providers may choose not to renew ourtotal return swaps for a number of reasons, including:

 

•                  increases in theprovider’s cost of funding;

•                  insufficientvolume of business with a particular provider;

•                  a desire by ourcompany to invest in a type of swap that the provider does not view as economicallyattractive due to changes in interest rates or other market factors; or

•                  the inability ofour company and a provider to agree on terms.

 

Furthermore, our abilityto invest in total return swaps, other than through a taxable REIT subsidiary,or TRS, may be severely limited by the REIT qualification requirements becausetotal return swaps are not qualifying assets and do not produce qualifyingincome for purposes of the REIT asset and income tests.

 

***We may be required to repurchase loans thatwe have sold or to indemnify holders of our CDOs.***

 

If any of the loans weoriginate or acquire and sell or securitize do not comply with representationsand warranties that we make about certain characteristics of the loans, theborrowers and the underlying properties, we may be required to repurchase thoseloans (including from a trust vehicle used to facilitate a structured financingof the assets through CDOs) or replace them with substitute loans. In addition,in the case of loans that we have sold instead of retained, we may be requiredto indemnify persons for losses or expenses incurred as a result of a breach ofa representation or warranty. Repurchased loans typically require a significantallocation of working capital to carry on our books, and our ability to borrowagainst such assets is limited. Any significant repurchases or indemnificationpayments could materially and adversely affect our financial condition andoperating results.

 

***Our hedging transactions may limit ourgains or result in losses.***

 

Subject to maintainingour qualification as a REIT, we use derivative instruments, including forwards,futures, swaps and options, in our risk management strategy to limit theeffects of changes in interest rates on our operations. Our primary hedgingstrategy consists of entering into interest rate swap contracts. Additionally,we, in certain select instances choose to hedge our exposure to fluctuations inCMBS credit spreads by purchasing swaps written against a broad-based CMBSindex. The value of our forwards, futures and swaps may fluctuate over time inresponse to changing market conditions, and will tend to change inversely withthe value of the risk in our liabilities that we intend to hedge. Hedges aresometimes ineffective because the correlation between changes in value of theunderlying investment and the derivative instrument is less than was expectedwhen the hedging transaction was undertaken. Since most of our hedging activityis intended to cover the period between origination or purchase of loans andtheir eventual sale or securitization, unmatched losses in our hedging programtend to occur when the planned securitization fails to occur, or if the hedgeproves to be ineffective.

 

Our hedgingtransactions, which are intended to limit losses, may actually limit gains andincrease our exposure to losses. The use of derivatives to hedge ourliabilities carries certain risks, including the risk that losses on a hedgeposition will reduce the cash available for distribution to stockholders andthat these losses may exceed the amount invested in such instruments. A hedgemay not be effective in eliminating all of the risks inherent in any particularposition and could result in higher interest rates than we would otherwisehave. In addition, there will be many market risks against which we may not beable to hedge effectively. Furthermore, we do not hedge any risks with respectto instruments that we may purchase or hold for investment rather thansecuritization. Moreover, no hedging activity can completely insulate us fromthe risks associated with changes in interest rates, and our qualification as aREIT may limit our ability to effectively hedge our interest rate exposure. Ourprofitability may be adversely affected during any period as a result of theuse of derivatives.

 

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***We are subject to significant competitionand we may not compete successfully.***

 

We have significantcompetition with respect to our acquisition and origination of assets with manyother companies, including other REITs, insurance companies, commercial banks,private investment funds, hedge funds, specialty finance companies and otherinvestors, some of which have greater resources than us, and we may not be ableto compete successfully for investments.

 

***Rapid changes in the values of our MBS andother real estate related investments may make it more difficult for us tomaintain our qualification as a REIT or exemption from the Investment CompanyAct.***

 

If the market value orincome potential of our MBS and other real estate-related investments declinesas a result of increased interest rates, prepayment rates or other factors, wemay need to increase our real estate investments and income and/or liquidateour non-qualifying assets in order to maintain our REIT qualification orexemption from the Investment Company Act. If the decline in real estate assetvalues and/or income occurs quickly, this may be especially difficult toaccomplish. This difficulty may be exacerbated by the illiquid nature of manyof our non-real estate assets. We may have to make investment decisions that weotherwise would not make absent the REIT and Investment Company Actconsiderations.

 

***Terrorist attacks and other acts ofviolence or war may affect the market for our common stock, the industry inwhich we conduct our operations and our profitability.***

 

Terrorist attacks mayharm our results of operations and the stockholder’s investment. We cannot beassured that there will not be further terrorist attacks against the U.S. orU.S. businesses. These attacks or armed conflicts may directly impact theproperty underlying our asset-based securities or the securities markets ingeneral. Losses resulting from these types of events are uninsurable.

 

More generally, any ofthese events could cause consumer confidence and spending to decrease or resultin increased volatility in the U.S. and worldwide financial markets andeconomy. Adverse economic conditions could harm the value of the propertyunderlying our asset-backed securities or the securities markets in generalwhich could harm our operating results and revenues and may result in thevolatility of the value of our securities.

 

***We are highly dependent on informationsystems and third parties, and systems failures could significantly disrupt ourbusiness, which may, in turn, negatively affect the market price of our commonstock and our ability to pay dividends.***

 

Our business is highlydependent on communications and information systems. Any failure orinterruption of our systems could cause delays or other problems in oursecurities trading activities, including mortgage-backed securities tradingactivities, which could have a material adverse effect on our operating resultsand negatively affect the market price of our common stock and our ability topay dividends.

 

**Risks Related to Our Investments**

 

***Some of our portfolio investments may berecorded at fair value as determined in good faith by our Manager and, as aresult, there will be uncertainty as to the value of these investments.***

 

Some of our portfolioinvestments may be in the form of securities that are not publicly traded. Thefair value of securities and other investments that are not publicly traded maynot be readily determinable. We value these investments quarterly at fair valueas determined in good faith by our Manager. Because such valuations areinherently uncertain, may fluctuate over short periods of time and may be basedon estimates, our determinations of fair value may differ materially from thevalues that would have been used if a ready market for these securitiesexisted. The value of our common stock could be adversely affected if ourdeterminations regarding the fair value of these investments were materiallyhigher than the values that we ultimately realize upon their disposal.

 

***A prolonged economic slowdown, a lengthy orsevere recession or declining real estate values could harm our operations.***

 

We believe the risksassociated with our business is more severe during periods of economic slowdownor recession if these periods are accompanied by declining real estate values.Declining real estate values will likely reduce our level of new mortgage loanoriginations, since borrowers often use increases in the value of theirexisting properties to support the purchase or investment in additionalproperties. Borrowers may also be less able to pay principal and interest onour loans if the real estate economy weakens. Further, declining real estatevalues significantly increase the likelihood that we will incur losses on ourloans in the event of default because the value of our collateral may beinsufficient to cover our cost on the loan. Any sustained period of increasedpayment

 

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delinquencies, foreclosuresor losses could adversely affect both our net interest income from loans in ourportfolio as well as our ability to originate, sell and securitize loans, whichwould significantly harm our revenues, results of operations, financialcondition, business prospects and our ability to make distributions to thestockholders.

 

***We may be adversely affected by unfavorableeconomic changes in geographic areas where our properties are concentrated.***

 

Adverse conditions inthe areas where the properties underlying our investments are located(including business layoffs or downsizing, industry slowdowns, changingdemographics and other factors) and local real estate conditions (such asoversupply of, or reduced demand for, office and industrial properties) may havean adverse effect on the value of our properties. A material decline in thedemand or the ability of tenants to pay rent for office and industrial space inthese geographic areas may result in a material decline in our cash availablefor distribution.

 

***Joint investments could be adverselyaffected by our lack of sole decision-making authority and reliance upon aco-venturer’s financial condition.***

 

We co-invest with thirdparties through partnerships, joint ventures, co-tenancies or other entities,acquiring non-controlling interests in, or sharing responsibility for managingthe affairs of, a property, partnership, joint venture, co-tenancy or otherentity. Therefore, we will not be in a position to exercise soledecision-making authority regarding that property, partnership, joint ventureor other entity. Investments in partnerships, joint ventures, or other entitiesmay involve risks not present were a third party not involved, including thepossibility that our partners, co-tenants or co-venturers might become bankruptor otherwise fail to fund their share of required capital contributions.Additionally, our partners or co-venturers might at any time have economic orother business interests or goals which are inconsistent with our businessinterests or goals. These investments may also have the potential risk ofimpasses on decisions such as a sale, because neither we nor the partner,co-tenant or co-venturer would have full control over the partnership or jointventure. Consequently, actions by such partner, co-tenant or co-venturer mightresult in subjecting properties owned by the partnership or joint venture toadditional risk. In addition, we may in specific circumstances be liable forthe actions of our third-party partners, co-tenants or co-venturers.

 

Although our existingjoint venture agreements do not contain such provisions, we may in the futureenter into joint venture agreements that contain terms in favor of our partnersthat may have an adverse effect on the value of our investments in the jointventures. For example, we may be entitled under a particular joint ventureagreement to an economic share in the profits of the joint venture that issmaller than our ownership percentage in the joint venture, our partner may beentitled to a specified portion of the profits of the joint venture before weare entitled to any portion of such profits and our partner may have rights tobuy our interest in the joint venture, to force us to buy the partner’sinterest in the joint venture or to compel the sale of the property owned bysuch joint venture. These rights may permit our partner in a particular jointventure to obtain a greater benefit from the value or profits of the jointventure than us, which may have an adverse effect on the value of our investmentin the joint venture and on our financial condition and results of operations.

 

***Liability relating to environmental mattersmay impact the value of the properties that we may acquire or underlying ourinvestments.***

 

Under various U.S.federal, state and local laws, an owner or operator of real property may becomeliable for the costs of removal of certain hazardous substances released on itsproperty. These laws often impose liability without regard to whether the owneror operator knew of, or, was responsible for, the release of such hazardoussubstances.

 

If we acquire propertiesdirectly, there may be environmental problems associated with the propertywhich we were unaware of at the time of acquisition. The presence of hazardoussubstances may adversely affect an owner’s ability to sell real estate orborrow using real estate as collateral. To the extent that an owner of aproperty underlying one of our debt investments becomes liable for removalcosts, the ability of the owner to make debt payments to us may be reduced. This,in turn, may adversely affect the value of the relevant mortgage asset held byus and our ability to make distributions to stockholders.

 

If we acquire anyproperties, the presence of hazardous substances on a property may adverselyaffect our ability to sell the property and we may incur substantialremediation costs, thus harming our financial condition. In addition, althoughour leases, if any, will generally require our tenants to operate in compliancewith all applicable laws and to indemnify us against any environmentalliabilities arising from a tenant’s activities on the property, we nonethelesswould be subject to strict liability by virtue of our ownership interest forenvironmental liabilities created by such tenants, and we cannot ensure thestockholders that any tenants we might have would satisfy their indemnificationobligations under the applicable sales agreement or lease. The discovery ofmaterial environmental liabilities attached

 

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to such properties couldhave a material adverse effect on our results of operations and financialcondition and our ability to make distributions to our stockholders.

 

***Hedging instruments often are not traded onregulated exchanges, guaranteed by an exchange or its clearing house, orregulated by any U.S. or foreign governmental authorities and involve risks andcosts.***

 

The cost of usinghedging instruments increases as the period covered by the instrument increasesand during periods of rising and volatile interest rates. We may increase ourhedging activity and thus increase our hedging costs during periods wheninterest rates are volatile or rising and hedging costs have increased.

 

In addition, hedginginstruments involve risk since they often are not traded on regulatedexchanges, guaranteed by an exchange or its clearing house, or regulated by anyU.S. or foreign governmental authorities. Consequently, there are norequirements with respect to record keeping, financial responsibility orsegregation of customer funds and positions. Furthermore, the enforceability ofagreements underlying derivative transactions may depend on compliance withapplicable statutory and commodity and other regulatory requirements and,depending on the identity of the counterparty, applicable internationalrequirements. The business failure of a hedging counterparty with whom we enterinto a hedging transaction will most likely result in a default. Default by aparty with whom we enter into a hedging transaction may result in the loss ofunrealized profits and force us to cover our resale commitments, if any, at thethen current market price. Although generally we will seek to reserve the rightto terminate our hedging positions, it may not always be possible to dispose ofor close out a hedging position without the consent of the hedgingcounterparty, and we may not be able to enter into an offsetting contract inorder to cover our risk. We cannot be assured that a liquid secondary marketwill exist for hedging instruments purchased or sold, and we may be required tomaintain a position until exercise or expiration, which could result in losses.

 

***Prepayments can adversely affect the yieldson our investments.***

 

The yield of our assetsmay be affected by the rate of prepayments differing from our projections.Prepayments on debt instruments, where permitted under the debt documents, areinfluenced by changes in current interest rates and a variety of economic,geographic and other factors beyond our control, and consequently, suchprepayment rates cannot be predicted with certainty. In periods of declininginterest rates, prepayments on mortgage at similar yields, and loans generallyincrease. If we are unable to invest the proceeds of such prepayments received,the yield on our portfolio will decline. In addition, we may acquire assets ata discount or premium and if the asset does not repay when expected, ouranticipated yield may be impacted. Under certain interest rate and prepaymentscenarios we may fail to recoup fully our cost of acquisition of certaininvestments.

 

***The loans we invest in and the commercialmortgage loans underlying the CMBS we invest in are subject to risks ofdelinquency and foreclosure.***

 

Commercial mortgageloans are secured by commercial or multi-family property and are subject torisks of delinquency and foreclosure. These risks of loss are greater thansimilar risks associated with loans made on the security of single-familyresidential property. The ability of a borrower to pay principal and intereston a loan secured by an income-producing property typically is dependentprimarily upon the successful operation of the property rather than upon theexistence of independent income or assets of the borrower. If the net operatingincome of the property is reduced, the borrower’s ability to repay the loan maybe impaired. Net operating income of an income-producing property can beaffected by a number of conditions beyond our control, including:

 

•                  tenant mix;

•                  success oftenant businesses;

•                  propertymanagement decisions;

•                  propertylocation and condition;

•                  competition fromcomparable types of properties;

•                  changes in lawsthat increase operating expense or limit rents that may be charged;

•                  any need toaddress environmental contamination at the property;

•                  the occurrenceof any uninsured casualty at the property;

•                  changes innational, regional or local economic conditions and/or specific industrysegments;

•                  declines inregional or local real estate values;

•                  declines inregional or local rental or occupancy rates;

•                  increases ininterest rates, real estate tax rates and other operating expenses; and

•                  changes ingovernmental rules, regulations and fiscal policies, including environmentallegislation, acts of God, terrorism, social unrest and civil disturbances.

 

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Any of these factorscould have an adverse affect on the ability of the borrower to make payments ofprincipal and interest in a timely fashion, or at all, on the mortgage loans inwhich we invest and could adversely affect the cash flows we intend to receivefrom these investments.

 

In the event of anydefault under a mortgage loan held directly by us, we will bear the risk ofloss of principal to the extent of any deficiency between the value of thecollateral and the principal and accrued interest on the mortgage loan, whichcould have a material adverse effect on our cash flow from operations and ourability to make distributions to our stockholders. In the event of the bankruptcyof a mortgage loan borrower, the mortgage loan to the borrower will be deemedto be secured only to the extent of the value of the underlying collateral atthe time of bankruptcy (as determined by the bankruptcy court), and the liensecuring the mortgage loan will be subject to the avoidance powers of thebankruptcy trustee or debtor-in-possession to the extent the lien isunenforceable under state law. Foreclosure of a mortgage loan can be anexpensive and lengthy process which could have a substantial negative effect onour anticipated return on the foreclosed mortgage loan.

 

CMBS evidence interestsin or are secured by a single commercial mortgage loan or a pool of commercialmortgage loans. Residential MBS evidence interests in or are secured by a pool ofsingle-family residential mortgage loans. Accordingly, multi-property MBS weinvest in are subject to all of the risks of the underlying mortgage loans.

 

***The subordinate interests in whole loans inwhich we invest may be subject to additional risks relating to the privatelynegotiated structure and terms of the transaction, which may result in lossesto us.***

 

A subordinate interestin a whole loan is a mortgage loan typically (i) secured by a whole loanon a single large commercial property or group of related properties and(ii) subordinated to an senior interest secured by the same whole loan onthe same collateral. As a result, if a borrower defaults, there may not besufficient funds remaining for subordinate interest owners after payment to thesenior interest owners. Subordinate interests reflect similar credit risks tocomparably rated CMBS. However, since each transaction is privately negotiated,subordinate interests can vary in their structural characteristics and risks.For example, the rights of holders of subordinate interests to control theprocess following a borrower default may be limited in certain investments. Wecannot predict the terms of each subordinate investment. Further, subordinateinterests typically are secured by a single property, and so reflect theincreased risks associated with a single property compared to a pool ofproperties. Subordinate interests also are less liquid than CMBS, thus we maybe unable to dispose of underperforming or non-performing investments. Thehigher risks associated with our subordinate position in these investmentscould subject us to increased risk of losses.

 

***Investment in non-conforming andnon-investment grade loans may involve increased risk of loss.***

 

We acquire or originateand may continue to acquire or originate in the future certain loans that donot conform to conventional loan criteria applied by traditional lenders andare not rated or are rated as non-investment grade (for example, forinvestments rated by Moody’s Investors Service, ratings lower than Baa3, andfor Standard & Poor’s, BBB- or below). The non-investment graderatings for these loans typically result from the overall leverage of theloans, the lack of a strong operating history for the properties underlying theloans, the borrowers’ credit history, the properties’ underlying cash flow orother factors. As a result, these loans have a higher risk of default and lossthan conventional loans. Any loss we incur may reduce distributions to ourstockholders. There are no limits on the percentage of unrated ornon-investment grade assets we may hold in our portfolio.

 

***Investments in mezzanine loans involvegreater risks of loss than senior loans secured by income producing properties.***

 

Investments in mezzanineloans are secured by a pledge of the ownership interests in the entity thatdirectly or indirectly owns the property. These types of investments involve ahigher degree of risk than a senior mortgage loan because the investment maybecome unsecured as a result of foreclosure by the senior lender. In the eventof a bankruptcy of the entity providing the pledge of its ownership interestsas security, we may not have full recourse, to the assets of the propertyowning entity, or the assets of the entity may not be sufficient to satisfy ourmezzanine loan. If a borrower defaults on our mezzanine loan or debt senior toour loan, or in the event of a borrower bankruptcy, our mezzanine loan will besatisfied only after the senior debt is paid in full. As a result, we may notrecover some or all of our investment, which could result in losses. Inaddition, mezzanine loans may have higher loan to value ratios thanconventional mortgage loans, resulting in less equity in the property andincreasing the risk of loss of principal.

 

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***Bridge loans involve a greater risk of lossthan traditional mortgage loans.***

 

We provide bridge loanssecured by first lien mortgages on a property to borrowers who are typicallyseeking short-term capital to be used in an acquisition or renovation of realestate. The borrower has usually identified an undervalued asset that has beenunder-managed or is located in a recovering market. If the market in which theasset is located fails to recover according to the borrower’s projections, orif the borrower fails to improve the quality of the asset’s management or thevalue of the asset, the borrower may not receive a sufficient return on theasset to satisfy the bridge loan, and we may not recover some or all of ourinvestment.

 

In addition, ownersusually borrow funds under a conventional mortgage loan to repay a bridge loan.We may therefore be dependent on a borrower’s ability to obtain permanentfinancing to repay our bridge loan, which could depend on market conditions andother factors. Bridge loans are also subject to risks of borrower defaults,bankruptcies, fraud, losses and special hazard losses that are not covered bystandard hazard insurance. In the event of any default under bridge loans heldby us, we bear the risk of loss of principal and non-payment of interest andfees to the extent of any deficiency between the value of the mortgagecollateral and the principal amount of the bridge loan. To the extent we suffersuch losses with respect to our investments in bridge loans, the value of ourcompany and the price of our common stock may be adversely affected.

 

***Preferred equity investments involve agreater risk of loss than transitional debt financing.***

 

Preferred equityinvestments are subordinate to debt financing and are not secured. Should theissuer default on our investment, we would only be able to proceed against theentity that issued the preferred equity in accordance with the terms of thepreferred security, and not any property owned by the entity. Furthermore, inthe event of bankruptcy or foreclosure, we would only be able to recoup ourinvestment after any lenders to the entity are paid. As a result, we may notrecover some or all of our investment, which could result in losses.

 

***Our investments in subordinate loans andsubordinated CMBS are subject to losses.***

 

We acquire subordinatedloans and may invest in subordinated CMBS. In the event a borrower defaults ona loan and lacks sufficient assets to satisfy our loan, we may suffer a loss ofprincipal or interest. In the event a borrower declares bankruptcy, we may nothave full recourse to the assets of the borrower, or the assets of the borrowermay not be sufficient to satisfy the loan. In addition, certain of our loansmay be subordinate to other debt of the borrower. If a borrower defaults on ourloan or on debt senior to our loan, or in the event of a borrower bankruptcy,our loan will be satisfied only after the senior debt is paid in full. Wheredebt senior to our loan exists, the presence of intercreditor arrangements maylimit our ability to amend our loan documents, assign our loans, acceptprepayments, exercise our remedies (through “standstill periods”) and controldecisions made in bankruptcy proceedings relating to borrowers.

 

In general, losses on amortgage loan included in a securitization will be borne first by the equityholder of the property, then by a cash reserve fund or letter of credit, ifany, and then by the “first loss” subordinated security holder. In the event ofdefault and the exhaustion of any equity support, reserve fund, letter ofcredit and any classes of securities junior to those in which we invest, wewill not be able to recover all of our investment in the securities wepurchase. Likewise, we may not be able to recover some or all of our investmentin certain subordinated loans in which we obtain interests. In addition, if theunderlying mortgage portfolio has been overvalued by the originator, or if thevalues subsequently decline and, as a result, less collateral is available tosatisfy interest and principal payments due on the related MBS, the securitiesin which we invest may effectively become the “first loss” position behind themore senior securities, which may result in significant losses to us.

 

An economic downturncould increase the risk of loss on our investments in subordinated MBS. Theprices of lower credit-quality securities, such as the subordinated MBS inwhich we may invest, are generally less sensitive to interest rate changes thanmore highly rated investments, but are more sensitive to adverse economicdownturns or individual property developments. An economic downturn or aprojection of an economic downturn could cause a decline in the price of lowercredit quality securities because the ability of obligors of mortgagesunderlying MBS to make principal and interest payments may be impaired. In suchevent, existing credit support to a securitized structure may be insufficientto protect us against loss of our principal on these securities.

 

***Our investments in debt securities aresubject to specific risks relating to the particular issuer of the securitiesand to the general risks of investing in subordinated real estate securities.***

 

Our investments in debtsecurities involve special risks. REITs generally are required to investsubstantially in real estate or real estate-related assets and are subject tothe inherent risks associated with real estate-related investments discussed inthis filing. Our investments in debt are subject to the risks described abovewith respect to mortgage loans and MBS and similar risks, including:

 

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•                  risks ofdelinquency and foreclosure, and risks of loss in the event thereof;

•                  the dependenceupon the successful operation of and net income from real property;

•                  risks generallyincident to interests in real property; and

•                  risks that maybe presented by the type and use of a particular commercial property.

 

Debt securities aregenerally unsecured and may also be subordinated to other obligations of theissuer. We may also invest in debt securities that are rated below investmentgrade. As a result, investments in debt securities are also subject to risksof:

 

•                  limitedliquidity in the secondary trading market;

•                  substantialmarket price volatility resulting from changes in prevailing interest rates;

•                  subordination tothe prior claims of banks and other senior lenders to the issuer;

•                  the operation ofmandatory sinking fund or call/redemption provisions during periods of declininginterest rates that could cause the issuer to reinvest premature redemptionproceeds in lower yielding assets;

•                  the possibilitythat earnings of the debt security issuer may be insufficient to meet its debtservice; and

•                  the decliningcreditworthiness and potential for insolvency of the issuer of such debtsecurities during periods of rising interest rates and economic downturn.

 

These risks mayadversely affect the value of outstanding debt securities and the ability ofthe issuers thereof to repay principal and interest.

 

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

 

We own assets secured byreal estate and may own real estate directly. Real estate investments aresubject to risks particular to real property.

 

•                  acts of God,including earthquakes floods and other natural disasters, which may result inuninsured losses;

•                  acts of war orterrorism, including the consequences of terrorist attacks, such as those thatoccurred on September 11, 2001;

•                  adverse changesin national and local economic and market conditions;

•                  changes ingovernmental laws and regulations, fiscal policies and zoning ordinances andthe related costs of compliance with laws and regulations, fiscal policies andordinances;

•                  costs ofremediation and liabilities associated with environmental conditions such asindoor mold; and

•                  the potentialfor uninsured or under-insured property losses.

 

If any of these orsimilar events occur, it may reduce our return from an affected property orinvestment and reduce or eliminate our ability to make distributions tostockholders.

 

***Our real estate investments may beilliquid, which could restrict our ability to respond rapidly to changes ineconomic conditions.***

 

The real estate and realestate-related assets in which we invest are generally illiquid. In addition,the instruments that we purchase in connection with privately negotiatedtransactions are not registered under the relevant securities laws, resultingin a prohibition against their transfer, sale, pledge or other dispositionexcept in a transaction that is exempt from the registration requirements of,or is otherwise in accordance with, those laws. A majority of the MBS and debtinstruments that we purchase are purchased in private, unregistered transactions.As a result, the majority of our investments in securities are subject torestrictions on resale or otherwise have no established trading market. As aresult, our ability to sell under-performing assets in our portfolio or respondto changes in economic and other conditions may be relatively limited.

 

***Investments in CTL properties may generatelosses.***

 

The value of ourinvestments and the income from our investments in CTL properties may besignificantly adversely affected by a number of factors, including:

 

•                  national, stateand local economic climates;

•                  real estateconditions, such as an oversupply of or a reduction in demand for real estatespace in the area;

•                  the perceptionsof tenants and prospective tenants of the convenience, attractiveness andsafety of our properties;

 

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•                  competition fromcomparable properties;

•                  the occupancyrate of our properties;

•                  the ability tocollect on a timely basis all rent from tenants;

•                  the effects ofany bankruptcies or insolvencies of major tenants;

•                  the expense ofre-leasing space;

•                  changes ininterest rates and in the availability, cost and terms of mortgage funding;

•                  the impact ofpresent or future environmental legislation and compliance with environmentallaws;

•                  cost ofcompliance with the American with Disabilities Act of 1990;

•                  adverse changesin governmental rules and fiscal policies;

•                  civil unrest;

•                  acts of nature,including earthquakes, hurricanes and other natural disasters (which may resultin uninsured losses);

•                  acts ofterrorism or war;

•                  adverse changesin zoning laws; and

•                  other factorswhich are beyond our control.

 

***Our due diligence may not reveal all of aborrower’s liabilities and may not reveal other weaknesses in its business.***

 

Before investing in acompany or making a loan to a borrower, we assess the strength and skills ofsuch entity’s management and other factors that we believe are material to theperformance of the investment. In making the assessment and otherwiseconducting customary due diligence, we rely on the resources available to usand, in some cases, an investigation by third parties. This process isparticularly subjective with respect to newly organized entities because theremay be little or no information publicly available about the entities. Therecan be no assurance that our due diligence processes will uncover all relevantfacts or that any investment will be successful.

 

**Risks Related to Our Organization and Structure**

 

***The concentration of our ownership may adverselyaffect the ability of investors to influence our policies.***

 

SL Green ownsapproximately 25% of the outstanding shares of our common stock. In addition,SL Green has the right to purchase 25% of the shares in any future offering ofcommon stock. Accordingly, SL Green has significant influence over us. Theownership level of SL Green may discourage or prevent others from trying toacquire control of us and increase the difficulty of consummating any offer,including potential acquisitions that might involve a premium price for ourcommon stock or otherwise be in the best interest of our stockholders. Thisconcentration of ownership may result in decisions affecting us that may notserve the best interest of all stockholders.

 

***Maryland takeover statutes may prevent achange of control of our company, which could depress our stock price.***

 

Under Maryland law, “businesscombinations” between a Maryland corporation and an interested stockholder oran affiliate of an interested stockholder are prohibited for five years afterthe most recent date on which the interested stockholder becomes an interestedstockholder. These business combinations include a merger, consolidation, shareexchange, or, in circumstances specified in the statute, an asset transfer or issuanceor reclassification of equity securities. An interested stockholder is definedas:

 

•                  any person whobeneficially owns 10% or more of the voting power of the corporation’s shares;or

•                  an affiliate orassociate of the corporation who, at any time within the two-year period priorto the date in question, was the beneficial owner of 10% or more of the votingpower of the then outstanding voting stock of the corporation.

 

A person is not aninterested stockholder under the statute if the board of directors approves inadvance the transaction by which he otherwise would have become an interestedstockholder.

 

After the five-yearprohibition, any business combination between the Maryland corporation and aninterested stockholder generally must be recommended by the board of directorsof the corporation and approved by the affirmative vote of at least:

 

•                  80% of the votesentitled to be cast by holders of outstanding shares of voting stock of thecorporation; and

•                  two-thirds ofthe votes entitled to be cast by holders of voting stock of the corporationother than shares held by the interested stockholder with whom or with whoseaffiliate the business combination is to be effected or held by an affiliate orassociate of the interested stockholder.

 

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The business combinationstatute may discourage others from trying to acquire control of us and increasethe difficulty of consummating any offer, including potential acquisitions thatmight involve a premium price for our common stock or otherwise be in the bestinterest of our stockholders.

 

We have opted out ofthese provisions of the Maryland General Corporation Law, or the MGCL, withrespect to its business combination provisions and its control share provisionsby resolution of our board of directors and a provision in our bylaws,respectively. However, in the future our board of directors may reverse itsdecision by resolution and elect to opt in to the MGCL’s business combinationprovisions, or amend our bylaws and elect to opt in to the MGCL’s control shareprovisions.

 

Additionally, Title 8,Subtitle 3 of the MGCL permits our board of directors, without stockholderapproval and regardless of what is provided in our charter or bylaws, toimplement takeover defenses, some of which we do not have. These provisions mayhave the effect of inhibiting a third party from making us an acquisitionproposal or of delaying, deferring or preventing a change in our control undercircumstances that otherwise could provide the stockholders with an opportunityto realize a premium over the then-current market price.

 

***Our authorized but unissued preferred stockmay prevent a change in our control which could be in the shareholders’ bestinterests.***

 

Our charter authorizesus to issue additional authorized but unissued shares of our common stock orpreferred stock. Any such issuance could dilute our existing stockholders’interests. In addition, our board of directors may classify or reclassify anyunissued shares of preferred stock and may set the preferences, rights andother terms of the classified or reclassified shares. As a result, our board ofdirectors may establish a series of preferred stock that could delay or preventa transaction or a change in control that might be in the best interest of ourstockholders.

 

***Our staggered board of directors and otherprovisions of our charter and bylaws may prevent a change in our control.***

 

Our board of directorsis divided into three classes of directors. The current terms of the directorsexpire in 2006, 2007 and 2008. Directors of each class are chosen forthree-year terms upon the expiration of their current terms, and each year oneclass of directors is elected by the stockholders. The staggered terms of ourdirectors may reduce the possibility of a tender offer or an attempt at achange in control, even though a tender offer or change in control might be inthe best interest of our stockholders. In addition, our charter and bylaws alsocontain other provisions that may delay or prevent a transaction or a change incontrol that might be in the best interest of our stockholders.

 

***Changes in market conditions couldadversely affect the market price of our common stock.***

 

As with other publiclytraded equity securities, the value of our common stock depends on variousmarket conditions which may change from time to time. Among the marketconditions that may affect the value of our common stock are the following:

 

•                  the generalreputation of REITs and the attractiveness of our equity securities incomparison to other equity securities, including securities issued by otherreal estate-based companies;

•                  our financialperformance; and

•                  general stockand bond market conditions.

 

The market value of ourcommon stock is based primarily upon the market’s perception of our growthpotential and our current and potential future earnings and cash dividends.Consequently, our common stock may trade at prices that are higher or lowerthan our net asset value per share of common stock. If our future earnings orcash dividends are less than expected, it is likely that the market price ofour common stock will diminish.

 

***An increase in market interest rates mayhave an adverse effect on the market price of our common stock.***

 

One of the factors thatinvestors may consider in deciding whether to buy or sell shares of our commonstock is our distribution rate as a percentage of our share price relative tomarket interest rates. If the market price of our common stock is basedprimarily on the earnings and return that we derive from our investments andincome with respect to our investments and our related distributions tostockholders, and not from the market value of the investments themselves, theninterest rate fluctuations and capital market conditions will likely affect themarket price of our common stock. For instance, if market rates rise without anincrease in our distribution rate,

 

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the market price of ourcommon stock could decrease as potential investors may require a higherdistribution yield on our common stock or seek other securities paying higherdistributions or interest. In addition, rising interest rates would result inincreased interest expense on our variable rate debt, thereby adversely affectingcash flow and our ability to service our indebtedness and pay distributions.

 

**Risks Related to Our Taxation as a REIT**

 

***Our failure to qualify as a REIT wouldresult in higher taxes and reduced cash available for stockholders.***

 

We intend to continue tooperate in a manner so as to qualify as a REIT for U.S. federal income taxpurposes. Our continued qualification as a REIT depends on our satisfaction ofcertain asset, income, organizational, distribution and stockholder ownershiprequirements on a continuing basis. Our ability to satisfy some of the assettests depends upon the fair market values of our assets, some of which are notable to be precisely determined and for which we will not obtain independentappraisals. If we were to fail to qualify as a REIT in any taxable year, andcertain statutory relief provisions were not available, we would be subject toU.S. federal income tax, including any applicable alternative minimum tax, onour taxable income at regular corporate rates, and distributions tostockholders would not be deductible by us in computing our taxable income. Anysuch corporate tax liability could be substantial and would reduce the amountof cash available for distribution. Unless entitled to relief under certainInternal Revenue Code provisions, we also would be disqualified from taxationas a REIT for the four taxable years following the year during which we ceasedto qualify as a REIT. See “Material U.S. Federal Tax Considerations” for adiscussion of material U.S. federal income tax considerations relating to usand our common stock.

 

***REIT distribution requirements couldadversely affect our liquidity.***

 

In order to qualify as aREIT, each year we must distribute to our stockholders at least 90% of our REITtaxable income, determined without regard to the dividends paid deduction, andnot including any net capital gain. To the extent that we satisfy thisdistribution requirement, but distribute less than 100% of our net taxableincome, we will be subject to U.S. federal corporate income tax on ourundistributed net taxable income. In addition, we will be subject to a 4%nondeductible excise tax if the actual amount that we pay out to ourstockholders in a calendar year is less than a minimum amount specified underU.S. federal tax laws.

 

We intend to continue tomake distributions to our stockholders to comply with the REIT distributionrequirements and avoid corporate income tax and/or excise tax. However,differences in timing between the recognition of taxable income and the actual receiptof cash could require us to sell assets or borrow funds on a short-term orlong-term basis to meet the 90% distribution requirement or avoid corporateincome or excise tax. We may own assets that generate mismatches betweentaxable income and available cash. These assets may include (a) securitiesthat have been financed through financing structures which require some or allof available cash flows to be used to service borrowings, (b) loans or MBSwe hold that have been issued at a discount and require the accrual of taxableeconomic interest in advance of receipt in cash, and (c) distressed debton which we may be required to accrue taxable interest income even though theborrower is unable to make current debt service payments in cash. As a result,the requirement to distribute a substantial portion of our net taxable incomecould cause us to: (a) sell assets in adverse market conditions,(b) borrow on unfavorable terms or (c) distribute amounts that wouldotherwise be invested in future acquisitions, capital expenditures or repaymentof debt to comply with REIT requirements.

 

To maximize the returnon our funds, cash generated from operations is expected to be used totemporarily pay down borrowings. When making distributions, we may borrow therequired funds by drawing on credit capacity available under our credit orrepurchase facilities. If distributions exceed the amount of cash generatedfrom operations, we may be required to borrow additional funds, which, in turn,would reduce the amount of funds available for other purposes.

 

Further, amountsdistributed will not be available to fund investment activities. We expect tofund our investments by raising equity capital and through borrowings fromfinancial institutions. If we fail to obtain debt or equity capital in thefuture, it could limit our ability to grow, which could have a material adverseeffect on the value of our common stock.

 

***Complying with REIT requirements may limitour ability to hedge effectively.***

 

The existing REITprovisions of the Internal Revenue Code may substantially limit our ability tohedge our operations. Except to the extent provided by Treasury regulations,any income from a hedging transaction we enter into in the normal course of ourbusiness primarily to manage risk of interest rate or price changes or currencyfluctuations with respect to borrowings made or to be made, or ordinaryobligations incurred or to be incurred, to acquire or carry real estate assets,which is clearly identified as specified in Treasury

 

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regulations before theclose of the day on which it was acquired, originated, or entered into,including gain from the sale or disposition of such a transaction, will notconstitute gross income for purposes of the 95% gross income test (and willgenerally constitute non-qualifying income for purposes of the 75% gross incometest). To the extent that we enter into other types of hedging transactions,the income from those transactions is likely to be treated as non-qualifyingincome for purposes of both of the gross income tests. In addition, we mustlimit our aggregate income from non-qualified hedging transactions, from ourprovision of services and from other non-qualifying sources, to less than 5% ofour annual gross income (determined without regard to gross income fromqualified hedging transactions). As a result, we may have to limit our use ofcertain hedging techniques or implement those hedges through TRSs. This couldresult in greater risks associated with changes in interest rates than we wouldotherwise want to incur or could increase the cost of our hedging activities.If we fail to satisfy the 25% or 5% limitations, we could lose our REITqualification for U.S. federal income tax purposes, unless our failure was dueto reasonable cause and not due to willful neglect, and we meet certain othertechnical requirements. Even if our failure was due to reasonable cause, wemight incur a penalty tax.

 

***The stock ownership limit imposed by theInternal Revenue Code for REITs and our charter may inhibit market activity inour stock and may restrict our business combination opportunities.***

 

In order for us tomaintain our qualification as a REIT under the Internal Revenue Code, not morethan 50% in value of our outstanding stock may be owned, directly or indirectly,by five or fewer individuals (as defined in the Internal Revenue Code toinclude certain entities) at any time during the last half of each taxableyear. Our charter, with certain exceptions, authorizes our directors to takesuch actions as are necessary and desirable to preserve our qualification as aREIT. Unless exempted by our board of directors, no person may own more than9.8% of the aggregate value of the outstanding shares of our stock. Our boardof directors may not grant such an exemption to any proposed transferee whoseownership of in excess of 9.8% of the value of our outstanding shares wouldresult in the termination of our status as a REIT. Our board of directors haswaived this provision in connection with SL Green’s purchase of our shares. Wehave also granted waivers to two other purchases in connection with theirpurchase of our share in a previous private placement. These ownership limitscould delay or prevent a transaction or a change in our control that might bein the best interest of our stockholders.

 

***The tax on prohibited transactions willlimit our ability to engage in transactions, including certain methods ofsecuritizing mortgage loans, that would be treated as sales for U.S. federalincome tax purposes.***

 

A REIT’s net income fromprohibited transactions is subject to a 100% tax. In general, prohibitedtransactions are sales or other dispositions of property, other thanforeclosure property, but including mortgage loans, held primarily for sale tocustomers in the ordinary course of business. We might be subject to this taxif we were to sell or securitize loans in a manner that was treated as a saleof the loans for U.S. federal income tax purposes. Therefore, in order to avoidthe prohibited transactions tax, we may choose not to engage in certain salesof loans and may limit the structures we utilize for our securitizationtransactions even though such sales or structures might otherwise be beneficialfor us.

 

It may be possible toreduce the impact of the prohibited transaction tax by engaging insecuritization transactions treated as sales through one or more of our TRSs,subject to certain limitations as described below. To the extent that we engagein such activities through one or more TRSs, the income associated with suchactivities may be subject to full corporate income tax.

 

***The “taxable mortgage pool” rules may limitthe manner in which we effect future securitizations and may subject us to U.S.federal income tax and increase the tax liability of our stockholders.***

 

Certain of our currentand future securitizations, such as our CDOs could be considered to result inthe creation of taxable mortgage pools for U.S. federal income tax purposes. Asa REIT, so long as we or another private subsidiary REIT own 100% of the equityinterests in a taxable mortgage pool, our qualification as a REIT would not beadversely affected by the characterization of the securitization as a taxablemortgage pool. We would generally be precluded, however, from holding equityinterests in such securitizations through our operating partnership (unlessheld through a private subsidiary REIT), selling to outside investors equityinterests in such securitizations or from selling any debt securities issued inconnection with such securitizations that might be considered to be equityinterests for tax purposes. These limitations will preclude us from usingcertain techniques to maximize our returns from securitization transactions.

 

Furthermore, althoughthe law on the matter is unclear, we might be taxable at the highest corporateincome tax rate on a portion of the income arising from a taxable mortgage poolthat is allocable to the percentage of our shares held by “disqualifiedorganizations,” which are generally certain cooperatives, governmental entitiesand tax-exempt organizations that are exempt from unrelated business taxableincome. We expect that disqualified organizations will own our shares. Becausethis tax would be imposed on us, all of our

 

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investors, includinginvestors that are not disqualified organizations, would bear a portion of thetax cost associated with the classification of us or a portion of our assets asa taxable mortgage pool. See “Material U.S. Federal Income Tax Considerations—Effectof Subsidiary Entities—Taxable Mortgage Pools.”

 

In addition, if werealize excess inclusion income and allocate it to stockholders, this incomecannot be offset by net operating losses of our stockholders. If thestockholder is a tax-exempt entity and not a disqualified organization, thenthis income would be fully taxable as unrelated business taxable income underSection 512 of the Internal Revenue Code. If the stockholder is a foreignperson, it would be subject to U.S. federal income tax withholding on this.

 

***We may be unable to generate sufficientrevenue from operations to pay our operating expenses and to pay distributionsto our stockholders.***

 

As a REIT, we aregenerally required to distribute at least 90% of our REIT taxable income(determined without regard to the dividends paid deduction and not includingnet capital gains) each year to our stockholders. To qualify for the taxbenefits accorded to REITs, we have and intend to continue to pay quarterlydistributions and to make distributions to our stockholders in amounts suchthat we distribute all or substantially all our net taxable income each year,subject to certain adjustments. However, our ability to make distributions maybe adversely affected by the risk factors described in this Annual Report onForm 10-K. In the event of a downturn in our operating results and financialperformance or unanticipated declines in the value of our asset portfolio, wemay be unable to declare or pay quarterly distributions or make distributionsto our stockholders. The timing and amount of distributions are in the solediscretion of our board of directors, which considers, among other factors, ourearnings, financial condition, debt service obligations and applicable debtcovenants, REIT qualification requirements and other tax considerations andcapital expenditure requirements as our board may deem relevant from time totime.

 

***Although our use of TRSs may be able topartially mitigate the impact of meeting the requirements necessary to maintainour qualification as a REIT, our ownership of and relationship with our TRSswill be limited and a failure to comply with the limits would jeopardize ourREIT qualification and may result in the application of a 100% excise tax.***

 

A REIT may own up to100% of the stock of one or more TRSs. A TRS generally may hold assets and earnincome that would not be qualifying assets or income if held or earned directlyby a REIT. Both the subsidiary and the REIT must jointly elect to treat thesubsidiary as a TRS. A corporation of which a TRS directly or indirectly ownsmore than 35% of the voting power or value of the stock will automatically betreated as a TRS. Overall, no more than 20% of the value of a REIT’s assets mayconsist of stock or securities of one or more TRSs. In addition, the TRS ruleslimit the deductibility of interest paid or accrued by a TRS to its parent REITto assure that the TRS is subject to an appropriate level of corporatetaxation. The rules also impose a 100% excise tax on certain transactionsbetween a TRS and its parent REIT that are not conducted on an arm’s-lengthbasis.

 

Our TRSs, including GKKTrading Corp. and GIT Trading Corp., will pay federal, state and local incometax on their taxable income, and their after-tax net income will be availablefor distribution to us but will not be required to be distributed to us. Weanticipate that the aggregate value of TRS securities owned by us will be lessthan 20% of the value of our total assets (including our TRS securities).Furthermore, we will monitor the value of our respective investments in ourTRSs for the purpose of ensuring compliance with the rule that no more than 20%of the value of a REIT’s assets may consist of TRS securities (which is appliedat the end of each calendar quarter). In addition, we will scrutinize all ofour transactions with our TRSs for the purpose of ensuring that they areentered into on arm’s-length terms in order to avoid incurring the 100% excisetax described above. The value of the securities that we hold in our TRSs maynot be subject to precise valuation. Accordingly, there can be no completeassurance that we will be able to comply with the 20% limitation discussedabove or avoid application of the 100% excise tax discussed above.

 

**Cautionary Note Regarding Forward-Looking Information**

 

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 Exchange Act.You can identify forward-looking statements by the use of forward-lookingexpressions such as “may,” “will,” “should,” “expect,” “anticipate,”“estimate,” “believe,” “intend,” “plan,” “project,” “continue,” or any negativeor 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 our plans, intentions and expectations asreflected in or suggested by those forward-looking statements are reasonable,we can give no assurance that the plans, intentions or expectations will beachieved. We have listed below some important risks, uncertainties and contingencieswhich could cause our actual results, performance or achievements to be

 

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materially different from the forward-looking statements we make inthis report. These risks, uncertainties and contingencies include, but are notlimited to, the following:

 

•      thesuccess or failure 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;

•      theactions of our competitors and our ability to respond to those actions;

•      thecost of our capital, which depends in part on our asset quality, the nature ofour relationships 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;

•      theadequacy of our cash reserves and working capital;

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

•      thetiming of cash flows, if any, from our investments;

•      risksof structured finance investments;

•      GKKManager LLC remaining as our Manager;

•      environmentaland/or safety requirements;

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

•      competitionwith other companies;

•      ourability to satisfy complex rules in order for us to qualify as a REIT forfederal income tax purposes and qualify for our exemption under the InvestmentCompany Act, our operating partnership’s ability to satisfy the rules in orderfor it to qualify as a partnership for federal income tax purposes, the abilityof certain of our subsidiaries to qualify as REITs, and the ability of certainof our subsidiaries to qualify as taxable REIT subsidiaries for federal incometax purposes, and our ability and the ability of our subsidiaries to operateeffectively within the limitations imposed by these rules;

•      changesin governmental 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 mayinclude additional factors that could adversely affect our business andfinancial performance. Moreover, we operate in a very competitive and rapidlychanging environment. New risk factors emerge from time to time and it is notpossible for management to predict all such risk factors, nor can it assess theimpact of all such risk factors on our business or the extent to which anyfactor, or combination of factors, may cause actual results to differmaterially from those contained in any forward-looking statements. Given theserisks and uncertainties, investors should not place undue reliance onforward-looking statements as a prediction of actual results.

 

**ITEM 1B.****      ****UNRESOLVED STAFF COMMENTS**

 

**As of December 31, 2005, we did not have any unresolvedcomments with the Staff of the SEC.**

** **

**ITEM 2.****         ****PROPERTIES**

 

Ourcorporate offices are located in midtown Manhattan at 420 Lexington Avenue, NewYork, New York 10170. We can be contacted at (212) 297-1000. We maintain awebsite at *www.gramercycapitalcorp.com*.

 

**ITEM 3.****          LEGAL PROCEEDINGS**

 

As of December 31, 2005, we were not involved in any materiallitigation nor, to management’s knowledge, is any material litigationthreatened against us or our Manager.

 

**ITEM4.**          SUBMISSION OF MATTERS TOA VOTE OF SECURITY HOLDERS

** **

No matters were submitted to a vote of our stockholders during thefourth quarter ended December 31, 2005.

 

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**PART II**

** **

**ITEM5.**  MARKET FOR REGISTRANT’S COMMONEQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

** **

Our common stock began tradingon the New York Stock Exchange (“NYSE”) on August 2, 2004 under the symbol“GKK.” On March 10, 2006, the reported closing sale price per share of commonstock on the NYSE was $23.55 and there were approximately 38 holders of recordof our common stock. The table below sets forth the quarterly high and lowclosing sales prices of our common stock on the NYSE since our initial publicoffering and the distributions paid by us with respect to the periodsindicated.

 
| ** **             | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------|------------|----------|------------|----------|------------|
| **Quarter Ended** | ** ** | **High** | ** ** | **Low**  | ** ** | **Dividends** | ** ** | **High** | ** ** | **Low** | ** ** | **Dividends** | ** ** |
| March 31               |       | $        | 22.25      |     | $          | 19.23 |   | $ | 0.22 |   | $ | — |   | $ | — |   | $ | — |   |
| June 30                |       | $        | 24.98      |     | $          | 18.64 |   | $ | 0.35 |   | $ | — |   | $ | — |   | $ | — |   |
| September 30           |       | $        | 26.91      |     | $          | 22.47 |   | $ | 0.45 |   | $ | 16.20 |   | $ | 14.00 |   | $ | 0.00 |   |
| December 31            |       | $        | 24.00      |     | $          | 22.41 |   | $ | 0.475 |   | $ | 21.30 |   | $ | 15.20 |   | $ | 0.15 |   |

 

If dividendsare declared in a quarter, those dividends will be paid during the subsequentquarter. We expect to continue our policy of generally distributing 100% of ourtaxable income through regular cash dividends on a quarterly basis, althoughthere is no assurance as to future dividends because they depend on futureearnings, capital requirements and financial condition. See Item 7“Management’s Discussion and Analysis of Financial Condition and Results ofOperations – Dividends” for additional information regarding our dividends.

 

We declared aquarterly dividend of $0.475 per share, payable on January 17, 2006, forstockholders of record of our common stock on December 30, 2005.

 

The following table summarizesinformation, as of December 31, 2005, relating to our equity compensation planspursuant to which shares of our common stock or other equity securities may begranted from time to time.

 
| **Plan category**                                      | ** ** | **(a)  Number of securities  to be issued upon  exercise of outstanding  options, warrants and  rights** | ** ** | **(b)  Weighted average  exercise price of  outstanding  options, warrants  and rights** | ** ** | **(c)  Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  column (a))** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity compensation plans approved by  security holders (1) |       | 733,584                                                                                                                                               |       | $                                                                                                                 | 16.47      |                                                                                                                                                                                                              | 1,077,431  |   |
| Equity compensation plans not approved by  security holders |       | N/A                                                                                                                                                   |       | N/A                                                                                                               |       | N/A                                                                                                                                                                                                               |       |
|                                                        |       |                                                                                                                                                  |       |                                                                                                              |       |                                                                                                                                                                                                              |       |
| Total                                                       |       | 733,584                                                                                                                                               |       | $                                                                                                                 | 16.47      |                                                                                                                                                                                                              | 1,077,431  |   |

 

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(1)   Includes information related to our 2004 EquityIncentive Plan.

 

**SALE OF UNREGISTERED AND REGISTERED SECURITIES; USE OF PROCEEDS FROMREGISTERED SECURITIES**

 

On August 2,2004, we consummated the initial public offering of our common stock, $0.001par value per share. The shares of common stock sold in the offering wereregistered under the Securities Act of 1933, as amended, or the Securities Act.All 12,500,000 shares of common stock registered under the RegistrationStatement were sold at a price to the public of $15.00 per share, generatinggross proceeds of approximately $187.5 million. We paid underwriting discountsand commissions of $9.8 million in this offering. The net proceeds to us wereapproximately $172.9 million, which were contributed to the OperatingPartnership to make investments in commercial real estate-related loans andsecurities and for general corporate purposes, including financing andoperating expenses and other expenses of our company. All of the shares of commonstock were sold by us and there were no selling stockholders in the offering.Wachovia Capital Markets, LLC, Merrill Lynch, Pierce, Fenner & SmithIncorporated, Banc of America LLC and JMP

 

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Securities LLCacted as our principal underwriters in this offering.

 

On December 3,2004 we sold 5,500,000 shares of common stock, at a price of $17.27 per share,through a private placement exempt from registration pursuant to Section 4(2)of the Securities Act. A total of 4,225,000 shares were sold to variousinstitutional investors and an additional 1,275,000 were sold to SL GreenOperating Partnership, L.P., an affiliate of SL Green Realty Corp., pursuant toits contractual right to choose to maintain a 25% ownership interest in theoutstanding shares of our common stock. On December 31, 2004, 2,000,000 sharessold in the offering were issued. The remaining 3,500,000 shares were issued onJanuary 3, 2005. The net proceeds from the offering (approximately $93.7 million)were used to fund additional investments, repay borrowings and for generalcorporate purposes. We did not use an underwriter, however our Manager arrangedthe transaction and received a fee of $1.0 million.

 

On September14, 2005 we sold 3,833,333 shares of common stock, at a price of $25.80 pershare, under our $350 million shelf registration statement declared effectivein August 2005 resulting in net proceeds of approximately $97.8 million. Wepaid underwriting discounts and commissions of $546 thousand in this offering.A total of 2,875,000 shares were sold through public offering and an additional958,333 shares were sold to SL Green Operating Partnership, L.P. pursuant toits contractual right to choose to maintain a 25% ownership interest in our outstandingshares of common stock. Net proceeds were used for acquisitions, repayment ofoutstanding principal under one of our repurchase facilities and generalcorporate purposes. Wachovia Capital Markets, LLC acted as our underwriter inthis offering.

 

**ITEM 6.**** ****SELECTED FINANCIAL DATA**

 

The followingtables set forth our selected financial data and should be read in conjunctionwith our Financial Statements and notes thereto included in Item 8, “FinancialStatements and Supplementary Data” and Item 7, “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” in this Form 10-K.

 

**Operating Data**

 
| **(In thousands, except per share data)**                                      | ** ** | **For the Year  ended  December 31,  2005** | ** ** | **For the Period  April 12, 2004  (formation)  through  December 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|
| Total revenues                                                                                          |       | $                                                          | 88,085     |                                                                                                  | $          | 7,151 |   |
| Interest expense                                                                                        |       | 33,771                                                     |       | 1,463                                                                                                 |       |
| Management fees                                                                                         |       | 9,600                                                      |       | 1,965                                                                                                 |       |
| Incentive fee                                                                                           |       | 2,276                                                      |       | —                                                                                                |       |
| Depreciation and amortization                                                                           |       | 672                                                        |       | 38                                                                                                    |       |
| Marketing, general and administrative                                                                   |       | 6,976                                                      |       | 1,358                                                                                                 |       |
| Provision for loan loss                                                                                 |       | 1,030                                                      |       | —                                                                                                |       |
| Total expenses                                                                                          |       | 54,325                                                     |       | 4,824                                                                                                 |       |
| Income from continuing operations before  equity in net loss of unconsolidated joint ventures and taxes |       | 33,760                                                     |       | 2,327                                                                                                 |       |
| Equity in net loss of unconsolidated joint  ventures                                                    |       | (1,489                                                     | )          | —                                                                                                |       |
| Income from continuing operations before  provision for taxes and GKK formation costs                   |       | 32,271                                                     |       | 2,327                                                                                                 |       |
| Provision for taxes                                                                                     |       | (900                                                       | )          | —                                                                                                |       |
| GKK formation costs                                                                                     |       | —                                                     |       | (275                                                                                                  | )          |
| Net income available to common stockholders                                                             |       | $                                                          | 31,371     |                                                                                                  | $          | 2,052 |   |
| Net income per common share - Basic                                                                     |       | $                                                          | 1.57       |                                                                                                  | $          | 0.15 |   |
| Net income per common share - Diluted                                                                   |       | $                                                          | 1.51       |                                                                                                  | $          | 0.15 |   |
| Cash dividends declared per common share                                                                |       | $                                                          | 1.495      |                                                                                                  | $          | 0.15 |   |
| Basic weighted average common shares  outstanding                                                       |       | 20,027                                                     |       | 13,348                                                                                                |       |
| Diluted weighted average common shares and  common share equivalents outstanding                        |       | 20,781                                                     |       | 13,411                                                                                                |       |

 

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**Balance Sheet Data**

 
| ** **                                                                                                | ** ** | **As of December 31** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| **(In thousands)**                                                                                   | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| Loans and other lending investments, net                                                                  |       | $                                    | 1,163,745  |   | $ | 395,717 |   |
| Commercial mortgage backed securities, net                                                                |       | —                               |       | 10,898 |   |
| Loans held for sale, net                                                                                  |       | 42,000                               |       | — |   |
| Operating real estate, net                                                                                |       | 51,173                               |       | — |   |
| Investment in unconsolidated joint ventures                                                               |       | 58,040                               |       | — |   |
| Total assets                                                                                              |       | 1,469,810                            |       | 514,047 |   |
| Collateralized debt obligations                                                                           |       | 810,500                              |       | — |   |
| Repurchase agreements                                                                                     |       | 117,366                              |       | 238,885 |   |
| Mortgage note payable                                                                                     |       | 41,000                               |       | — |   |
| Junior subordinated deferrable interest  debentures held by trusts that issued trust preferred securities |       | 100,000                              |       | — |   |
| Total liabilities                                                                                         |       | 1,097,406                            |       | 245,088 |   |
| Stockholders’ equity                                                                                 |       | 372,404                              |       | 268,959 |   |
|                                                                                                           |            |                                      |            |  |  |  |  |

 

**Other Data**

 
| **(In thousands)**                      | ** ** | **For the year  ended  December 31,  2005** | ** ** | **For the Period  April 12, 2004  (formation)  through  December 31,  2004** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|
| Funds from  operations (1)                   |       | $                                                          | 36,490     |                                                                                                  | $          | 2,052 |   |
| Cash flows  provided by operating activities |       | $                                                          | 2,160      |                                                                                                  | $          | 1,145 |   |
| Cash flows  used in investing activities     |       | $                                                          | (918,930   | )                                                                                                     | $          | (407,056 | ) |
| Cash flows  provided by financing activities |       | $                                                          | 948,252    |                                                                                                  | $          | 444,805 |   |

 

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(1) FFO is awidely recognized measure of REIT performance. We compute FFO in accordancewith standards established by the National Association of Real EstateInvestment Trusts, or NAREIT, which may not be comparable to FFO reported byother REITs that do not compute FFO in accordance with the NAREIT definition,or that interpret the NAREIT definition differently than we do. The revisedWhite Paper on FFO approved by the Board of Governors of NAREIT in April 2002defines FFO as net income (loss) (computed in accordance with GAAP), excludinggains (or losses) from debt restructuring and sales of properties, plus realestate related depreciation and amortization and after adjustments forunconsolidated partnerships and joint ventures. We present FFO because weconsider it an important supplemental measure of our operating performance andbelieve that it is frequently used by securities analysts, investors and otherinterested parties in the evaluation of REITS. We also use FFO as one ofseveral criteria to determine performance-based bonuses for members of our seniormanagement. FFO is intended to exclude GAAP historical cost depreciation andamortization of real estate and related assets, which assumes that the value ofreal estate assets diminishes ratably over time. Historically, however, realestate values have risen or fallen with market 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. Weconsider gains and losses on the sales of debt investments to be a normal partof our recurring operations and therefore do not exclude such gains and losseswhen arriving at FFO. FFOdoes not represent cash generated from operating activities in accordance withGAAP and should not be considered as an alternative to net income (determinedin accordance with GAAP), as an indication of our financial performance or tocash flow from operating activities (determined in accordance with GAAP) as ameasure of our liquidity, nor is it indicative of funds available to fund ourcash needs, including our ability to make cash distributions.

 

Areconciliation of FFO to net income computed in accordance with GAAP isprovided under the heading of “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations – Funds From Operations.”

 

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**ITEM 7.**** ****MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Overview**

** **

We are a national commercialreal estate specialty finance company that specializes in the directorigination and acquisition of whole loans, subordinate interests in wholeloans, mezzanine loans, preferred equity, and net lease investments involvingcommercial properties throughout the United States. When evaluatingtransactions, we assess our risk-adjusted return and target transactions withyields that ensure an equitable balance between risks and return. We conductsubstantially all of our operations through our operating partnership, GKKCapital LP. We are externally managed and advised by GKK Manager LLC, or theManager, a majority-owned subsidiary of SL Green Realty Corp., or SL Green. Wehave elected to be taxed as a REIT under the Internal Revenue Code andgenerally will not be subject to federal income taxes to the extent wedistribute our income to our stockholders. However, we may establish TRSs toeffect various taxable transactions. Those TRSs would incur federal, state andlocal taxes on the taxable income from their activities. Unless the contextrequires otherwise, all references to “we,” “our” and “us” mean GramercyCapital 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 generally achieved through the directorigination of whole loans, the ownership of which permits a wide variety offinancing syndication and securitization executions to achieve excess returns.By providing a single source of financing for developers and sponsors, westreamline the lending process, provide greater certainty for borrowers andretain the high yield debt instruments that we manufacture. By creating, ratherthan buying whole loans, subordinate interests in whole loans, mezzanine debtand preferred equity, we strive to deliver superior returns to ourshareholders.

 

Since our inception, we havecompleted transactions in a variety of markets and secured by a variety ofproperty types. Since our inception, the market for commercial real estate debthas continued to demonstrate low rates of default, high relative returns andtremendous 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 wholeloans for resale to investors have driven debt yields lower while maintainingsubstantial liquidity because of the strong demand for the resultingsecurities. Because of reduced profits in the most liquid sectors of themortgage finance business, several large institutions have begun originatinglarge bridge loans for the purpose of generating interest income, rather thanthe typical focus on trading profits. In this environment we have focused onareas where we have comparative advantages rather than competing for productmerely on the basis of yield or structure. This has particularly included wholeloan origination in markets and transactions where we have an advantage due to(i) knowledge or relationships we have, (ii) knowledge or relationships of ourlargest shareholder, SL Green, and (iii) where we have an ability to betterassess and manage risks over time. When considering investment opportunities insecondary market transactions in tranched debt, we generally avoid first lossrisk in larger transactions due to the high current valuation of the underlyingreal estate relative to historic valuation levels. Because of the significantincrease in the value of institutional quality assets relative to historicnorms, we typically focus on positions in which a conventional refinancing atloan maturity would provide for a complete return of our investment.

 

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 andliabilities in terms of base interest rate (generally 30-day LIBOR) andexpected duration. We raised $95.0 million of additional equity in December2004 and January 2005 to reduce our outstanding indebtedness and maintainsufficient liquidity for our investment portfolio. We sold a total of $100.0million of trust preferred securities in two $50.0 million issuances in May2005 and August 2005 through wholly-owned subsidiaries of the OperatingPartnership with 30 year terms expiring in June 2035 and October 2035,respectively. The securities issued in May bear interest at a fixed rate of7.57% for the first ten years ending June 2015 while the securities issued inAugust bear interest at a fixed rate of 7.75% for the first ten years endingOctober 2015. After the first ten years, both issuances bear interest atthree-month LIBOR plus 300 basis points. The proceeds from the issuances of thetrust preferred securities were used to fund existing and future investmentopportunities. In July 2005 we closed on $1.0 billion of collateralized debtobligations, or CDO, which extended the term of our liabilities and reduced ouroverall cost of funds with respect to debt investments financed by the CDO andpreviously financed by our repurchase agreements, to approximately 49 basispoints over LIBOR, excluding transaction costs. The proceeds of the CDO were usedto refinance our repurchase facilities and to fund additional investmentactivities. In September 2005 we sold 3,833,333 shares of common stockresulting in net proceeds of approximately $97.8 million, which was used tofund acquisitions, repay outstanding principal amounts under our repurchasefacilities and for general corporate purposes.

 

As of December 31, 2005, weheld loans and other lending investments of approximately $1.2 billion net offees, discounts,

 

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repayments, asset sales andunfunded commitments. At December 31, 2005 we held interests in three credittenant lease, or CTL, investments totaling $109.2 million comprised of the$51.2 million carrying value of 200 Franklin Square Drive, net of $315 thousandof depreciation, and $58.0 million in joint venture investments.

 

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

 
| ** **                                           | ** ** | **Carrying Value (1)  ($ in thousands)** | ** ** | **Allocation by  Investment Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average Spread over  LIBOR (2)** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                                     | ** ** | **2004**                                     | ** ** | **2005**                                 | ** ** | **2004**                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Whole loans, floating rate                           |       | $                                                            | 561,388    |                                         | $          | 155,215                                  |       | 46                                                                     | %          | 38 | % | — |   | — |   | 325 | bps | 373 | bps |
| Whole loans, fixed rate                              |       | 94,448                                                       |       | —                                       |       | 8                                        | %          | —                                                                 |       | 10.64 | % | — |   | — |   | — |   |
| Subordinate interests in whole loans,  floating rate |       | 362,983                                                      |       | 209,286                                      |       | 30                                       | %          | 51                                                                     | %          | — |   | — |   | 443 | bps | 640 | bps |
| Subordinate interests in whole loans, fixed  rate    |       | 37,104                                                       |       | 31,216                                       |       | 3                                        | %          | 8                                                                      | %          | 9.19 | % | 9.57 | % | — |   | — |   |
| Mezzanine loans, floating rate                       |       | 82,793                                                       |       | —                                       |       | 7                                        | %          | —                                                                 |       | — |   | — |   | 858 | bps | — |   |
| Mezzanine loans, fixed rate                          |       | 43,352                                                       |       | —                                       |       | 4                                        | %          | —                                                                 |       | 8.88 | % | — |   | — |   | — |   |
| Preferred equity, floating rate                      |       | 11,795                                                       |       | —                                       |       | 1                                        | %          | —                                                                 |       | — |   | — |   | 900 | bps | — |   |
| Preferred equity, fixed rate                         |       | 11,882                                                       |       | —                                       |       | 1                                        | %          | —                                                                 |       | 10.28 | % | — |   | — |   | — |   |
| Commercial mortgage backed securities                |       | —                                                       |       | 10,898                                       |       | —                                   |       | 3                                                                      | %          | — |   | 13.49 | % | — |   | — |   |
| Total / Average                                      |       | $                                                            | 1,205,745  |                                         | $          | 406,615                                  |       | 100                                                                    | %          | 100 | % | 9.92 | % | 10.58 | % | 417 | bps | 526 | bps |

 

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**(1)**   Debt investments arepresented after scheduled amortization payments and prepayments, and are net ofunamortized fees, discounts, asset sales and unfunded commitments.

** **

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

** **

**The followingdiscussion related to our consolidated financial statements should be read inconjunction with financial statements appearing in Item 8 of the Annual Reporton Form 10K.**

** **

**CriticalAccounting Policies**

** **

Our discussion and analysis offinancial condition and results of operations is based on our financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States, known as GAAP. These accountingprinciples require us to make some complex and subjective decisions andassessments. Our most critical accounting policies involve decisions andassessments, which could significantly affect our reported assets, liabilitiesand contingencies, as well as our reported revenues and expenses. We believethat all of the decisions and assessments upon which our financial statementsare based were reasonable at the time made based upon information available tous at that time. We evaluate these decisions and assessments on an ongoingbasis. Actual results may differ from these estimates under differentassumptions or conditions. We have identified our most critical accountingpolicies to be the following:

 

**Loans andInvestments and Loans Held for Sale**

 

Loans held for investmentare intended to be held to maturity and, accordingly, are carried at cost, netof unamortized loan origination 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 thelower of cost or market value using available market information obtainedthrough consultation with dealers or other originators of such investments. Wemay 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 apreferred equity investment, we must determine whether that investment shouldbe accounted for as a loan, joint venture or as an interest in real estate. Ourcurrent preferred equity investments do not entitle us to a percentage of theunderlying properties’ cash flows from operations or proceeds from a sale orrefinancing and are, therefore, accounted for as loans.

 

Specific valuation allowances are established for impaired loans basedon the fair value of collateral on an individual loan basis. The fair value ofthe collateral is determined by selecting the most appropriate valuationmethodology, or methodologies, among several generally available and acceptedin the commercial real estate industry. The determination of the mostappropriate valuation methodology is based on the key characteristics of thecollateral type. These methodologies include the evaluation of operating cashflow from the property during the projected holding period, and the estimatedsales value of the collateral computed by applying an

 

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expected capitalization rate to the stabilized net operating income ofthe specific property, less selling costs, all of which are discounted atmarket discount rates.

 

If upon completion of thevaluation, the fair value of the underlying collateral securing the impairedloan is less than the net carrying value of the loan, an allowance is createdwith a corresponding charge to the provision for loan losses. The allowance foreach loan is maintained at a level we believe is adequate to absorb probablelosses. At December 31, 2005 we maintained a reserve of $1.0 million.

 

Our Manager evaluates ourassets on a regular basis to determine if they continue to satisfy ourinvestment criteria. Subject to certain restrictions, our Manager may cause usto sell our investments opportunistically and use the proceeds of any such salefor debt reduction, additional acquisitions or working capital purposes.

 

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

#### ** **

MBS are classified asavailable-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. If available-for-sale securities were classified astrading securities, there could be substantially greater volatility in earningsfrom period-to-period as these investments would be marked to market and anyreduction in the value of the securities versus the previous carrying valuewould be considered an expense on our statement of operations. We had noinvestments as of December 31, 2005 that were accounted for as tradingsecurities.

 

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

#### ** **

All MBS are carried onthe balance sheet at fair value. We determine the fair value of MBS based onthe types of securities in which we have invested. For liquid, investment-gradesecurities, we consult with dealers of such securities to periodically obtainupdated market pricing for the same or similar instruments. For non-investmentgrade securities, we actively monitor the performance of the underlyingproperties and loans and update our pricing model to reflect changes inprojected cash flows. The value of the securities is derived by applyingdiscount rates to such cash flows based on current market yields. The yieldsemployed are obtained from our own experience in the market, advice fromdealers and/or information obtained in consultation with other investors insimilar instruments. Because fair value estimates may vary to some degree, wemust make certain judgments and assumptions about the appropriate price to useto calculate the fair values for financial reporting purposes. Differentjudgments and assumptions 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, an other-than-temporary impairment exists,the cost basis of the security is written down to the then-current fair value,and this loss is realized and charged against earnings. The determination ofother-than temporary impairment is a subjective process, and different judgmentsand assumptions could affect the timing of loss realization.

 

#### **CreditTenant Lease Investments**

#### ** **

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

 

Results ofoperations of properties acquired are included in the Statement of Operationsfrom the date of acquisition.

 

In accordancewith FASB No. 144, or SFAS 144, “Accounting for the Impairment or 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 anasset is held for sale, depreciation expense and straight-line rent adjustmentsare no longer recorded and historic results are reclassified as Discontinued Operations.

 

In accordance with FASBNo. 141, or SFAS 141, “Business Combinations,” we allocate the purchase priceof real estate to land and building and, if determined to be material,intangibles, such as the value of above-market, below-market and at-marketleases and origination costs associated with the in-place leases.  Wedepreciate the amount allocated to building and other intangible assets overtheir estimated useful lives, which generally range from three to 40years.  The values of the above-market and below-market leases areamortized and recorded as either an increase (in the case of below-marketleases) or a decrease (in the case of above-market leases) to

 

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rental income over theremaining term of the associated lease.  The value associated within-place leases and tenant relationships are amortized over the expected termof the relationship, which includes an estimated probability of the leaserenewal, and its estimated term.  If a tenant vacates its space prior tothe contractual termination of the lease and no rental payments are being madeon the lease, any unamortized balance of the related intangible will be writtenoff.  The tenant improvements and origination costs are amortized as anexpense over the remaining life of the lease (or charged against earnings ifthe lease is terminated prior to its contractual expiration date).  Weassess fair value of the leases based on estimated cash flow projections thatutilize appropriate discount and capitalization rates and available marketinformation.  Estimates of future cash flows are based on a number offactors including the historical operating results, known trends, andmarket/economic conditions that may affect the property.

 

As a result of our evaluationunder SFAS No. 141 of our acquisition of 200 Franklin Square Drive, we recordeda liability of $872 thousand representing the net value of the acquiredbelow-market lease and assumed lease origination costs. We recognized adecrease of approximately $22 thousand in rental revenue for the year endedDecember 31, 2005 for the amortization of the below-market lease and leaseorigination costs including leasing commissions and tenant improvement coststhat would be borne by us, resulting from the reallocation of the purchaseprice of the property.

 

AtDecember 31, 2005 we held interests in three CTL investments totaling $109.2million comprised of the $51.2 million carrying value of 200 Franklin SquareDrive, net of $315 thousand of depreciation, and $58.0 million in joint ventureinvestments.

 

**Investments in Unconsolidated Joint Ventures**

 

#### **We account for our investments inunconsolidated joint ventures under the equity method of accounting since weexercise significant influence, but do not unilaterally control, the entitiesand are not considered to be the primary beneficiary under FASB InterpretationNo. 46, “Consolidation of Variable Interest Entities,” or FIN 46. In the jointventures, the rights of the other investor are protective and participating.Unless we are determined to be the primary beneficiary, these rights precludeus from consolidating the investments.  The investments are recordedinitially at cost as an investment in unconsolidated joint ventures, andsubsequently are adjusted for equity in net income (loss) and cashcontributions and distributions.  Any difference between the carryingamount of the investments on our balance sheet and the underlying equity in netassets is amortized as an adjustment to equity in net income (loss) ofunconsolidated joint ventures over the lesser of the joint venture term or 40years.  None of the joint venture debt is recourse to us.**

#### ** **

#### **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 inconnection with loan commitments are deferred until the loan is funded and arethen recognized over the term of the loan as an adjustment to yield.Anticipated exit fees, whose collection is expected, are also recognized overthe term of the loan as an adjustment to yield. Fees on commitments that expireunused are recognized at expiration. Fees received in exchange for the creditenhancement of another lender, either subordinate or senior to us, in the formof a guarantee are recognized over the term of that guarantee using thestraight-line method.

 

Incomerecognition is generally suspended for debt investments at the earlier of thedate at which payments become 90 days past due or when, in our opinion, a fullrecovery of income and principal becomes doubtful. Income recognition isresumed when the loan becomes contractually current and performance isdemonstrated to be resumed.

 

Insome instances we may sell all or a portion of our investments to a thirdparty. To the extent the fair value received for an investment exceeds theamortized cost of that investment and FASB Statement No. 140, or SFAS 140,“Accounting for Transfers and Servicing of Financial Assets and Extinguishmentsof Liabilities,” criteria is met, under which control of the asset that is soldis surrendered making it a “true sale,” a gain on the sale will be recordedthrough earnings as other income. To the extent an investment that is sold hasa discount or fees, which were deferred at the time the investment was made andwere being recognized over the term of the investment, the unamortized portionof the discount or fees are recognized at the time of sale and recorded as again on the sale of the investment through other income. We recognized $10.5million in gains from the sale of debt investments, of which $1.8 millionrepresents the recognition of unamortized discounts or fees at the time ofsale, for the year ended December 31, 2005.

 

Rental revenue is recognized on a straight-line basis over the term ofthe lease. The excess of rents recognized over amounts contractually duepursuant to the underlying leases is included in other assets on theaccompanying balance sheets. We may establish, on a current basis, an allowanceagainst this account for future potential tenant credit losses which may occur.The balance reflected on the balance sheet will be net of such allowance.

 

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In addition to base rent, the tenants in our CTL investments also pay alloperating costs of owned property including real estate taxes.

 

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

#### ** **

Theexpense for possible credit losses in connection with debt investments is thecharge to earnings to increase the allowance for possible credit losses to thelevel that management estimates to be adequate considering delinquencies, lossexperience and collateral quality. Other factors considered relate togeographic trends and project diversification, the size of the portfolio andcurrent economic conditions. Based upon these factors, we may establish theprovision for possible credit losses by individual asset or category of asset.When it is probable that we will be unable to collect all amounts contractuallydue, the account is considered impaired.

 

Whereimpairment is indicated, a valuation write-down or write-off is measured basedupon the excess of the recorded investment amount over the net fair value ofthe collateral, as reduced by selling costs. Any deficiency between thecarrying amount of an asset and the net sales price of foreclosedcollateral is charged to the allowance for credit losses. At December 31, 2005we maintained a reserve for possible credit losses of $1.0 million againstinvestments with a carrying value of $68.3 million.

 

**Stock Based Compensation Plans**

 

Wehave a stock-based compensation plan, described more fully in Note 13. Weaccount for this plan using the fair value recognition provisions of FASBStatement No. 123, “Accounting for Stock-Based Compensation,” or SFAS 123.

 

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, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Becauseour plan has characteristics significantly different from those of tradedoptions and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in our opinion, the existing models do notnecessarily provide a reliable single measure of the fair value of our stockoptions.

 

Compensation cost for stock options, if any, is recognized ratably overthe vesting period of the award. Our policy is to grant options with anexercise price equal to the quoted closing market price of our stock on thebusiness 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         |       | 4.16      | %          | 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 onthe Class B limited partner interests as an incentive distribution expense inthe period when earned and when payment of such amounts has become probable andreasonably estimable in accordance with the partnership agreement. These cashdistributions will reduce the amount of cash available for distribution to ourcommon unitholders in our Operating Partnership and to common stockholders. Weincurred approximately $2.3 million with respect to such Class B limitedpartner interests for the year ended December 31, 2005 and $0 in 2004.

 

**Derivative Instruments**

** **

**In thenormal course of business, we use a variety of derivative instruments tomanage, or hedge, interest rate risk. We require that hedging derivativeinstruments be effective in reducing the interest rate risk exposure that theyare designated to hedge. This effectiveness is essential for qualifying forhedge accounting. Some derivative instruments are associated with ananticipated transaction. In those cases, hedge effectiveness criteria alsorequire that it be probable that the underlying transaction occurs. Instrumentsthat meet these hedging criteria are formally designated as hedges at theinception of the derivative contract.**

 

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**Todetermine the fair value of derivative instruments, we use a variety of methodsand assumptions that are based on market conditions and risks existing at eachbalance sheet date. For the majority of financial instruments including mostderivatives, long-term investments and long-term debt, standard market conventionsand techniques such as discounted cash flow analysis, option-pricing models,replacement cost, and termination cost are used to determine fair value. Allmethods of assessing fair value result in a general approximation of value, andsuch 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. To address exposure to interest rates, we usederivatives primarily to hedge the mark-to-market risk of our liabilities withrespect to certain of our assets.

 

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

 

**FASB No. 133, or SFAS 133, “Accounting for Derivative Instruments andHedging Activities,” as amended by FASB No. 149, requires us to recognize allderivatives on the balance sheet at fair value. Derivatives that are not hedgesmust be adjusted to fair value through income. If a derivative is a hedge,depending on the nature of the hedge, changes in the fair value of 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. Theineffective portion of a derivative’s change in fair value will be immediatelyrecognized in earnings. SFAS 133 may increase or decrease reported net incomeand stockholders’ equity prospectively, depending on future levels of LIBOR,swap spreads and other variables affecting the fair values of derivativeinstruments and hedged items, but will have no effect on cash flows, providedthe contract is carried through to full term.**

** **

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

 

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

 

**IncomeTaxes**

 

We elected to be taxed asa REIT, under Sections 856 through 860 of the Internal Revenue Code, beginningwith our taxable year ending December 31, 2004. To qualify as a REIT, we mustmeet certain organizational and operational requirements, including arequirement to distribute at least 90% of our ordinary taxable income tostockholders. As a REIT, we generally will not be subject to federal income taxon taxable income that we distribute to our stockholders. If we fail to qualifyas a REIT in any taxable year, we will then be subject to federal income taxeson our taxable income at regular corporate rates and we will not be permittedto qualify for treatment as a REIT for federal income tax purposes for fouryears following the year during which qualification is lost unless the InternalRevenue Service grants us relief under certain statutory provisions. Such anevent could materially adversely affect our net income and net cash availablefor distributions to stockholders. However, we believe that we will beorganized and operate in such a manner as to qualify for treatment as a REITand we intend to operate in the foreseeable future in such a manner so that wewill qualify as a REIT for federal income tax purposes. We may, however, besubject to certain state and local taxes.

 

**Our wholly-owned TRSs are subject to federal, state andlocal taxes.**

 

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**Results ofOperations (Amounts in thousands)**

 

***Comparison of the year endedDecember 31, 2005 to the period from April 12, 2004 (formation) throughDecember 31, 2004***

 

***Revenues***

 
| ** **                                           | ** ** | **2005** | ** **   | **2004** | ** ** | **$ Change** | ** ** |
|------------------------------------------------------|------------|----------|--------------|----------|------------|-------------------|------------|
| Investment  income                                   |       | $        | 73,302       |     | $          | 6,841             |       | $ | 66,461 |   |
| Rental  revenue, net                                 |       | 1,219    |         | —   |       | 1,219             |       |
| Gain on  sales and other income                      |       | 13,564   |         | 310      |       | 13,254            |       |
| Total revenues                                       |       | $        | 88,085       |     | $          | 7,151             |       | $ | 80,934 |   |
|                                                 |       |     |         |     |       |              |       |
| Equity in  net loss of unconsolidated joint ventures |       | $        |  (1,489 | )        | $          | —            |       | $ | (1,489 | ) |
|                                                      |            |          |              |          |            |                   |            |  |  |  |  |  |

 

Investment income isgenerated on our whole and bridge loans, subordinate interests in whole loans,mezzanine loans, preferred equity interests and CMBS investments. For the yearended December 31, 2005 $10,701 was earned on fixed rate investments while theremaining $62,601 was earned on floating rate investments. The increase overthe prior year is due to a significantly higher number of investments in 2005versus 2004 and the effect of a full twelve months of operations in 2005.

 

**Rental revenue of $1,219 in 2005 was earned on 200 Franklin Square Drive,which was acquired in September 2005. This amount includes the effect ofadjustments for straight-line rent and FASB 141 adjustments for below-marketleases. We did not hold any real estate investments during 2004.**

** **

Other income of $13,564for the year ended December 31, 2005 is comprised primarily of income recordedon the sale of fixed and floating rate debt investments of $10,474, including$1,849 attributable to the recognition of unamortized discounts and fees on theinvestments sold and interest on restricted cash balances in the CDO (which wasnot in place in 2004) of approximately $2,274. For the period from April 12,2004 (formation) through December 31, 2004, other income of $310 was comprisedonly of interest income on cash balances.

 

**The loss on investments in unconsolidated joint ventures of $1,489 in2005 represents our proportionate share of the losses generated by our jointventure interests including $4,804 of real estate related depreciation andamortization, which when added back, results in a contribution to FFO of$3,315. We did not maintain any joint venture investments during 2004. Our useof FFO as an important financial measure is discussed in more detail in Item 6.**

** **

***Expenses***

*** ***
| ** **                             | ** ** | **2005** | ** ** | **2004** | ** ** | **$ Change** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|-------------------|------------|
| Interest  expense                      |       | $        | 33,771     |     | $          | 1,463             |       | $ | 32,308 |   |
| Management  fees                       |       | 9,600    |       | 1,965    |       | 7,635             |       |
| Incentive  fee                         |       | 2,276    |       | —   |       | 2,276             |       |
| Depreciation  and amortization         |       | 672      |       | 38       |       | 634               |       |
| Marketing,  general and administrative |       | 6,976    |       | 1,358    |       | 5,618             |       |
| Provision  for loan loss               |       | 1,030    |       | —   |       | 1,030             |       |
| Provision  for taxes                   |       | 900      |       | —   |       | 900               |       |
| GKK  formation costs                   |       | —   |       | 275      |       | (275              | )          |
| Total expenses                         |       | $        | 55,225     |     | $          | 5,099             |       | $ | 50,126 |   |

 

Interest expense was $33,771for the year ended December 31, 2005 versus $1,463 for the period from April12, 2004 (formation) through December 31, 2004. Interest expense in 2005consists primarily of $17,429 of interest on the investment grade tranches ofour CDO, that was not in place in 2004, $11,756 of interest on borrowings onour master repurchase facilities with Wachovia Capital Markets, LLC, orWachovia, and Goldman Sachs Mortgage Company, or Goldman Sachs, and $3,838 ofexpense accrued against our two $50,000 issuances of trust preferredsecurities. The $1,463 of interest expense in 2004 was comprised primarily ofinterest on borrowings on the master repurchase facility with Wachovia and theamortization of deferred financing costs.

 

Management fees increased $7,635for the year ended December 31, 2005 versus the period from April 12, 2004(formation) through December 31, 2004 due primarily to an increase in ourstockholder’s equity, the issuance of trust preferred securities and a fulltwelve months of operations in 2005. The remaining increase is comprised of$944 payable to the Manager under the CDO collateral management agreement, inlieu of the 0.15% fee otherwise payable to SL Green Operating Partnership, L.P.on investments in the CDO under the asset servicing agreement, and higher feespaid or payable to SL Green Operating Partnership, L.P. of $745 and $942 underour outsourcing and servicing agreements, respectively, due to a full twelvemonths of operations in 2005 and a

 

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larger asset base on which tocalculate the servicing fee. These fees and the relationship between us, theManager and SL Green Operating Partnership, L.P. are discussed further in“Related Party Transactions.”

 

We recorded an incentive feeexpense of $2,276 during the twelve months ended December 31, 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 threshold was not reached during 2004 and,consequently, no expense was recorded. This fee and the relationship betweenus, the Manager and SL Green Operating Partnership, L.P. are discussed furtherin “Related Party Transactions.”

 

The increase in marketing,general and administrative expenses of $5,618 for the year ended December 31,2005 versus the period from April 12, 2004 (formation) through December 31,2004 reflects a full twelve months of operations in 2005 and a correspondingincrease in professional fees, stock-based compensation, insurance and generaloverhead costs.

 

**Liquidityand Capital Resources**

 

**Liquidity is a measurement of the ability to meet cash requirements,including ongoing commitments to repay borrowings, fund and maintain loans andinvestments, pay dividends and other general business needs. Our principalsources of working capital and funds for additional investments primarilyinclude: 1) cash flow from operations; 2) borrowings under our repurchase andcredit facilities; 3) our CDO; 4) other forms of financing or additionalsecuritizations including CMBS or subsequent CDO offerings; 5) proceeds fromcommon or preferred equity offerings; 6) issuances of trust preferredsecurities and, to a lesser extent, 7) the proceeds from principal payments onour investments, and 8) the sale or syndication of certain of our debtinvestments. We believe these sources of financing will be sufficient to meetour 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. Our inability to renew,replace or expand our sources of financing on substantially similar terms, mayhave an adverse effect on our business and results of operations. In addition,an event of default is triggered under our repurchase facility with Wachovia ifthe management agreement with GKK Manager LLC is terminated. Depending onmarket conditions, our debt financing will generally be in the range of 70% to80% of the carrying value of our total assets. Any indebtedness we incur willlikely be subject to continuing covenants and we will likely be required tomake continuing representations and warranties in connection with such debt.Our debt financing terms may require us to keep uninvested cash on hand, or tomaintain a certain portion of our assets free of liens, each of which could serveto limit our borrowing ability. Moreover, our debt may be secured by ourassets. 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 such payment, our lender could foreclose onour assets that are pledged as collateral to such lender. The lender could alsosue us or force us into bankruptcy. Any such event would have a materialadverse effect on our liquidity and the value of our common stock. In addition,posting additional collateral to support our credit and repurchase facilities willreduce our liquidity and limit our ability to leverage our assets.

 

**To maintain our status as a REIT under the Internal RevenueCode, 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 oursignificant capital resources and access to financing will provide us withfinancial flexibility at levels sufficient to meet current and anticipated capitalrequirements, including funding new lending and investment opportunities.**

 

**Cash Flows(Amounts in thousands)**

 

**2005 Compared to 2004**

** **

Net cash provided byoperating activities increased $1,015 to $2,160 for the year ended December 31,2005 compared to $1,145 for the period from April 12, 2004 (formation) throughDecember 31, 2004.  Operating cash flow was generated primarily byinterest income on our whole and bridge loans, subordinate interests in wholeloans, mezzanine loans, preferred equity interests and CMBS investments andgains on loan sales. Cash flow from a higher number of investments in 2005versus 2004 and the effect of a full twelve months of operations in 2005 wasoffset primarily by a $42,000 net use of cash related to the origination of investmentsheld for sale at December 31, 2005.

 

Net cash used ininvesting activities increased $511,874 to $918,930 for the year endedDecember 31, 2005 compared to $407,056 used during the period from April12, 2004 (formation) through December 31, 2004.  The primary reasonfor the increase is a full

 

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twelve months ofoperations in 2005, during which we invested $1,030,149 in new debt investmentsand $110,145 in new real estate investments, including joint ventures, offsetby $273,897 of principal collections on our debt investments. This compares to$407,603 invested during the period from April 12, 2004 (formation) throughDecember 31, 2004 in new debt investments, offset by $736 of principal repaymentson debt investments.

 

Net cash provided byfinancing activities increased $503,447 to $948,252 for the year endedDecember 31, 2005 compared to $444,805 provided during the period fromApril 12, 2004 (formation) through December 31, 2004.  The increasewas due primarily to proceeds of $100,000 from the sale of trust preferredsecurities in May and August 2005, proceeds of $810,500 from the issuance theCDO in July 2005 and $41,000 in new mortgage debt on 200 Franklin Square Drive,offset by a reduction in borrowings on our repurchase facilities of $360,405and reduced proceeds from the issuance of common stock of $48,761.

 

**Capitalization**

** **

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 wecompleted our initial public offering of 12,500,000 shares of common stockresulting in net proceeds of approximately $172.9 million, which was used tofund investments and commence our operations. As of December 31, 2005, 338,000restricted shares had also been issued under our 2004 Equity Incentive Plan, orthe Equity Incentive Plan. These shares have a vesting period of three to fouryears and are not entitled to receive distributions declared by us on our commonstock until such time as the shares have vested, or the shares have beendesignated to receive dividends by the Compensation Committee of our Board ofDirectors.

 

OnDecember 3, 2004 we sold 5,500,000 shares of common stock resulting in netproceeds of approximately $93.7 million under a private placement exemptionfrom the registration requirements of Section 5 of the Securities Act of 1933,as amended. A total of 4,225,000 shares were sold to various institutionalinvestors and an additional 1,275,000 shares were sold to SL Green OperatingPartnership, L.P. pursuant to its contractual right to choose to maintain a 25%ownership interest in the outstanding shares of our common stock. Of the5,500,000 shares sold, 2,000,000 shares were settled on December 31, 2004 andthe remaining 3,500,000 shares were settled on January 3, 2005. The value ofthe shares settled on January 3, 2005 were reflected as a stock subscriptionreceivable for financial statement purposes as of December 31, 2004.

 

OnSeptember 14, 2005 we sold 3,833,333 shares of common stock resulting in netproceeds of approximately $97.8 million. A total of 2,875,000 shares were soldthrough public offering and an additional 958,333 shares were sold to SL GreenOperating Partnership, L.P. pursuant to its contractual right to choose to maintaina 25% ownership interest in our outstanding shares of common stock. After thisoffering, SL Green Operating Partnership, L.P. owned 5,668,333 shares of ourcommon stock. Net proceeds were used for acquisitions, repayment of outstandingprincipal under one of our repurchase facilities and general corporatepurposes.

 

InAugust 2005 our $350 million shelf registration statement was declaredeffective by the 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 $251.1 millionavailable under the shelf.

 

As of December 31, 2005,22,802,642 shares of common stock and no shares of preferred stock were issuedand outstanding.

 

**Outperformance Plan**

 

InJune 2005, the compensation committee of our board of directors approved along-term incentive compensation program, the 2005 Outperformance Plan.Participants in the 2005 Outperformance Plan, all of whom are co-leasedemployees, will share in a “performance pool” if our total return tostockholders for the period from June 1, 2005 through May 31, 2008 exceeds acumulative total return to stockholders of 30% during the measurement period overa base share price of $20.21 per share. The size of the pool will be 10% of theoutperformance amount in excess of the 30% benchmark, subject to a maximumlimit equal to the lesser of 4% of our outstanding shares and units of limitedpartnership interest as of the end of the performance period or 1,200,000shares. If our total return to stockholders from June 1, 2005 to any subsequentdate exceeds 80% and remains at that level or higher for 30 consecutive days,then a minimum performance pool will be established. In the event the potentialperformance pool reaches the maximum dilution cap before May 31, 2008 andremains at that level or higher for 30 consecutive days, the performance periodwill end early and the pool will be formed on the last day of such 30 dayperiod. Each participant’s award under the 2005 Outperformance

 

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Planis designated as a specified percentage of the aggregate performance pool to beallocated to such participant assuming the 30% benchmark is achieved.Individual awards under the 2005 Outperformance Plan will be made in the formof partnership units, or LTIP Units, that may ultimately become exchangeablefor shares of our common stock or cash, at our election. LTIP Units will be grantedprior to the determination of the performance pool; however, they will onlyvest upon satisfaction of performance and other thresholds, and will not beentitled to distributions until after the performance pool, or minimumperformance pool, is established. The 2005 Outperformance Plan provides that ifa pool is established, each participant will also be entitled to thedistributions that would have been paid on the number of LTIP Units earned, hadthey been issued at the beginning of the performance period. Thosedistributions will be paid in the form of additional LTIP Units. Once aperformance pool has been established, the earned LTIP Units will receiveregular quarterly distributions on a per unit basis equal to the dividends pershare paid on our common stock, whether or not they are vested. Any LTIP Unitsthat are not earned upon the establishment of the performance pool will beautomatically forfeited, and the LTIP Units that are earned will be subject totime-based vesting, with 50% of the LTIP Units earned vesting in May 2009 andthe balance vesting one year later based on continued employment with theManager or SL Green.   We willrecord the expense of the restricted stock award in accordance with FASBStatement No. 123, or SFAS 123, “Accounting for Stock-Based Compensation.”  Compensation expense of $1.2 million wasrecorded for the year ended December 31, 2005 related to the 2005Outperformance Plan.

 

**Deferred Stock Compensation Plan for Directors**

 

Under our IndependentDirector’s Deferral Program, which commenced April 2005, our independent 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 ofcommon stock upon such directors’ termination of service from the Board ofDirectors or a change in control by us, as defined by the program.  Phantomstock units are credited to each independent director quarterly using theclosing price of our common stock on the applicable dividend record date forthe respective quarter.  Each participating independent director whoelects to receive fees in the form of phantom stock units has the option tohave their account credited for an equivalent amount of phantom stock unitsbased on the dividend rate for each quarter or have dividends paid in cash.

 

As of December 31, 2005there were approximately 2,228 phantom stock units outstanding.

 

**Market Capitalization**

 

At December 31, 2005, ourCDO and borrowings under our repurchase facilities, revolving credit facilityand mortgage loans (excluding our share of joint venture debt of $335.5million) represented 65% of our consolidated market capitalization of $1.5billion (based on a common stock price of $22.78 per share, the closing priceof our common stock on the New York Stock Exchange on December 31, 2005).Market capitalization includes our consolidated debt and common stock.

 

**Indebtedness**

** **

**The table below summarizes borrowings under our Wachovia and Goldmanrepurchase facilities and any consolidated mortgage debt or term loans atDecember 31, 2005 and 2004, respectively (amounts in thousands).**

** **
| ** **                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Debt Summary:**                       |       |                  |       |   |   |
| **Balance:**                                 |       |                  |       |   |   |
| Fixed rate                                   |       | $                     | 41,000     |   | $ | — |   |
| Variable  rate                               |       | 117,366               |       | 238,885 |   |
| Total                                        |       | $                     | 158,366    |   | $ | 238,885 |   |
|                                         |       |                  |       |   |   |
| **Effective  interest rate for the period:** |       |                  |       |   |   |
| Fixed rate                                   |       | 4.90                  | %          | — |   |
| Variable  rate                               |       | LIBOR + 1.59          | %          | LIBOR + 1.99 | % |

** **

**Repurchase Facilities**

** **

We have two repurchase facilities with anaggregate of $700 million of total debt capacity. In August 2004 we closed on a$250 million repurchase facility with Wachovia. This facility was thenincreased to $350 million on January 3, 2005 and subsequently increased to $500million on April 22, 2005. As part of the April 2005 increase to $500 million,the initial term of this facility was modified to reflect a staggered term inwhich $250 million matures in August 2007, $150 million matures in December2007 and the remaining $100 million matures in June 2008. Also in conjunctionwith the April 2005 upsize, the $50 million repurchase facility we previouslymaintained with Wachovia was consolidated into the $500 million repurchasefacility. The $500 million facility bears interest at spreads of 1.15% to 3.50%over 30-day LIBOR and, based on our investment activities, provides for advancerate that vary from 60% to 100% based upon the collateral provided under aborrowing base calculation. The lender has a consent right with respect

 

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to the inclusion of investments in thisfacility, determines periodically the market value of the investments, and hasthe right to require additional collateral if the estimated market value of theincluded investments declines. We had outstanding borrowings under thisfacility of $67.7 million at a weighted average spread to LIBOR of 1.50% and$238.9 million at a weighted average spread to LIBOR of 1.99% at December 31,2005 and 2004, respectively. We can utilize the $25 million revolving creditfacility described below to fund requirements for additional collateralpursuant to the repurchase facility or to fund the acquisition of assets.

 

On January 3, 2005 weclosed an additional repurchase facility of $200 million with Goldman Sachs.This facility has an initial term of three years expiring in January 2008 withone six-month extension option. This facility bears interest at spreads of1.00% to 2.75% over a 30-day LIBOR and, based on our investment activities,provides for advance rates that vary from 40% to 85% based upon the collateralprovided under a borrowing base calculation. As with the Wachovia repurchasefacility, the lender has a consent right to the inclusion of investments inthis facility, determines periodically the market value of the investments, andhas the right to require additional collateral if the estimated market value ofthe included investments declines. At December 31, 2005 we had outstandingborrowings under this facility of $49.6 million at a weighted average spread toLIBOR of 1.71%.

 

The repurchase facilitiesrequire that we pay down borrowings under these facilities as principalpayments on the loans and investments pledged to these facilities are received.Assets pledged ascollateral under these facilities may include stabilized and transitional wholeloans, subordinate interests in whole loans, mezzanine loans, and rated CMBS orcommercial real estate CDO securities originated or acquired by us.

 

In certain circumstances, wehave purchased debt investments from a counterparty and subsequently financedthe acquisition of those debt investments through repurchase agreements withthe same counterparty. We currently record the acquisition of the debtinvestments as assets and the related repurchase agreements as financingliabilities gross on the consolidated balance sheets. Interest income earned onthe debt investments and interest expense incurred on the repurchase obligationsare reported gross on the consolidated income statements. However, under acertain technical interpretation of FAS 140, such transactions may not qualifyas a purchase by us. We believe, and it is industry practice, that we areaccounting for these transactions in an appropriate manner.  However, the result of this technicalinterpretation would prevent us from presenting the debt investments andrepurchase agreements and the related interest income and interest expense on agross basis on our financial statements. Instead, we would present the netinvestment in these transactions with the counterparty and a derivative withthe corresponding change in fair value of the derivative being recorded throughearnings. The value of the derivative would reflect changes in the value of theunderlying debt investments and changes in the value of the underlying creditprovided by the counterparty.

 

**Credit Facility**

** **

We have one $25 millioncredit facility with Wachovia witha term of two years. Amounts drawn under this facility for liquidity purposesbear interest at a spread over LIBOR of 525 basis points. Amounts drawn underthis facility for acquisition purposes bear interest at a spread over LIBOR of225 basis points. Amounts drawn under this facility for liquidity purposes mustbe repaid within 105 days. Amounts drawn under this facility generally will besecured by assets established under a borrowing base calculation unless certainfinancial covenants are satisfied. These covenants are generally more restrictivethan those set forth below. We had no borrowings under this facility atDecember 31, 2005 and 2004.

 

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

** **

**Restrictive Covenants**

** **

**The terms of both of our repurchase facilities and our credit facilityinclude covenants that (a) limit our maximum total indebtedness to no more than85% of our total assets, (b) require us to maintain minimum liquidity of atleast $10 million for the first two years and $15 million thereafter, (c) ourfixed charge coverage ratio shall at no time be less than 1.50 to 1.00, (d) ourminimum interest coverage ratio shall at no time be less than 1.75 to 1.00, (e)require us to maintain minimum tangible net worth of not less than the greaterof (i) $129.75 million, or (i) plus (ii) 75% of the proceeds of our subsequentequity issuances and (f) restrict the maximum amount of our total indebtedness.The covenants also restrict us from making distributions in excess of a maximumof 103% of our funds from operations (as defined by the National Association ofReal Estate Investment Trusts, or NAREIT) through July 2005 and 100%thereafter, except that we may in any case pay distributions necessary tomaintain our REIT status. Under our facility with Wachovia, an event of defaultwill be triggered if GKK Manager LLC ceases to be the Manager. As of December31, 2005, we were in compliance with all such covenants.**

 

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#### **MortgageLoan**

#### ** **

We have one consolidatedinterest-only mortgage loan of $41.0 million that bears interest at a fixedrate of 4.90% and has a term of ten years, resulting in a balloon payment in2015. This mortgage was used to finance our acquisition of 200 Franklin SquareDrive for approximately $50.3 million, excluding closing costs, in September2005.

 

#### **CollateralizedDebt Obligations**

#### ** **

#### **On July 14,2005, we issued approximately $1.0 billion of collateralized debt obligationsthrough two newly-formed indirect subsidiaries, Gramercy Real EstateCDO 2005-1 Ltd., or the Issuer, and Gramercy Real Estate CDO 2005-1 LLC,or the Co-Issuer. The CDO consists of $810.5 million of investment grade notes,and $84.5 million of non-investment grade notes, which were co-issued by theIssuer and the Co-Issuer, and $105.0 million of preferred shares, which wereissued by the Issuer. We retained all non-investment grade securities, thepreferred shares and the common shares in 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 $11.8 million of issuance costs, whichwill be amortized on a level-yield basis over the average life of the CDO. TheIssuer is consolidated in our financial statements. The investment grade notesare treated as a secured financing, and are non-recourse to us. Proceeds fromthe sale of the investment grade notes issued were used to repay substantiallyall outstanding debt under our repurchase agreements and fund additionalinvestments.**

#### ** **

**Junior Subordinated Debentures**

** **

**On May 20,2005 we completed the issuance of $50.0 million in unsecured trust preferredsecurities through a newly formed Delaware statutory trust, Gramercy CapitalTrust I, or GCTI, that is a wholly-owned subsidiary of the OperatingPartnership. The securities bear interest at a fixed rate of 7.57% for thefirst ten years ending June 2015. Thereafter the rate will float based on thethree-month LIBOR plus 300 basis points.**

** **

**On August 9,2005 we completed an additional issuance of $50.0 million in unsecured trustpreferred securities through a separate newly formed Delaware statutory trust,Gramercy Capital Trust II, or GCTII, that is also a wholly-owned subsidiary ofthe Operating Partnership. The securities bear interest at a fixed rate of7.75% for the first ten years ending October 2015. Thereafter the rate willfloat based on the three-month LIBOR plus 300 basis points.**

** **

**Both issuancesof trust preferred securities require quarterly interest distributions;however, payments may be deferred while the interest expense is accrued for aperiod of up to four consecutive quarters if the Operating Partnershipexercises its right to defer such payments. The trust preferred securities areredeemable, at the option of the Operating Partnership, in whole or in part,with no prepayment premium any time after June 30, 2010 for the securitiesissued in May 2005, and October 30, 2010 for the securities issued in August2005.**

** **

**GCTI and GCTIIeach issued $1.55 million aggregate liquidation amount of common securities,representing 100% of the voting common stock of GCTI and GCTII to the OperatingPartnership for a total purchase price of $3.1 million. GCTI and GCTII used theproceeds from the sale of the trust preferred securities and the commonsecurities to purchase the Operating Partnership’s junior subordinated notes.The terms of the junior subordinated notes match the terms of the trust preferredsecurities. The notes are subordinate and junior in right of payment to allpresent and future senior indebtedness and certain other of our financialobligations. We realized net proceeds from each offering of approximately $49.0million.**

** **

Ourinterests in GCTI and GCTII are accounted for using the equity method and theassets and liabilities of GCTI and GCTII are not consolidated into ourfinancial statements. Interest on the junior subordinated notes is included ininterest expense on our consolidated income statements while the juniorsubordinated notes are presented as a separate item in our consolidated balancesheet.

 

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**Contractual Obligations**

** **

Combinedaggregate principal maturities of our CDO, repurchase facilities, trustpreferred securities, mortgage note payable, revolving credit facility and ourobligations under our management agreement, outsourcing agreement, CDOcollateral management agreement and operating lease as of December 31, 2005 areas follows (amounts in thousands):

 
| ** ** | ** ** | **CDO** | ** ** | **Repurchase  Facilities** | ** ** | **Trust  Preferred  Securities** | ** ** | **Mortgage  Note  Payable** | ** ** | **Revolving  Credit  Facility** | ** ** | **Outsourcing  and  Management  Agreements (1)** | ** ** | **CDO  Collateral  Management  Agreement** | ** ** | **Operating  Lease** | ** ** | **Total** | ** ** |
|------------|------------|---------|------------|----------------------------|------------|----------------------------------|------------|-----------------------------|------------|---------------------------------|------------|-------------------------------------------------------|------------|--------------------------------------------|------------|----------------------|------------|-----------|------------|
| 2006       |       | $       | —     |                       | $          | —                           |       | $                           | —     |                            | $          | —                                                |       | $                                          | —     |                 | $          | 10,565    |       | $ | 2,026 |   | $ | 252 |   | $ | 12,843 |   |
| 2007       |       | —  |       | 67,717                     |       | —                           |       | —                      |       | —                          |       | 10,666                                                |       | 2,026                                      |       | 256                  |       | 80,665    |       |
| 2008       |       | —  |       | 49,649                     |       | —                           |       | —                      |       | —                          |       | —                                                |       | 2,026                                      |       | 261                  |       | 51,936    |       |
| 2009       |       | —  |       | —                     |       | —                           |       | —                      |       | —                          |       | —                                                |       | 2,026                                      |       | 265                  |       | 2,291     |       |
| 2010       |       | —  |       | —                     |       | —                           |       | —                      |       | —                          |       | —                                                |       | 1,092                                      |       | 283                  |       | 1,375     |       |
| Thereafter |       | 810,500 |       | —                     |       | 100,000                          |       | 41,000                      |       | —                          |       | —                                                |       | —                                     |       | 1,351                |       | 952,851   |       |
|       |       | $       | 810,500    |                       | $          | 117,366                          |       | $                           | 100,000    |                            | $          | 41,000                                                |       | —                                     |       | $                    | 21,231     |      | $          | 9,196 |   | $ | 2,668 |   | $ | 1,101,961 |   |
|            |            |         |            |                            |            |                                  |            |                             |            |                                 |            |                                                       |            |                                            |            |                      |            |           |            |  |  |  |  |  |  |  |  |  |

 

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(1)   Managementfee is calculated as 1.75% of our gross stockholders equity (as defined in themanagement agreement and inclusive of the trust preferred securities issued onMay 20, 2005 and August 9, 2005) on January 31, 2006, inclusive of the trustpreferred securities issued on May 20, 2005, August 9, 2005 and January 27,2006.

 

**Off-Balance-SheetArrangements**

** **

Wehave several off-balance-sheet investments, including joint ventures andstructured finance investments.  These investments all have varyingownership structures.  Substantially all of our joint venture arrangementsare accounted for under the equity method of accounting as we have the abilityto exercise significant influence, but not control over the operating andfinancial decisions of these joint venture arrangements.  Our off-balance-sheetarrangements are discussed in Note 4, “Investments in Unconsolidated JointVentures” in the accompanying financial statements.

 

**Dividends**

 

Tomaintain our qualification as a REIT, we must pay annual dividends to ourstockholders of at least 90% of our REIT taxable income, determined beforetaking into consideration the dividends paid deduction and net capital gains.We intend to continue to pay regular quarterly dividends to our stockholders.Before we pay any dividend, whether for Federal income tax purposes orotherwise, which would only be paid out of available cash to the extentpermitted under our unsecured and secured credit and repurchase facilities, andour term loans, we must first meet both our operating requirements andscheduled debt service on our mortgages and loans payable.

 

**Related Party Transactions (Amounts inthousands)**

 

In connection with ourinitial public offering, we entered into a management agreement with ourManager, which provides for an initial term through December 2007 withautomatic one-year extension options and is subject to certain terminationrights. We pay the Manager an annual management fee equal to 1.75% of our grossstockholders equity (as defined in the management agreement) inclusive of thetrust preferred securities issued on May 20, 2005 and August 9, 2005. Werealized expense to the Manager under this agreement of an aggregate ofapproximately $6,337 for the year ended December 31, 2005 and approximately$1,349 for the period from April 12, 2004 (formation) through December 31,2004.

 

At December 31, 2005, the majority of the Class Blimited partnership interests were owned by our Manager and SL Green OperatingPartnership, L.P. Interests were also held by certain officers and employees ofSL Green Realty Corp., including some of whom are among our executive officers,which interests are subject to performance thresholds. To provide an incentivefor the Manager to enhance the value of the common stock, the holders of the ClassB limited partner interests of the Operating Partnership are entitled to anincentive return equal to 25% of the amount by which funds from operations (asdefined in the partnership agreement of the Operating Partnership) plus certainaccounting gains exceed the product of our weighted average stockholders equity(as defined in the partnership agreement of the Operating Partnership)multiplied by 9.5% (divided by 4 to adjust for quarterly calculations). We willrecord any distributions on the Class B limited partner interests as an incentivedistribution expense in the period when earned and when payments of suchamounts have become probable and reasonably estimable in accordance with thepartnership agreement. We realized approximately $2,276 of incentivedistribution expense for the year ended December 31, 2005.

 

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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 servicing agreement provides for an annual feepayable to SL Green Operating Partnership, L.P. by us of 0.15% of the carryingvalue of our investments, which amount SL Green Operating Partnership, L.P. hasagreed to reduce for certain investments and which fee may be further reducedby SL Green Operating Partnership, L.P. for fees paid directly to outsideservicers by us. The outsourcing agreement currently provides for a fee payableby us of $1,288 per year, increasing 3% annually over the prior year. For theyear ended December 31, 2005 and the period from April 12, 2004 (formation)through December 31, 2004, we realized expense of an aggregate of $1,266 and$521, respectively, to our Manager under the outsourcing agreement. For theyear ended December 31, 2005 and the period from April 12, 2004 (formation)through December 31, 2004, we realized expense of an aggregate of $1,037 and$95 to our Manager under the asset servicing agreement, 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 managementagreement provides for a senior collateral management fee, payable quarterly inaccordance with the priority of payments as set forth in the indenture, equalto 0.15% per annum of the net outstanding portfolio balance, and an additionalsubordinate collateral management fee, payable quarterly in accordance with thepriority of payments as set forth in the indenture, equal to 0.25% per annum ofthe net outstanding portfolio balance. Net outstanding portfolio balance is thesum of the (i) aggregate principal balance of the collateral debt securities,excluding defaulted securities, (ii) aggregate principal balance of allprincipal proceeds held as cash and eligible investments in certain accounts,and (iii) with respect to the defaulted securities, the calculation amount ofsuch defaulted securities. As compensation for the performance of itsobligations as collateral manager, our Board of Directors has allocated to theManager the portion of the subordinate collateral management fee paid onsecurities not held by us. Thesenior collateral management fee and balance of the subordinate collateralmanagement fee is allocated to us. For the year ended December 31, 2005 werealized expense of $944 to the Manager under the collateral managementagreement.

 

In connection with the5,500 shares of common stock that were sold on December 3, 2004 and settled onDecember 31, 2004 and January 3, 2005 in a private placement, we agreed to paythe Manager a fee of $1,000 as compensation for financial advisory, structuringand costs incurred on our behalf. This fee was recorded as a reduction in theproceeds of the private placement. Apart from legal fees and stock clearingcharges totaling $245, no other fees were paid by us to an investment bank,broker/dealer or other financial advisor in connection with the privateplacement, resulting in total costs of 1.3% of total gross proceeds.

 

**On April 29, 2005, we closed on a $57,503 initial investment in a jointventure with SL Green to acquire, own and operate the South Building located atOne Madison Avenue, New York, New York, or the Property. The joint venture,which was created to acquire, own and operate the Property, is owned 45% by awholly-owned subsidiary of us and 55% by a wholly-owned subsidiary of SL Green.The joint venture interests are *pari passu*.Also on April 29, 2005, the joint venture completed the acquisition of theProperty from Metropolitan Life Insurance Company for the purchase price ofapproximately $802,800 plus closing costs, financed in part through a $690,000first mortgage loan on the Property. The Property comprises approximately 1.2million square feet and is almost entirely net leased to Credit SuisseSecurities (USA) LLC, or CS, 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 for approximately five thousand square feet withan option to lease an additional approximately two thousand square feet andcarries a term of ten years with rents on the entire seven thousand square feetof approximately $249 per annum for year one rising to $315 per annum in yearten. For the year ended December 31, 2005 we paid $90 under this lease.

 

**Bright Star Couriers LLC, or Bright Star, provides messenger services tous. Bright Star is owned by Gary Green, a son of Stephen L. Green, ourChairman. The aggregate amount of fees paid by us for such services for theyear ended December 31, 2005 was approximately $3, and less than $1 for theperiod from April 12, 2004 (formation) through December 31, 2004.**

** **

**SL Green Operating Partnership, L.P. has invested $75,000 and $6,100 inpreferred equity interests that are subordinate to two of our investments withbook values of $29,026 and $6,441, respectively, as of December 31, 2005. SLGreen Operating Partnership, L.P. had invested $75,000 in a preferred equityinterest that was subordinate to our investment with a book value of $68,879 asof December 31, 2004.**

 

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**On July 14, 2005, we closed on the purchase from an SL Green affiliate ofa $40,000 mezzanine loan which bears interest at 11.20%. As part of that sale,the seller retained an interest-only participation. We have determined that theyield on our mezzanine loan after giving effect to the interest-onlyparticipation retained by the seller is at market. The mezzanine loan issecured by the equity interests in an office property in New York, New York.**

** **

**Funds from Operations**

 

FFO is a widelyrecognized measure of REIT performance. We compute FFO in accordance withstandards established by the National Association of Real Estate InvestmentTrusts, or NAREIT, which may not be comparable to FFO reported by other REITsthat do not compute FFO in accordance with the NAREIT definition, or thatinterpret the NAREIT definition differently than we do. The revised White Paperon FFO approved by the Board of Governors of NAREIT in April 2002 defines FFOas net income (loss) (computed in accordance with GAAP), excluding gains (orlosses) from debt restructuring and sales of properties, plus real estaterelated depreciation and amortization and after adjustments for unconsolidatedpartnerships and joint ventures. We present FFO because we consider it animportant supplemental measure of our operating performance and believe that itis frequently used by securities analysts, investors and other interestedparties in the evaluation of REITS. We also use FFO as one of several criteriato determine performance-based bonuses for members of our senior management.FFO is intended to exclude GAAP historical cost depreciation and amortizationof real estate and related assets, which assumes that the value of real estateassets diminishes ratably over time. Historically, however, real estate valueshave risen or fallen with market conditions. Because FFO excludes depreciationand amortization unique to real estate, gains and losses from propertydispositions and extraordinary items, it provides a performance measure that,when compared year over year, reflects the impact to operations from trends inoccupancy rates, rental rates, operating costs, interest costs, providingperspective not immediately apparent from net income. Weconsider gains and losses on the sales of debt investments to be a normal partof our recurring operations and therefore do not exclude such gains and losseswhen arriving at FFO. FFOdoes not represent cash generated from operating activities in accordance withGAAP and should not be considered as an alternative to net income (determinedin accordance with GAAP), as an indication of our financial performance or tocash flow from operating activities (determined in accordance with GAAP) as ameasure of our liquidity, nor is it indicative of funds available to fund ourcash needs, including our ability to make cash distributions.

 

Funds from Operations for the year ended December 31, 2005, and theperiod from April 12, 2004 (formation) through December 31, 2004 is as follows(amounts in thousands):

 
| ** **                                       | ** ** | **For the Year  ended  December 31,  2005** | ** ** | **For the Period  April 12, 2004  (formation)  through  December 31,  2004** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|
| Net income  available to common stockholders     |       | $                                                          | 31,371     |                                                                                                  | $          | 2,052 |   |
| Add:                                             |       |                                                       |       |                                                                                                  |       |
| Depreciation and amortization                    |       | 3,448                                                      |       | 327                                                                                                   |       |
| FFO adjustment for unconsolidated joint ventures |       | 4,804                                                      |       | —                                                                                                |       |
| Less:                                            |       |                                                       |       |                                                                                                  |       |
| Non real estate depreciation and amortization    |       | (3,133                                                     | )          | (327                                                                                                  | )          |
| Funds from  operations                           |       | $                                                          | 36,490     |                                                                                                  | $          | 2,052 |   |
|                                             |       |                                                       |       |                                                                                                  |       |
| Cash flows  provided by operating activities     |       | $                                                          | 2,160      |                                                                                                  | $          | 1,145 |   |
| Cash flows  used in investing activities         |       | $                                                          | (918,930   | )                                                                                                     | $          | (407,056 | ) |
| Cash flows  provided by financing activities     |       | $                                                          | 948,252    |                                                                                                  | $          | 444,805 |   |

 

**Recently Issued Accounting Pronouncements**

 

**SFAS No. 123(R), “Share-Based Payment, a revision of FASB Statement No.123, Accounting for Stock-Based Compensation,” requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the income statement based on their fair value.  The newstandard is effective for interim or annual reporting periods beginning afterJanuary 1, 2006. The implementation of SFAS No. 123(R) is expected to have noimpact on our financial statements.**

** **

In June 2005, the FASBratified the consensus in EITF Issue No. 04-5, or Issue 04-5, DeterminingWhether a General Partner, or the General Partners as a Group, Controls aLimited Partnership or Similar Entity When the Limited Partners Have CertainRights, which provides guidance in determining whether a general partnercontrols a limited partnership.  Issue 04-5 states that the general partnerin

 

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a limited partnership ispresumed to control that limited partnership.  The presumption may beovercome if the limited partners have either (1) the substantive ability todissolve the limited partnership or otherwise remove the general partnerwithout cause or (2) substantive participating rights, which provide thelimited partners with the ability to effectively participate in significantdecisions that would be expected to be made in the ordinary course of thelimited partnership’s business and thereby preclude the general partner fromexercising unilateral control over the partnership.  If the criteria inIssue 04-5 are met, a company could be required to consolidate certain of itsexisting unconsolidated joint ventures.  Our adoption of Issue 04-5 fornew or modified limited partnership arrangements effective June 30, 2005 andexisting limited partnership arrangements effective January 1, 2006 is notexpected to have any effect on our financial position or results of operations.

 

In March 2005, the FASB issued FASB Interpretation No. 47, or FIN 47,“Accounting for Conditional Asset Retirement Obligations” an interpretation ofFASB Statement No. 143, or SFAS 143. FIN 47 clarifies the term *conditional asset retirement obligation* inSFAS 143 as a legal obligation to perform an asset retirement activity in whichthe timing and/or method of settlement are conditional on a future event thatmay or may not be within the control of the entity.  FIN 47 clarifies that future expenses toremove asbestos from buildings should be estimated and accrued as a liabilityat the time of acquisition with an offset to increase the cost of theassociated structure. Uncertainty about the timing and/or method ofsettlement of a conditional asset retirement obligation should be factored intothe measurement of a liability when sufficient information exists. SFAS No. 143acknowledges that in some cases, sufficient information may not be available toreasonably estimate the fair value of an asset retirement obligation.  FIN47 also clarifies when an entity would have sufficient information toreasonably estimate the fair value of an asset retirement obligation.  FIN47 is effective for the year ended December 31, 2005 and did not have amaterial effect on our financial position or results of operations for 2005.

 

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**ITEM 7A.****               QUANTITATIVE AND QUALITATIVE DISCLOSUREABOUT MARKET RISK**

 

##### **MarketRisk**

##### ** **

Market risk includesrisks that arise from changes in interest rates, commodity prices, equityprices and other market changes that affect market sensitive instruments. Inpursuing our business plan, we expect that the primary market risks to which wewill be exposed are real estate and interest 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 incomedecreases, a borrower may have difficulty repaying our loans, which couldresult in losses to us. In addition, decreases in property values reduce thevalue of the collateral and the potential proceeds available to a borrower torepay our loans, which could also cause us to suffer losses. Even when aproperty’s net operating income is sufficient to cover the property’s debtservice, at the time a loan is made, there can be no assurance that this willcontinue in the future.

 

###### **Interest Rate 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. A hypothetical 100 basis point increase in interestrates along the entire interest rate curve for the year ended December 31, 2005and the period from April 12, 2004 (formation) through December 31, 2004 wouldhave increased our interest cost by approximately $5.8 million and $204,000,respectively, offset by an increase in our investment income of approximately$7.9 million and $713,000, respectively.

 

Our operating resultswill depend in large part on differences between the income from our assets andour borrowing costs. Most of our assets and borrowings are variable-rateinstruments that we finance with variable rate debt. The objective of thisstrategy is to minimize the impact of interest rate changes on the spreadbetween the yield on our assets and our cost of funds. We enter into hedgingtransactions with respect to all liabilities relating to fixed rate assets. Ifwe were to finance fixed rate assets with variable rate debt and the benchmarkfor our variable rate debt increased, our net income would decrease.Furthermore, as most of our available financing provides for an ability of thelender to mark-to-market our assets and make margin calls based on a change inthe value of our assets, financing fixed rate assets with this debt creates therisk that an increase in fixed rate benchmarks (such as “swap” yields) woulddecrease the value of our fixed rate assets. We have entered into certain swaptransactions in anticipation of drawing upon our mark-to-market debt to hedgeagainst this risk. Some of our loans are subject to various interest ratefloors. As a result, if interest rates fall below the floor rates, the spreadbetween the yield on our assets and our cost of funds will increase, which willgenerally increase our returns. Because we generate income principally from thespread between the yields on our assets and the cost of our borrowing andhedging activities, our net income will generally increase if LIBOR increasesand decreases if LIBOR decreases, but this may not always be true in thefuture. Our exposure to interest rates will also be affected by our overallcorporate leverage, which we generally target to be 70% to 80% of the carryingvalue of our assets, although our actual leverage may vary depending on our mixof 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 or defaults could have an adverse effecton the spreads between interest-earning assets and interest-bearingliabilities.

 

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**The aggregatecarrying values, allocation by product type and weighted average coupons of ourinvestments as of December 31, 2005 and 2004 were as follows:**

** **

| ** **                                           | ** ** | **Carrying Value (1)  ($ in thousands)** | ** ** | **Allocation by  Investment Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average Spread over  LIBOR (2)** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                                     | ** ** | **2004**                                     | ** ** | **2005**                                 | ** ** | **2004**                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Whole loans, floating rate                           |       | $                                                            | 561,388    |                                         | $          | 155,215                                  |       | 46                                                                     | %          | 38 | % | — |   | — |   | 325 |  bps | 373 |  bps |
| Whole loans, fixed rate                              |       | 94,448                                                       |       | —                                       |       | 8                                        | %          | —                                                                 |       | 10.64 | % | — |   | — |   | — |   |
| Subordinate interests in whole loans,  floating rate |       | 362,983                                                      |       | 209,286                                      |       | 30                                       | %          | 51                                                                     | %          | — |   | — |   | 443 |  bps | 640 |  bps |
| Subordinate interests in whole loans, fixed  rate    |       | 37,104                                                       |       | 31,216                                       |       | 3                                        | %          | 8                                                                      | %          | 9.19 | % | 9.57 | % | — |   | — |   |
| Mezzanine loans, floating rate                       |       | 82,793                                                       |       | —                                       |       | 7                                        | %          | —                                                                 |       | — |   | — |   | 858 |  bps | — |   |
| Mezzanine loans, fixed rate                          |       | 43,352                                                       |       | —                                       |       | 4                                        | %          | —                                                                 |       | 8.88 | % | — |   | — |   | — |   |
| Preferred equity, floating rate                      |       | 11,795                                                       |       | —                                       |       | 1                                        | %          | —                                                                 |       | — |   | — |   | 900 |  bps | — |   |
| Preferred equity, fixed rate                         |       | 11,882                                                       |       | —                                       |       | 1                                        | %          | —                                                                 |       | 10.28 | % | — |   | — |   | — |   |
| Commercial mortgage backed securities                |       | —                                                       |       | 10,898                                       |       | —                                   |       | 3                                                                      | %          | — |   | 13.49 | % | — |   | — |   |
| Total / Average                                      |       | $                                                            | 1,205,745  |                                         | $          | 406,615                                  |       | 100                                                                    | %          | 100 | % | 9.92 | % | 10.58 | % | 417 |  bps | 526 |  bps |

** **

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**(1)**   Debt investments arepresented after scheduled amortization payments and prepayments, and are net ofunamortized fees, discounts, asset sales and unfunded commitments.

** **

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

** **

As of December 31, 2005, ourinvestment portfolio had the following maturity characteristics:

 
| **Year of Maturity** | ** ** | **Number of  Investments  Maturing** | ** ** | **Current  Carrying Value  (In thousands)** | ** ** | **% of Total** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|--------------------------------------------------|------------|--------------------------|------------|
| 2006                           |       | 12                                        |       | $                                                | 206,457    |                     | 17         | % |
| 2007                           |       | 27                                        |       | 643,425                                          |       | 53                       | %          |
| 2008                           |       | 9                                         |       | 199,552                                          |       | 17                       | %          |
| 2009                           |       | 2                                         |       | 47,117                                           |       | 4                        | %          |
| 2010                           |       | 3                                         |       | 36,198                                           |       | 3                        | %          |
| Thereafter                     |       | 4                                         |       | 72,996                                           |       | 6                        | %          |
|                           |       | 57                                        |       | $                                                | 1,205,745  |                     | 100.00     | % |
|                           |       |                                      |       |                                             |       |                     |       |
| Weighted  average maturity     |       |                                      |       | 2.3 years                                        |  (1)  |                     |       |

 

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**(1)   The calculation of weighted average maturityis based upon the initial term of the investment and does not include option orextension periods, which may be available to the borrower.**

 

Combined aggregateprincipal maturities of our CDO, repurchase facilities, trust preferredsecurities, mortgage note payable and revolving credit facility as of December31, 2005 are as follows (amounts in thousands):

 
| ** ** | ** ** | **Collateralized  Debt  Obligations** | ** ** | **Repurchase  Facilities** | ** ** | **Trust  Preferred  Securities** | ** ** | **Mortgage  Note  Payable** | ** ** | **Revolving  Credit  Facility** | ** ** | **Total** | ** ** |
|------------|------------|---------------------------------------|------------|----------------------------|------------|----------------------------------|------------|-----------------------------|------------|---------------------------------|------------|-----------|------------|
| 2006       |       | $                                     | —     |                       | $          | —                           |       | $                           | —     |                            | $          | —    |       | $ | — |   | $ | — |   |
| 2007       |       | —                                |       | 67,717                     |       | —                           |       | —                      |       | —                          |       | 67,717    |       |
| 2008       |       | —                                |       | 49,649                     |       | —                           |       | —                      |       | —                          |       | 49,649    |       |
| 2009       |       | —                                |       | —                     |       | —                           |       | —                      |       | —                          |       | —    |       |
| 2010       |       | —                                |       | —                     |       | —                           |       | —                      |       | —                          |       | —    |       |
| Thereafter |       | 810,500                               |       | —                     |       | 100,000                          |       | 41,000                      |       | —                          |       | 951,500   |       |
|       |       | $                                     | 810,500    |                       | $          | 117,366                          |       | $                           | 100,000    |                            | $          | 41,000    |       | — |   | $ | 1,068,866 |   |
|            |            |                                       |            |                            |            |                                  |            |                             |            |                                 |            |           |            |  |  |  |  |  |  |

 

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The following table summarizes the notional and fair value of ourderivative financial instrument at December 31, 2005. All derivativeinstruments with the exception of the $15,500 swap which was entered incontemplation of a future sale transaction, have been designated as cash flowhedges. The notional value is an indication of the extent of our involvement inthis instrument at that time, but does not represent exposure to credit,interest rate or market risks (amounts in thousands):

 
| ** **          | ** ** | **Benchmark Rate** | ** ** | **Notional  Value** | ** ** | **Strike  Rate** | ** ** | **Effective  Date** | ** ** | **Expiration  Date** | ** ** | **Fair  Value** | ** ** |
|---------------------|------------|-------------------------|------------|---------------------|------------|------------------|------------|---------------------|------------|----------------------|------------|-----------------|------------|
| Interest  Rate Swap |       | 3 month LIBOR           |       | $                   | 40,000     |             | 4.42       | %                   | 7/2005     |                 | 2/2014     |            | $          | 905 |   |
| Interest  Rate Swap |       | 1 month LIBOR           |       |                | 26,235     |             | 4.188      | %                   | 6/2005     |                 | 6/2010     |            | 588        |   |
| Interest  Rate Swap |       | 1 month LIBOR           |       |                | 3,465      |             | 3.300      | %(1)                | 7/2005     | (1)                  | 2/2006     | (1)             | 60         |   |
| Interest  Rate Swap |       | 1 month LIBOR           |       |                | 31,686     |             | 3.855      | %                   | 7/2005     |                 | 11/2009    |            | 996        |   |
| Interest Rate  Swap |       | 1 month LIBOR           |       |                | 19,800     |             | 3.625      | %                   | 7/2005     |                 | 2/2006     |            | 13         |   |
| Interest  Rate Swap |       | 3 month LIBOR           |       |                | 15,500     |             | 5.135      | %                   | 12/2005    |                 | 12/2015    |            | (265       | ) |
| Interest  Rate Swap |       | 1 month LIBOR           |       |                | 3,960      |             | 4.959      | %                   | 12/2005    |                 | 12/2015    |            | (48        | ) |
| Interest  Rate Cap  |       | 3 month LIBOR           |       |                | 23,713     |             | 5.70       | %                   | 11/2005    |                 | 12/2007    |            | 20         |   |
| Interest  Rate Cap  |       | 1 month LIBOR           |       |                | 14,120     |             | 5.50       | %                   | 12/2005    |                 | 1/2007     |            | 2          |   |
|                |       |                    |       | $                   | 178,479    |             |       |                |       |                 |       |            | $          | 2,271 |   |

 

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(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. The total fair value of the initial swap andthe step-up provisions are reflected in the fair value.

 

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**ITEM 8.**** ****FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

**Index to Financial Statements and Schedules**

 
| **GRAMERCY CAPITAL CORP.**                                                                                                                                                | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|                                                                                                                                                                      |       |       |
| Report of Independent Registered Public Accounting Firm                                                                                                                   |       |       |
| Consolidated Balance Sheets as of December 31, 2005 and 2004                                                                                                         |       |       |
| Consolidated Statements of Income for the year ended  December 31, 2005 and the period from April 12, 2004 (formation) through  December 31, 2004                    |       |       |
| Consolidated Statements of Stockholders’ Equity for the year ended  December 31, 2005 and the period from April 12, 2004 (formation) through  December 31, 2004 |       |       |
| Consolidated Statements of Cash Flows for the year ended  December 31, 2004 and the period from April 12, 2004 (formation) through  December 31, 2004                |       |       |
| **Notes to Consolidated Financial Statements**                                                                                                                            | ** ** | ** ** |
| ** **                                                                                                                                                                | ** ** | ** ** |
| **Schedules**                                                                                                                                                             | ** ** | ** ** |
| ** **                                                                                                                                                                | ** ** | ** ** |
| Schedule IV Mortgage Loans on Real  Estate as of December 31, 2005                                                                                                   | ** ** |       |
|                                                                                                                                                                      | ** ** | ** ** |
| All other schedules are omitted because  they are not required or the required information is shown in the financial  statements or notes thereto.                        | ** ** | ** ** |

 

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**Report of Independent Registered PublicAccounting Firm**

 

To the Board of Directors andShareholders of Gramercy Capital Corp.

 

We have audited theaccompanying consolidated balance sheets of Gramercy Capital Corp. as ofDecember 31, 2005 and 2004, and the related consolidated statements of income,stockholders’ equity and cash flows for the year ended December 31, 2005and for the period from April 12, 2004 (formation) through December 31, 2004.Our audits also included the financial statement schedule listed in the Indexas Item 15(a)(2). These financial statements and schedule are theresponsibility of Gramercy Capital Corp.’s management.  Our responsibilityis to express an opinion on these financial statements and schedule based onour audits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includes assessing the accounting principlesused and significant estimates made by management, as well as evaluating the overallfinancial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the financialstatements referred to above present fairly, in all material respects, theconsolidated financial position of Gramercy Capital Corp. at December 31,2005 and 2004, and the consolidated results of its operations and its cashflows for the year ended December 31, 2005 and for the period from April12, 2004 (formation) through December 31, 2004, in conformity with U.S. generallyaccepted accounting principles. Also, in our opinion, the related financialstatement schedule, when considered in relation to the basic financialstatements taken as a whole, presents fairly in all material respects, theinformation set forth therein.

 

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Gramercy Capital Corp.’s internal controlover financial reporting as of December 31, 2005, based on criteria establishedin Internal Control-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated March 13, 2006expressed an unqualified opinion thereon.

 

 
| /s/                 | Ernst & Young LLP |   |
|---------------------|-----------------------|--------|
|                |
|                |
| New York,  New York |
| March 13,  2006     |

 

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**Report of Independent Registered PublicAccounting Firm**

 

**The Board of Directors and Shareholders of GramercyCapital Corp.**

** **

We have auditedmanagement’s assessment, included in the accompanying Item 9A.  Controlsand Procedures - “Management’s Report on Internal Control over FinancialReporting,” that Gramercy Capital Corp. maintained effective internal controlover financial reporting as of December 31, 2005, based on criteria established in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria). GramercyCapital Corp.’s management is responsible for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of thecompany’s internal control over financial reporting based on our audit.

 

We conducted our auditin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether effective internal controlover financial reporting was maintained in all material respects. Our auditincluded obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we considered necessary in the circumstances. We believethat our audit provides a reasonable basis for our opinion.

 

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2)provide reasonable assurance that transactions are recorded as necessary topermit preparation of financial statements in accordance with generallyaccepted accounting principles, and that receipts and expenditures of thecompany are being made only in accordance with authorizations of management anddirectors of the company; and (3) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the company’s assets that could have a material effect on the financialstatements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

In our opinion, management’sassessment that Gramercy Capital Corp. maintained effective internal controlover financial reporting as of December 31, 2005, is fairly stated, in allmaterial respects, based on the COSO criteria. Also, in our opinion, GramercyCapital Corp. maintained, in all material respects, effective internal controlover financial reporting as of December 31, 2005, based on****theCOSO criteria**.**

 

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of Gramercy Capital Corp. asof December 31, 2005 and 2004, and the related consolidated statements ofincome, stockholders’ equity and cash flows for the year endedDecember 31, 2005 and for the period from April 12, 2004 (formation)through December 31, 2004 of Gramercy Capital Corp. and our report dated March13, 2006 expressed an unqualifiedopinion thereon.

 

 
| /s/                 | Ernst & Young LLP |   |
|---------------------|-----------------------|--------|
|                |
|                |
| New York,  New York |
| March 13,  2006     |

 

56

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

 
| ** **                                                                                                                                                                        | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                        | ** ** | ** **             | ** ** | ** **             | ** ** |
| **Assets:**                                                                                                                                                                       |       |                   |       |                   |       |
| Cash and  cash equivalents                                                                                                                                                        |       | $                      | 70,576     |                   | $          | 39,094 |   |
| Restricted  cash                                                                                                                                                                  |       | 53,833                 |       | 1,901                  |       |
| Loans and  other lending investments, net                                                                                                                                         |       | 1,163,745              |       | 395,717                |       |
| Commercial  mortgage backed securities, net                                                                                                                                       |       | —                 |       | 10,898                 |       |
| Investment  in unconsolidated joint ventures                                                                                                                                      |       | 58,040                 |       | —                 |       |
| Loans held  for sale, net                                                                                                                                                         |       | 42,000                 |       | —                 |       |
| Operating  real estate, net                                                                                                                                                       |       | 51,173                 |       | —                 |       |
| Stock  subscriptions receivable                                                                                                                                                   |       | —                 |       | 60,445                 |       |
| Accrued  interest                                                                                                                                                                 |       | 7,187                  |       | 2,921                  |       |
| Deferred  financing costs                                                                                                                                                         |       | 17,488                 |       | 2,044                  |       |
| Deferred  costs                                                                                                                                                                   |       | 1,894                  |       | 189                    |       |
| Derivative  instruments, at fair value                                                                                                                                            |       | 2,271                  |       | 249                    |       |
| Other assets                                                                                                                                                                      |       | 1,603                  |       | 589                    |       |
| Total assets                                                                                                                                                                      |       | $                      | 1,469,810  |                   | $          | 514,047 |   |
|                                                                                                                                                                              |       |                   |       |                   |       |
| **Liabilities  and Stockholders’ Equity:**                                                                                                                                   |       |                   |       |                   |       |
| Repurchase  agreements                                                                                                                                                            |       | $                      | 117,366    |                   | $          | 238,885 |   |
| Collateralized  debt obligations                                                                                                                                                  |       | 810,500                |       | —                 |       |
| Mortgage  note payable                                                                                                                                                            |       | 41,000                 |       | —                 |       |
| Management  fees payable                                                                                                                                                          |       | 1,329                  |       | 416                    |       |
| Incentive  fee payable                                                                                                                                                            |       | 1,237                  |       | —                 |       |
| Dividends  payable                                                                                                                                                                |       | 10,726                 |       | 1,951                  |       |
| Accounts  payable and accrued expenses                                                                                                                                            |       | 11,561                 |       | 1,935                  |       |
| Other  liabilities                                                                                                                                                                |       | 3,687                  |       | 1,901                  |       |
| Junior subordinated deferrable interest  debentures held by trusts that issued trust preferred securities                                                                         |       | 100,000                |       | —                 |       |
| Total  liabilities                                                                                                                                                                |       | 1,097,406              |       | 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, 22,802,642 and 18,812,500 shares issued and outstanding at  December 31, 2005 and December 31, 2004, respectively |       | 22                     |       | 19                     |       |
| Additional  paid-in-capital                                                                                                                                                       |       | 369,529                |       | 268,558                |       |
| Accumulated  other comprehensive income                                                                                                                                           |       | 2,851                  |       | 282                    |       |
| Retained  earnings                                                                                                                                                                |       | 2                      |       | 100                    |       |
| Total stockholders’ equity                                                                                                                                                   |       | 372,404                |       | 268,959                |       |
| Total  liabilities and stockholders’ equity                                                                                                                                  |       | $                      | 1,469,810  |                   | $          | 514,047 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

57

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**Gramercy Capital Corp.****Consolidated Statements of Income****(Amounts in thousands, except per share data)**

 
| ** **                                                                                                     | ** ** | **For the Year  ended  December 31,  2005** | ** ** | **For the Period  April 12, 2004  (formation)  through  December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|
| **Revenues**                                                                                                   |       |                                                       |       |                                                                                                  |       |
| Investment income                                                                                              |       | $                                                          | 73,302     |                                                                                                  | $          | 6,841 |   |
| Rental revenue, net                                                                                            |       | 1,219                                                      |       | —                                                                                                |       |
| Gain on sales and other income                                                                                 |       | 13,564                                                     |       | 310                                                                                                   |       |
| Total revenues                                                                                                 |       | 88,085                                                     |       | 7,151                                                                                                 |       |
|                                                                                                           |       |                                                       |       |                                                                                                  |       |
| **Expenses**                                                                                                   |       |                                                       |       |                                                                                                  |       |
| Interest expense                                                                                               |       | 33,771                                                     |       | 1,463                                                                                                 |       |
| Management fees                                                                                                |       | 9,600                                                      |       | 1,965                                                                                                 |       |
| Incentive fee                                                                                                  |       | 2,276                                                      |       | —                                                                                                |       |
| Depreciation and amortization                                                                                  |       | 672                                                        |       | 38                                                                                                    |       |
| Marketing, general and administrative                                                                          |       | 6,976                                                      |       | 1,358                                                                                                 |       |
| Provision for loan loss                                                                                        |       | 1,030                                                      |       | —                                                                                                |       |
| Total expenses                                                                                                 |       | 54,325                                                     |       | 4,824                                                                                                 |       |
| Income from continuing operations before  equity in net loss of unconsolidated joint ventures and income taxes |       | 33,760                                                     |       | 2,327                                                                                                 |       |
| Equity in net loss of unconsolidated joint ventures                                                            |       | (1,489                                                     | )          | —                                                                                                |       |
| Income from continuing operations before income taxes and GKK  formation costs                                 |       | 32,271                                                     |       | 2,327                                                                                                 |       |
| Provision for income taxes                                                                                     |       | (900                                                       | )          | —                                                                                                |       |
| GKK formation costs                                                                                            |       | —                                                     |       | (275                                                                                                  | )          |
| Net income available to common stockholders                                                                    |       | $                                                          | 31,371     |                                                                                                  | $          | 2,052 |   |
|                                                                                                           |       |                                                       |       |                                                                                                  |       |
| **Basic  earnings per share:**                                                                                 |       |                                                       |       |                                                                                                  |       |
| Net income available to common stockholders                                                                    |       | $                                                          | 1.57       |                                                                                                  | $          | 0.15 |   |
| **Diluted  earnings per share:**                                                                               |       |                                                       |       |                                                                                                  |       |
| Net income available to common stockholders                                                                    |       | $                                                          | 1.51       |                                                                                                  | $          | 0.15 |   |
| Dividends per common share                                                                                     |       | $                                                          | 1.495      |                                                                                                  | $          | 0.00 |   |
| Basic weighted average common shares outstanding                                                               |       | 20,027                                                     |       | 13,348                                                                                                |       |
| Diluted weighted average common shares and  common share equivalents outstanding                               |       | 20,781                                                     |       | 13,411                                                                                                |       |

 

Theaccompanying notes are an integral part of these financial statements.

 

58

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**Gramercy Capital Corp.**

**ConsolidatedStatement of Stockholders’ Equity**

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

 
| ** **                                                                                                                            | ** ** | **Common  Stock** | ** ** | **Additional   Paid-  In-Capital** | ** ** | **Accumulated Other Comprehensive  Income** | ** ** | **Retained  Earnings** | ** ** | **Total**  | ** ** | **Comprehensive  Income** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------------------|------------|---------------------------------------------|------------|------------------------|------------|------------|------------|---------------------------|------------|
| ** **                                                                                                                            | ** ** | **Shares**        | ** ** | **Par Value**                      | ** ** | ** **                                  | ** ** | ** **             | ** ** | ** ** |
| **Balance at April 12, 2004 (formation)**                                                                                             |       | 500               |       | $                                  | 1          |                                        | $          | 199                    |       | $          | —     |                      | $          | — |   | $ | 200 |   | $ | — |   |
| Net income                                                                                                                            |       |              |       |                               |       |                                        |       |                   |       | 2,052      |       | 2,052                     |       | 2,052 |   |
| Net unrealized gain on derivative  instruments                                                                                        |       |              |       |                               |       |                                        |       | 282                    |       |       |       | 282                       |       | 282 |   |
| Net proceeds from common stock offerings                                                                                              |       | 18,000            |       | 18                                 |       | 267,955                                     |       |                   |       |       |       | 267,973                   |       |   |   |
| Stock-based compensation – fair value                                                                                            |       |              |       |                               |       | 404                                         |       |                   |       |       |       | 404                       |       |   |   |
| Deferred compensation plan, net                                                                                                       |       | 313               |       | —                             |       |                                        |       |                   |       |       |       | —                    |       |   |   |
| Cash distributions declared ($0.15 per  common share of which none represented a return of capital for federal income  tax purposes)  |       |              |       |                               |       |                                        |       |                   |       | (1,952     | )          | (1,952                    | )          |   |   |
| **Balance at December 31, 2004**                                                                                                      |       | 18,813            |       | 19                                 |       | 268,558                                     |       | 282                    |       | 100        |       | 268,959                   |       | $ | 2,334 |   |
| Net income                                                                                                                            |       |              |       |                               |       |                                        |       |                   |       | 31,371     |       | 31,371                    |       | $ | 31,371 |   |
| Net unrealized gain on derivative  instruments                                                                                        |       |              |       |                               |       |                                        |       | 2,569                  |       |       |       | 2,569                     |       | 2,569 |   |
| Net proceeds from common stock offerings                                                                                              |       | 3,833             |       | 3                                  |       | 96,028                                      |       |                   |       |       |       | 96,031                    |       |   |   |
| Stock-based compensation – fair value                                                                                            |       |              |       |                               |       | 1,798                                       |       |                   |       |       |       | 1,798                     |       |   |   |
| Proceeds from stock option exercises                                                                                                  |       | 131               |       | —                             |       | 1,970                                       |       |                   |       |       |       | 1,970                     |       |   |   |
| Deferred compensation plan, net                                                                                                       |       | 26                |       | —                             |       | 1,175                                       |       |                   |       |       |       | 1,175                     |       |   |   |
| Cash distributions declared ($1.495 per  common share of which none represented a return of capital for federal income  tax purposes) |       |              |       |                               |       |                                        |       |                   |       | (31,469    | )          | (31,469                   | )          |   |   |
| **Balance at December 31, 2005**                                                                                                      |       | 22,803            |       | $                                  | 22         |                                        | $          | 369,529                |       | $          | 2,851      |                      | $          | 2 |   | $ | 372,404 |   | $ | 33,940 |   |

 

The accompanying notesare an integral part of these financial statements

 

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**GramercyCapital Corp.**

**ConsolidatedStatements of Cash Flows**

**(Amountsin thousands)**

 
| ** **                                                                                                           | ** ** | **For the Year  ended  December 31,  2005** | ** ** | **For the Period April 12, 2004  (formation) through  December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| **Operating Activities**                                                                                             | ** ** | ** **                                  | ** ** | ** **                                                                 | ** ** |
| Net income available to common stockholders                                                                          |       | $                                           | 31,371     |                                                                       | $          | 2,052 |   |
| Adjustments to reconcile net income  available to common stockholders to net cash provided by operating  activities: |       |                                        |       |                                                                       |       |
| Depreciation and amortization                                                                                        |       | 3,448                                       |       | 38                                                                         |       |
| Amortization of discount on investments                                                                              |       | (1,810                                      | )          | 253                                                                        |       |
| Equity in net loss of unconsolidated joint  ventures                                                                 |       | 1,489                                       |       | —                                                                     |       |
| Amortization of stock compensation                                                                                   |       | 2,569                                       |       | —                                                                     |       |
| Provision for loan losses                                                                                            |       | 1,030                                       |       | —                                                                     |       |
| Changes in operating assets and  liabilities:                                                                        |       |                                        |       |                                                                       |       |
| New investments in loans held for sale                                                                               |       | (182,431                                    | )          | —                                                                     |       |
| Principal collections on loans held for  sale                                                                        |       | 140,431                                     |       | —                                                                     |       |
| Accrued interest                                                                                                     |       | (4,266                                      | )          | (2,921                                                                     | )          |
| Other assets                                                                                                         |       | (1,364                                      | )          | (628                                                                       | )          |
| Management fees payable                                                                                              |       | 913                                         |       | 416                                                                        |       |
| Incentive fee payable                                                                                                |       | 1,237                                       |       | —                                                                     |       |
| Accounts payable, accrued expenses and other  liabilities                                                            |       | 9,543                                       |       | 1,935                                                                      |       |
| Net cash provided by operating activities                                                                            |       | 2,160                                       |       | 1,145                                                                      |       |
| **Investing Activities**                                                                                             |       |                                        |       |                                                                       |       |
| New investment originations                                                                                          |       | (1,030,149                                  | )          | (407,603                                                                   | )          |
| Principal collections on investments                                                                                 |       | 273,897                                     |       | 736                                                                        |       |
| Investment in operating real estate                                                                                  |       | (50,616                                     | )          | —                                                                     |       |
| Investment in joint ventures                                                                                         |       | (59,529                                     | )          | —                                                                     |       |
| Change in restricted cash for investments                                                                            |       | (50,935                                     | )          | —                                                                     |       |
| Settlement of derivative instruments                                                                                 |       | 106                                         |       | —                                                                     |       |
| Deferred investment costs                                                                                            |       | (1,704                                      | )          | (189                                                                       | )          |
| Net cash used in investing activities                                                                                |       | (918,930                                    | )          | (407,056                                                                   | )          |
| **Financing Activities**                                                                                             |       |                                        |       |                                                                       |       |
| Proceeds from repurchase facilities                                                                                  |       | 815,151                                     |       | 238,885                                                                    |       |
| Repayments of repurchase facilities                                                                                  |       | (936,670                                    | )          | —                                                                     |       |
| Proceeds from issuance of collateralized  debt obligations                                                           |       | 810,500                                     |       | —                                                                     |       |
| Proceeds from mortgage note payable                                                                                  |       | 41,000                                      |       | —                                                                     |       |
| Settlement of derivative instruments                                                                                 |       | 375                                         |       | —                                                                     |       |
| Proceeds from stock options exercised                                                                                |       | 1,970                                       |       | —                                                                     |       |
| Net proceeds from sale of common stock                                                                               |       | 156,848                                     |       | 268,409                                                                    |       |
| Stock subscription receivable                                                                                        |       | —                                      |       | (60,445                                                                    | )          |
| Issuance of trust preferred securities                                                                               |       | 100,000                                     |       | —                                                                     |       |
| Deferred financing costs                                                                                             |       | (18,227                                     | )          | (2,044                                                                     | )          |
| Dividends paid                                                                                                       |       | (22,695                                     | )          | —                                                                     |       |
| Net cash provided by financing activities                                                                            |       | 948,252                                     |       | 444,805                                                                    |       |
| Net increase in cash and cash equivalents                                                                            |       | 31,482                                      |       | 38,894                                                                     |       |
| Cash and cash equivalents at beginning of  period                                                                    |       | 39,094                                      |       | 200                                                                        |       |
| Cash and cash equivalents at end of period                                                                           |       | $                                           | 70,576     |                                                                       | $          | 39,094 |   |
| **Supplemental cash flow disclosures**                                                                               |       |                                        |       |                                                                       |       |
| Interest paid                                                                                                        |       | $                                           | 22,440     |                                                                       | $          | 558 |   |
| Income taxes paid                                                                                                    |       | $                                           | 828        |                                                                       | $          | — |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

60

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**Gramercy Capital Corp.**

**Notes To Consolidated Financial Statements**

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

**December 31, 2005**

 

**1.  Organization**

** **

Gramercy Capital Corp.(the Company or Gramercy), was organized in Maryland on April 12, 2004 as acommercial real estate specialty finance company specializing in the directorigination and acquisition of whole loans, subordinate interests in wholeloans, mezzanine loans, preferred equity, and net lease investments involvingcommercial properties throughout the United States. When evaluatingtransactions, we assess our risk-adjusted return and target transactions withyields that ensure an equitable balance between risks and return.

 

Substantially all of ouroperations are conducted through GKK Capital LP, a Delaware limitedpartnership, or the Operating Partnership. We, as the sole general partner of,and holder of 100% of the common units of, the Operating Partnership, hasresponsibility and discretion in the management and control of the OperatingPartnership, and the limited partners of the Operating Partnership, in suchcapacity, have no authority to transact business for, or participate in themanagement activities of, the Operating Partnership. Accordingly, weconsolidate the accounts of the Operating Partnership.

 

We are externally managedand advised by GKK Manager LLC, or the Manager, a majority-owned subsidiary ofSL Green Realty Corp., or SL Green. At December 31, 2005, SL Green also ownedapproximately 25% of the outstanding shares of our common stock. We qualifiedas a real estate investment trust, or REIT, under the Internal Revenue Codecommencing with our taxable year ending December 31, 2004 and expect to qualifyfor the current fiscal year. To maintain our tax status as a REIT, we plan todistribute at least 90% of our taxable income. Unless the context requiresotherwise, all references to “we,” “our,” and “us” means Gramercy Capital Corp.

 

Asof December 31, 2005, we held loans and other lending investments of $1,205,745net of fees, discounts, repayments, asset sales and unfunded commitments withan average spread to LIBOR of 417 basis points for our floating rateinvestments and an average yield of 9.92% for our fixed rate investments. As ofDecember 31, 2005 we also held interests in three CTL investmentstotaling $109,213 comprised of the $51,173 carrying value of 200 FranklinSquare Drive, a 200,000 square foot building inSomerset, New Jersey which is 100% net leased to Philips Holding USA Inc, awholly-owned subsidiary of Royal Philips Electronics, through December 2021 and $58,040 in joint ventureinvestments.

 

**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 beneficiaryis the party that absorbs a majority of the VIE’s anticipated losses and/or amajority of the expected returns. We have evaluated our investments forpotential classification as variable interests by evaluating the sufficiency ofthe entities’ equity investment at risk to absorb losses, and determined thatwe are not the primary beneficiary for any of our investments. Entities whichwe do not control and entities which are VIE’s, but where we are not theprimary beneficiary, are accounted for under the equity method. All significantintercompany balances and transactions have been eliminated.

 

**Cash and Cash Equivalents**

 

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

 

**Restricted Cash**

** **

**Restricted cash consists primarily of $50,936 on deposit with the trusteeof our CDO, representing proceeds from our CDO issuance that will be used tofund future investments that will be acquired by the CDO trust. Also includedare the proceeds of repayments from loans serving as CDO collateral, which willbe used to fund investments to replace those trust assets which are repaid orsold by the trust, interest payments received by the trustee on investmentsthat serve as collateral for the CDO, which are remitted to us on a quarterlybasis in the month following the end of our fiscal quarter, and future fundingobligations on certain investments. The remaining $2,897 consists of interestreserves held on behalf of borrowers.**

 

61

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**Loans andInvestments and Loans Held for Sale**

 

Loans held for investmentare intended to be held to maturity and, accordingly, are carried at cost, netof unamortized loan origination costs and fees, discounts, repayments, sales ofpartial interests in loans, and unfunded commitments unless such loan or investmentis deemed to be impaired. Loans held for sale are carried at the lower of costor market value using available market information obtained throughconsultation with dealers or other originators of such investments. We mayoriginate or acquire preferred equity interests that allow us to participate ina percentage of the underlying property’s cash flows from operations andproceeds 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 currentpreferred equity investments do not entitle us to a percentage of theunderlying properties’ cash flows from operations or proceeds from a sale orrefinancing and are, therefore, accounted for as loans.

 

Specific valuation allowances are established for impaired loans basedon the fair value of collateral on an individual loan basis. The fair value ofthe collateral is determined by selecting the most appropriate valuation methodology,or methodologies, among several generally available and accepted in thecommercial real estate industry. The determination of the most appropriatevaluation methodology is based on the key characteristics of the collateraltype. These methodologies include the evaluation of operating cash flow fromthe property during the projected holding period, and the estimated sales valueof the collateral computed by applying an expected capitalization rate to thestabilized net operating income of the specific property, less selling costs,all of which are discounted at market discount rates.

 

If upon completion of the valuation, the fair value of the underlyingcollateral securing the impaired loan is less than the net carrying value ofthe loan, an allowance is created with a corresponding charge to the provisionfor loan losses. The allowance for each loan is maintained at a level webelieve is adequate to absorb probable losses. At December 31, 2005 wemaintained a reserve of $1,030.

 

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

 

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

 

Mortgage-backedsecurities, or MBS, are classified as available-for-sale securities. As aresult, changes in fair value will be recorded as a balance sheet adjustment toaccumulated other comprehensive income, which is a component of stockholdersequity, rather than through our statement of operations. If available-for-salesecurities were classified as trading securities, there could be substantiallygreater volatility in earnings from period-to-period as these investments wouldbe marked to market and any reduction in the value of the securities versus theprevious carrying value would be considered an expense on our statement ofoperations. We had no investments as of December 31, 2005 that were accountedfor as trading securities.

 

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

 

All MBS are carried onthe balance sheet at fair value. We determine the fair value of MBS based onthe types of securities in which we have invested. For liquid, investment-gradesecurities, we consult with dealers of such securities to periodically obtainupdated market pricing for the same or similar instruments. For non-investmentgrade securities, we actively monitor the performance of the underlyingproperties and loans and update our pricing model to reflect changes inprojected cash flows. The value of the securities is derived by applyingdiscount rates to such cash flows based on current market yields. The yields employedare obtained from our own experience in the market, advice from dealers and/orinformation obtained in consultation with other investors in similarinstruments. Because fair value estimates may vary to some degree, we must makecertain judgments and assumptions about the appropriate price to use tocalculate the fair values for financial reporting purposes. Different judgmentsand assumptions could result in different presentations of value.

 

When the fair value of an available-for-sale security is less than theamortized cost, we consider whether there is an other-than-temporary impairmentin the value of the security (for example, whether the security will be soldprior to the recovery of fair value). If, in our judgment, 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. The determination of other-than-temporary impairmentis a subjective process, and different judgments and assumptions could affectthe timing of loss realization.

 

#### **Credit Tenant LeaseInvestments**

 

Credit tenantlease, or CTL, investments are recorded at cost less accumulated depreciation. Costsdirectly related to the acquisition of 

 

62

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suchinvestments are capitalized. Certain improvements are capitalized when they aredetermined to increase the useful life of the building. Capitalized items aredepreciated using the straight-line method over the shorter of the useful livesof the capitalized item or 40 years for buildings or facilities, the remaininglife of the facility for facility improvements, four to seven years forpersonal property and equipment, and the shorter of the remaining lease term orthe expected life for tenant improvements.

 

Results ofoperations of properties acquired are included in the Statement of Operationsfrom the date of acquisition.

 

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 anasset is held for sale, depreciation expense and straight-line rent adjustmentsare no longer recorded and historic results are reclassified as DiscontinuedOperations.

 

In accordance with FASBNo. 141, or SFAS 141, “Business Combinations,” we allocate the purchase priceof real 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 evaluation under SFAS No. 141 of our acquisition of200 Franklin Square Drive, we recorded a liability of $872 representing the netvalue of the acquired below-market lease and assumed lease origination costs. Werecognized a decrease of approximately $22 in rental revenue for the year endedDecember 31, 2005 for the amortization of the below-market lease and leaseorigination costs including leasing commissions and tenant improvement coststhat would be borne by us, resulting from the reallocation of the purchaseprice of the property.

 

At December 31, 2005 we held interests in three CTLinvestments totaling $109,213 comprised of the $51,173 carrying value of 200Franklin Square Drive, net of $315 of depreciation, and $58,040 in jointventure investments.

 

**Investments in Unconsolidated Joint Ventures**

 

#### **We account for our investments in unconsolidated jointventures under the equity method of accounting since we exercise significantinfluence, but do not unilaterally control, the entities and are not consideredto be the primary beneficiary under FIN 46.  In the joint ventures, therights of the other investor are protective and participating. Unless we aredetermined to be the primary beneficiary, these rights preclude us fromconsolidating the investments.  The investments are recorded initially atcost as an investment in unconsolidated joint ventures, and subsequently areadjusted for equity in net income (loss) and cash contributions anddistributions.  Any difference between the carrying amount of theinvestments on our balance sheet and the underlying equity in net assets isamortized as an adjustment to equity in net income (loss) of unconsolidatedjoint ventures over the lesser of the joint venture term or 40 years. None of the joint venture debt is recourse to us.**

#### ** **

#### **Revenue Recognition**

 

Interest income on debtinvestments is recognized over the life of the investment using the effectiveinterest method and recognized on the accrual basis. Fees received inconnection with loan commitments are deferred until the loan is funded and arethen recognized over the term of the loan as an adjustment to yield. Anticipatedexit fees, whose collection is expected, are also recognized over the term ofthe loan as an adjustment to yield. Fees on commitments that expire unused arerecognized at expiration. Fees received in exchange for the credit enhancementof another lender, either subordinate or senior to us, in the form of aguarantee are recognized 

 

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over the term of thatguarantee using the straight-line method.

 

Income recognition is generally suspended fordebt investments at the earlier of the date at which payments become 90 dayspast due or when, in our opinion, a full recovery of income and principalbecomes doubtful. Income recognition is resumed when the loan becomescontractually current and performance is demonstrated to be resumed.

 

In some instances we may sell all or aportion of our investments to a third party. To the extent the fair 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. To theextent an investment that is sold has a discount or fees, which were deferredat the time the investment was made and were being recognized over the term ofthe investment, the unamortized portion of the discount or fees are recognizedat the time of sale and recorded as a gain on the sale of the investmentthrough other income. We recognized $10,474 in gains from the sale of debtinvestments, of which $1,849 represents the recognition of unamortizeddiscounts or fees at the time of sale, for the year ended December 31, 2005.

 

Rental revenue is recognized on a straight-line basis over the term ofthe lease. The excess of rents recognized over amounts contractually duepursuant to the underlying leases is included in other assets on theaccompanying balance sheets. We may establish, on a current basis, an allowanceagainst this account for future potential tenant credit losses which may occur.The balance reflected on the balance sheet will be net of such allowance.

 

In addition to base rent, the tenants in our CTL investments also pay alloperating costs of owned property including real estate taxes.

 

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

 

The expense for possible credit losses inconnection with debt investments is the charge to earnings to increase theallowance for possible credit losses to the level that management estimates tobe adequate considering delinquencies, loss experience and collateral quality. Otherfactors considered relate to geographic trends and project diversification, thesize of the portfolio and current economic conditions. Based upon thesefactors, we may establish the provision for possible credit losses byindividual asset or category of asset. When it is probable that we will beunable to collect all amounts contractually due, the account is consideredimpaired.

 

Where impairment is indicated, a valuationwrite-down or write-off is measured based upon the excess of the recordedinvestment amount over the net fair value of the collateral, as reduced byselling costs. Any deficiency between the carrying amount of an asset and thenet sales price of foreclosed collateral is charged to the allowance for creditlosses. At December 31, 2005 we maintained a reserve for possible credit lossesof $1,030 against investments with a carrying value of $68,293.

 

**Deferred Costs**

 

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

 

**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 termsof the respective agreements and the amortization is reflected in interestexpense. Unamortized deferred financing costs are expensed when the associateddebt is refinanced or repaid before maturity. Costs incurred in seekingfinancing transactions, which do not close, are expensed in the period in whichit is determined that the financing will not close.

 

**Stock Based Compensation Plans**

 

Wehave a stock-based compensation plan, described more fully in Note 13. Weaccount for this plan using the fair value recognition provisions of FASBStatement No. 123, or SFAS 123, “Accounting for Stock-Based Compensation.”

 

TheBlack-Scholes option-pricing model was developed for use in estimating the fairvalue of traded options, which have no vesting restrictions and are fullytransferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Becauseour plan has characteristics significantly different from those of tradedoptions and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in our opinion, the existing 

 

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modelsdo not necessarily provide a reliable single measure of the fair value of ourstock options.

 

Compensation cost for stock options, if any, is recognized ratably overthe vesting period of the award. Our policy is to grant options with anexercise price equal to the quoted closing market price of our stock on thebusiness 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         |       | 4.16      | %          | 4.10     | %          |
| Expected  stock price volatility |       | 19.1      | %          | 18.0     | %          |

 

**Incentive Distribution (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 onthe Class B limited partner interests as an incentive distribution expense inthe period when earned and when payment of such amounts has become probable andreasonably estimable in accordance with the partnership agreement. These cashdistributions will reduce the amount of cash available for distribution to ourcommon unitholders in our Operating Partnership and to common stockholders. Weincurred approximately $2,276 with respect to such Class B limited partnerinterests for the year ended December 31, 2005 and $0 in 2004.

 

#### **Derivative Instruments**

 

**In thenormal course of business, we use a variety of derivative instruments tomanage, or hedge, interest rate risk. We require that hedging derivativeinstruments be effective in reducing the interest rate risk exposure that theyare designated to hedge. This effectiveness is essential for qualifying forhedge accounting. Some derivative instruments are associated with ananticipated transaction. In those cases, hedge effectiveness criteria alsorequire that it be probable that the underlying transaction occurs. Instrumentsthat meet these hedging criteria are formally designated as hedges at theinception 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 to determinefair value. All methods of assessing fair value result in a generalapproximation of value, and such value may never actually be realized.**

** **

In the normal course of business, we are exposed to the effect ofinterest rate changes and limit these risks by following established riskmanagement policies and procedures including the use of derivatives. To addressexposure 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 vanilla derivatives.These derivatives typically include interest rate swaps, caps, collars andfloors. We also use total rate of return swaps, or TROR swaps, which are tied tothe Lehman Brothers CMBS index. We expressly prohibit the use of unconventionalderivative instruments and using derivative instruments for trading orspeculative purposes. Further, we have a policy of only entering into contractswith major financial institutions based upon their credit ratings and otherfactors.

 

**FASB No. 133, or SFAS 133, “Accounting for Derivative Instruments andHedging Activities,” as amended by FASB No. 149, requires us to recognize allderivatives on the balance sheet at fair value. Derivatives that are not hedgesmust be adjusted to fair value through income. If a derivative is a hedge,depending on the nature of the hedge, changes in the fair value of 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. Theineffective portion of a derivative’s change in fair value will be immediately**

 

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**recognized in earnings. SFAS 133 may increase or decrease reported netincome and stockholders’ equity prospectively, depending on future levels ofLIBOR, swap spreads and other variables affecting the fair values of derivativeinstruments and hedged items, but will have no effect on cash flows, providedthe contract is carried through to full term.**

** **

We may employ swaps, forwards or purchased options to hedge qualifyingforecasted transactions. Gains and losses related to these transactions aredeferred and recognized in net income as interest expense in the same period orperiods that the underlying transaction occurs, expires or is otherwiseterminated.

 

All hedges held by us are deemed to be effective in meeting the hedgingobjectives established by our corporate policy governing interest rate riskmanagement. The effect of our derivative instruments on our financialstatements is discussed more fully in Note 17.

 

**IncomeTaxes**

 

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 mustmeet certain organizational and operational requirements, including arequirement to distribute at least 90% of our ordinary taxable income tostockholders. As a REIT, we generally will not be subject to federal income taxon taxable income that we distribute to our stockholders. If we fail to qualifyas a REIT in any taxable year, we will then be subject to federal income taxeson our taxable income at regular corporate rates and we will not be permittedto qualify for treatment as a REIT for federal income tax purposes for fouryears following the year during which qualification is lost unless the InternalRevenue Service grants us relief under certain statutory provisions. Such anevent could materially adversely affect our net income and net cash availablefor distributions to stockholders. However, we believe that we will beorganized and operate in such a manner as to qualify for treatment as a REITand we intend to operate in the foreseeable future in such a manner so that wewill qualify as a REIT for federal income tax purposes. We may, however, besubject to certain state and local taxes.

 

Our taxable REIT subsidiaries, individually referredto as a TRS, are subject to federal, state and local taxes.

 

**Underwriting Commissions and Costs**

 

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

 

**FormationCosts**

 

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 EPSexcludes dilution and is computed by dividing net income available to commonstockholders by the weighted average number of common shares outstanding duringthe period. Diluted EPS reflects the potential dilution that could occur ifsecurities or other contracts to issue common stock were exercised or convertedinto common stock, where such exercise or conversion would result in a lowerEPS amount.

 

**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.

 

**Reclassification**

 

Certain prior yearbalances have been reclassified to conform with the current year presentation.

 

**Concentrations of Credit Risk**

 

**Financial instruments that potentially subject us to concentrations ofcredit risk consist primarily of cash investments, debt investments andaccounts receivable. Gramercy places its cash investments in excess of insuredamounts with high quality financial institutions. Our Manager performs ongoinganalysis of credit risk concentrations in our debt investment portfolio byevaluating exposure to various markets, underlying property types, investmentstructure, term, sponsors, tenants and other credit metrics. Four investmentsaccounted for more than 20% of the total carrying value of our debt investmentsas of December 31, 2005. Two investments accounted for more than 37% of thetotal carrying value of our debt investments as of December 31, 2004. Threeinvestments accounted for approximately 25% of the revenue earned on our debtinvestments for the year ended December 31, 2005. Two investments accounted forapproximately 58% of**

 

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**the revenue earned on our debt investments for the period from April 12,2004 (formation) through December 31, 2004.**

** **

**Recently Issued AccountingPronouncements**

 

**SFAS No. 123(R), “Share-Based Payment, a revision of FASB Statement No.123, Accounting for Stock-Based Compensation,” requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the income statement based on their fair value.  The newstandard is effective for interim or annual reporting periods beginning afterJanuary 1, 2006. The implementation of SFAS No. 123(R) is expected to have noimpact on the our financial statements.**

** **

In June 2005, the FASBratified the consensus in EITF Issue No. 04-5, or Issue 04-5, DeterminingWhether a General Partner, or the General Partners as a Group, Controls aLimited Partnership or Similar Entity When the Limited Partners Have CertainRights, which provides guidance in determining whether a general partnercontrols a limited partnership.  Issue 04-5 states that the generalpartner in a limited partnership is presumed to control that limitedpartnership.  The presumption may be overcome if the limited partners haveeither (1) the substantive ability to dissolve the limited partnership orotherwise remove the general partner without cause or (2) substantiveparticipating rights, which provide the limited partners with the ability toeffectively participate in significant decisions that would be expected to bemade in the ordinary course of the limited partnership’s business and therebypreclude the general partner from exercising unilateral control over thepartnership.  If the criteria in Issue 04-5 are met, a company could berequired to consolidate certain of its existing unconsolidated joint ventures. Our adoption of Issue 04-5 for new or modified limited partnershiparrangements effective June 30, 2005 and existing limited partnershiparrangements effective January 1, 2006 is not expected to have any effect onour financial position or results of operations.

 

In March 2005, the FASBissued FASB Interpretation No. 47, or FIN 47, “Accounting for Conditional AssetRetirement Obligations” an interpretation of FASB Statement No. 143, or SFAS143. FIN 47 clarifies the term *conditionalasset retirement obligation* in SFAS 143 as a legal obligation toperform an asset retirement activity in which the timing and/or method ofsettlement are conditional on a future event that may or may not be within thecontrol of the entity.  FIN47 clarifies that future expenses to remove asbestos from buildings should beestimated and accrued as a liability at the time of acquisition with an offsetto increase the cost of the associated structure. Uncertainty about thetiming and/or method of settlement of a conditional asset retirement obligationshould be factored into the measurement of a liability when sufficientinformation exists. SFAS No. 143 acknowledges that in some cases, sufficientinformation may not be available to reasonably estimate the fair value of anasset retirement obligation.  FIN 47 also clarifies when an entity wouldhave sufficient information to reasonably estimate the fair value of an assetretirement obligation.  FIN 47 is effective for the year ended December31, 2005 and did not have a material effect on our financial position orresults of operations for 2005.

 

**3.             Loansand Other Lending Investments**

 

**The aggregatecarrying values, allocated by product type and weighted average coupons of ourloans and other lending investments as of December 31, 2005 and 2004 were asfollows:**

 
| ** **                                           | ** ** | **Carrying Value (1)  ($ in thousands)** | ** ** | **Allocation by  Investment Type** | ** ** | **Fixed Rate:  Average Yield** | ** ** | **Floating Rate:  Average Spread over  LIBOR (2)** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------|------------|--------------------------------|------------|----------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                      | ** ** | **2004**                           | ** ** | **2005**                       | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Whole loans, floating rate                           |       | $                                             | 561,388    |                               | $          | 155,215                        |       | 46                                                 | %          | 38 | % | — |   | — |   | 325 | bps | 373 | bps |
| Whole loans, fixed rate                              |       | 94,448                                        |       | —                             |       | 8                              | %          | —                                             |       | 10.64 | % | — |   | — |   | — |   |
| Subordinate interests in whole loans,  floating rate |       | 362,983                                       |       | 209,286                            |       | 30                             | %          | 51                                                 | %          | — |   | — |   | 443 | bps | 640 | bps |
| Subordinate interests in whole loans, fixed  rate    |       | 37,104                                        |       | 31,216                             |       | 3                              | %          | 8                                                  | %          | 9.19 | % | 9.57 | % | — |   | — |   |
| Mezzanine loans, floating rate                       |       | 82,793                                        |       | —                             |       | 7                              | %          | —                                             |       | — |   | — |   | 858 | bps | — |   |
| Mezzanine loans, fixed rate                          |       | 43,352                                        |       | —                             |       | 4                              | %          | —                                             |       | 8.88 | % | — |   | — |   | — |   |
| Preferred equity, floating rate                      |       | 11,795                                        |       | —                             |       | 1                              | %          | —                                             |       | — |   | — |   | 900 | bps | — |   |
| Preferred equity, fixed rate                         |       | 11,882                                        |       | —                             |       | 1                              | %          | —                                             |       | 10.28 | % | — |   | — |   | — |   |
| Commercial mortgage backed securities                |       | —                                        |       | 10,898                             |       | —                         |       | 3                                                  | %          | — |   | 13.49 | % | — |   | — |   |
| Total / Average                                      |       | $                                             | 1,205,745  |                               | $          | 406,615                        |       | 100                                                | %          | 100 | % | 9.92 | % | 10.58 | % | 417 | bps | 526 | bps |

 

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**(1) Debt investments arepresented after scheduled amortization payments and prepayments, and are net ofunamortized fees, discounts, asset sales and unfunded commitments.**

 

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**(2)**          Spreadsover an index other than LIBOR have been adjusted to a LIBOR based equivalent.

 

**The carryingvalue of our loans and other lending investments is net of unamortized fees anddiscounts of $13,336 and $9,409 at December 31, 2005 and 2004, respectively andunfunded commitments of $107,281 and $11,390 at December 31, 2005 and 2004,respectively.**

** **

As of December 31, 2005, our investment portfolio had the followingmaturity characteristics:

 

| **Year of Maturity**       | ** ** | **Number of  Investments  Maturing** | ** ** | **Current   Carrying Value  (In thousands)** | ** ** | **% of Total** | ** ** |
|----------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|----------------|------------|
| 2006                       |       | 12                                   |       | $                                            | 206,457    |           | 17         | % |
| 2007                       |       | 27                                   |       | 643,425                                      |       | 53             | %          |
| 2008                       |       | 9                                    |       | 199,552                                      |       | 17             | %          |
| 2009                       |       | 2                                    |       | 47,117                                       |       | 4              | %          |
| 2010                       |       | 3                                    |       | 36,198                                       |       | 3              | %          |
| Thereafter                 |       | 4                                    |       | 72,996                                       |       | 6              | %          |
|                       |       | 57                                   |       | $                                            | 1,205,745  |           | 100        | % |
|                       |       |                                 |       |                                         |       |           |       |
| Weighted  average maturity |       |                                 |       | 2.3 years                                    |       |           |       |

 

For year ended December31, 2005 and the period from April 12, 2004 (formation) through December 31,2004 the Company’s investment income from debt investments was generated by thefollowing investment types:

 

| ** **                            | ** ** | **For the Year Ended  December 31, 2005** | ** ** | **For the Period April 12,  2004 (formation)  through December 31,  2004** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| **Investment Type**                   | ** ** | **Investment Income**                     | ** ** | **% of  Total**                                                            | ** ** | **Investment Income** | ** ** | **%****of  Total** | ** ** |
| Whole loans                           |       | $                                         | 30,331     |                                                                       | 41         | % | 782 |   | 11 | % |
| Subordinate  interests in whole loans |       |                                      | 29,630     |                                                                       | 41         | % | $ | 5,499 |   | 80 | % |
| Mezzanine  loans                      |       | 10,356                                    |       | 14                                                                         | %          | — |   | — |   |
| Preferred  Equity                     |       | 1,574                                     |       | 2                                                                          | %          | — |   | — |   |
| CMBS                                  |       | 1,411                                     |       | 2                                                                          | %          | 560 |   | 9 | % |
|                                  |       | $                                         | 73,302     |                                                                       | 100        | % | $ | 6,841 |   | 100 | % |

 

At December 31, 2005 and2004, our debt investment portfolio had the following geographicdiversification:

 

| ** ** | ** ** | **2005**           | ** ** | **2004**        | ** ** |
|------------|------------|--------------------|------------|-----------------|------------|
| **Region** | ** ** | **Carrying Value** | ** ** | **% of  Total** | ** ** | **Carrying Value** | ** ** | **% of  Total** | ** ** |
| Northeast  |       | $                  | 464,054    |            | 39         | % | $ | 185,081 |   | 46 | % |
| West       |       | 378,040            |       | 31              | %          | 20,804 |   | 5 | % |
| South      |       | 258,511            |       | 21              | %          | 126,493 |   | 31 | % |
| Midwest    |       | 74,949             |       | 6               | %          | 26,284 |   | 6 | % |
| Various    |       | 30,191             |       | 3               | %          | 47,953 |   | 12 | % |
| Total      |       | $                  | 1,205,745  |            | 100        | % | $ | 406,615 |   | 100 | % |

 

For the year ended December 31, 2005, werecognized $10,474 in gains from the sale of eight fixed and two floating ratedebt investments totaling $182,035, of which $1,849 represents the recognitionof unamortized discounts or fees at the time of sale.

 

At December 31, 2005 we maintained a reserve for possible credit lossesof $1,030 against debt investments with a carrying value of $68,293. For theperiod during which a reserve was carried, these investments generated interestincome of $2,413 and income 

 

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recognition remained current. We did not maintain a reserve during2004.

 

In connection with apreferred equity investment we have guaranteed a portion of the outstandingprincipal balance of the first mortgage loan, up to approximately $1,400, thatis a financial obligation of the entity in which we have invested in the eventof a borrower default under such loan. The loan matures in 2032. This guaranteeis considered to be an off-balance-sheet arrangement. As compensation, wereceived a credit enhancement fee of $125 from the borrower, which isrecognized 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 under this guarantee is approximately $1,400as of December 31, 2005. Under the terms of the guarantee, the investmentsponsor is required to reimburse us for the entire amount paid under theguarantee until the guarantee expires.

 

**4. Investments in Unconsolidated Joint Ventures**

** **

***South Building at One Madison Avenue, New York, New York***

** **

**On April 29,2005, we closed on a $57,503 initial investment in a joint venture with SLGreen to acquire, own and operate the South Building located at One MadisonAvenue, New York, New York, or the Property. The joint venture is owned 45% byour wholly-owned subsidiary and 55% by a wholly-owned subsidiary of SL Green. Thejoint venture interests are *pari passu*. Alsoon April 29, 2005, the joint venture completed the acquisition of the Propertyfrom Metropolitan Life Insurance Company for the purchase price ofapproximately $802,800 plus closing costs, financed in part through a $690,000first mortgage loan on the Property. The first mortgage is non-recourse to us. TheProperty comprises approximately 1.2 million square feet and is almost entirelynet leased to Credit Suisse Securities (USA) LLC, or CS, pursuant to a leasewith a 15-year remaining term. As of December 31, 2005 the investment has acarrying value of $56,890. For the year ended December 31, 2005, we recordedour pro rata share of net losses of the joint venture of $1,358.**

** **

***101 S. Marengo Avenue, Pasadena, California***

** **

**On November29, 2005 we closed on the purchase of a 50% interest in an office building inPasadena, CA. We also acquired an interest in certain related assets as part ofthe transaction. The three hundred forty five thousand square foot officeproperty, which is net leased to Bank of America through September 2015,assuming the exercise of options, and related collateral were acquired for$52,000 plus closing costs, using a non-recourse, $50,000, 10-year fixed-ratefirst mortgage loan. As of December 31, 2005 the investment has a carryingvalue of $1,150. For the year ended December 31, 2005, we recorded our pro ratashare of net losses of the joint ventures of $131.**

** **

**5. Property Acquisition**

** **

***200 Franklin Square Drive***

** **

On September 6,2005, we closed on the acquisition of a 100% fee interest in 200 FranklinSquare Drive, located in Somerset, New Jersey. The property is a two hundredthousand square foot building which is 100% net leased to Philips Holding USAInc, a wholly-owned subsidiary of Royal Philips Electronics, through December2021. The property was acquired for a purchase price of $50,250, excludingclosing costs, and financed with a $41,000, 10-year, fixed-rate first mortgageloan.

 

The following is a schedule of future minimum rent payments to bereceived under the lease with Philips Holding USA Inc.:

 

| ** ** | ** ** | **Rent  Payments** | ** ** |
|------------|------------|--------------------|------------|
| 2006       |       | $                  | 3,300      |   |
| 2007       |       | 3,581              |       |
| 2008       |       | 3,581              |       |
| 2009       |       | 3,581              |       |
| 2010       |       | 3,581              |       |
| Thereafter |       | 42,116             |       |
|       |       | $                  | 59,740     |   |

 

**6. Junior Subordinated Debentures**

 

**On May 20,2005 we completed the issuance of $50,000 in unsecured trust preferredsecurities through a newly formed Delaware statutory**

 

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**trust,Gramercy Capital Trust I, or GCTI, that is a wholly-owned subsidiary of theOperating Partnership. The securities bear interest at a fixed rate of 7.57%for the first ten years ending June 2015. Thereafter the rate will float basedon the three-month LIBOR plus 300 basis points.**

** **

**On August 9,2005 we completed an additional issuance of $50,000 in unsecured trustpreferred securities through a separate newly formed Delaware statutory trust,Gramercy Capital Trust II, or GCTII, that is also a wholly-owned subsidiary ofthe Operating Partnership. The securities bear interest at a fixed rate of7.75% for the first ten years ending October 2015. Thereafter the rate willfloat based on the three-month LIBOR plus 300 basis points.**

** **

**Both issuancesof trust preferred securities require quarterly interest distributions;however, payments may be deferred while the interest expense is accrued for aperiod of up to four consecutive quarters if the Operating Partnershipexercises its right to defer such payments. The trust preferred securities areredeemable, at the option of the Operating Partnership, in whole or in part,with no prepayment premium any time after June 30, 2010 for the securitiesissued in May 2005, and October 30, 2010 for the securities issued in August2005.**

** **

**GCTI and GCTIIeach issued $1,550 aggregate liquidation amount of common securities,representing 100% of the voting common stock of GCTI and GCTII to the OperatingPartnership for a total purchase price of $3,100. GCTI and GCTII used theproceeds from the sale of the trust preferred securities and the commonsecurities to purchase the Operating Partnership’s junior subordinated notes. Theterms of the junior subordinated notes match the terms of the trust preferredsecurities. The notes are subordinate and junior in right of payment to allpresent and future senior indebtedness and certain other of our financialobligations. We realized net proceeds from each offering of approximately$48,956.**

** **

Our interests in GCTI and GCTII are accountedfor using the equity method and the assets and liabilities of GCTI and GCTIIare not consolidated into our financial statements. Interest on the juniorsubordinated notes is included in interest expense on our consolidated incomestatements while the junior subordinated notes are presented as a separate itemin our consolidated balance sheet.

 

In January 2006 we completed an additionalissuance of $50,000 in unsecured trust preferred securities as outlined in Note23.

 

**7. Collateralized Debt Obligations**

 

On July 14, 2005, we issued approximately $1,000,000 of CDOs throughtwo newly-formed indirect subsidiaries, Gramercy Real Estate CDO 2005-1Ltd., or the Issuer, and Gramercy Real Estate CDO 2005-1 LLC, or the Co-Issuer.The CDO consists of $810,500 of investment grade notes, and $84,500 ofnon-investment grade notes, which were co-issued by the Issuer and theCo-Issuer, and $105,000 of preferred shares, which were issued by the Issuer. Weretained all non-investment grade securities, the preferred shares and thecommon shares in the Issuer. The Issuer holds assets, consisting primarily ofwhole loans, subordinate interests in whole loans, mezzanine loans andpreferred equity investments, which serve as collateral for the CDO. Theinvestment grade notes were issued with floating rate coupons with a combinedweighted average rate of three-month LIBOR plus 0.49%. The CDO may bereplenished, pursuant to certain rating agency guidelines relating to creditquality and diversification, with substitute collateral for loans that arerepaid during the first five years of the CDO. Thereafter, the CDO securitieswill be retired in sequential order from senior-most to junior-most as loansare repaid. We incurred approximately $11,770 of issuance costs, which isamortized 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 thesale of the investment grade notes issued were used to repay substantially alloutstanding debt under our repurchase agreements and to fund additionalinvestments. The CDO was collateralized by investments with a carrying value of$955,287 at December 31, 2005.

 

**8. Debt Obligations**

 

#### **Repurchase and CreditFacilities**

 

**We have threefacilities: one repurchase facility and one credit facility with Wachovia orone or more of its affiliates and one repurchase facility with Goldman Sachs.**

** **

The first facility withWachovia is a $500,000 repurchase facility. This facility was increased to$350,000 from $250,000 effective January 3, 2005, and subsequently increased to$500,000 effective April 22, 2005. As part of the April 2005 increase to$500,000, the initial term of the facility was modified to reflect staggeredmaturities in which $250,000 matures in August 2007, $150,000 matures inDecember 2007 and the remaining $100,000 matures in June 2008. Also inconjunction with the April 2005 increase, the $50,000 repurchase facility wepreviously maintained with Wachovia was consolidated into the $500,000repurchase facility. The $500,000 facility bears interest at spreads of 1.15%to 3.50% over a 30-day LIBOR and, based on our expected investment activities,provides 

 

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for advance rates thatvary from 60% to 100% based upon the collateral provided under a borrowing basecalculation. The lender has a consent right to the inclusion of investments inthis facility, determines periodically the market value of the investments, andhas the right to require additional collateral if the estimated market value ofthe included investments declines. We had no accrued interest and borrowings of$67,717 at a weighted average spread to LIBOR of 1.50% and $238,885 at aweighted average spread to LIBOR of 1.99% under this facility at December 31,2005 and 2004, respectively. We can utilize the $25,000 revolving creditfacility described below to fund requirements for additional collateralpursuant to the repurchase facility or to fund the acquisition of assets.

 

Borrowings under the Wachovia facility atDecember 31, 2005 and 2004 were secured by the following investments:

 

| ** **                            | ** ** | **Carrying Value (1)** | ** ** |
|---------------------------------------|------------|------------------------|------------|
| **Investment Type**                   | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Whole loans                           |       | $                      | 33,223     |   | $ | 113,216 |   |
| Subordinate  interests in whole loans |       | 74,689                 |       | 200,745 |   |
| CDO  securities                       |       | 49,500                 | (2)        | — |   |
| CMBS                                  |       | —                 |       | 10,898 |   |
|                                  |       | $                      | 157,412    |   | $ | 324,859 |   |

 

----

**(1)**          Approximates fair value.

**(2)**          Represents the BB rated securities in our CDOthat were retained by us.

 

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 forliquidity purposes bear interest at a rate equal to a spread over LIBOR of 525basis points. Amounts drawn under this facility for acquisition purposes bearinterest at a spread over LIBOR of 225 basis points. Amounts drawn under thisfacility for liquidity purposes must be repaid within 105 days. Amounts drawnunder this facility generally will be secured by assets established under aborrowing base calculation unless certain financial covenants are satisfied. Thesecovenants are generally more restrictive than those set forth below. AtDecember 31, 2005 and 2004 we had no borrowings under this facility.

 

We have an additional repurchase facility of $200,000 with GoldmanSachs Mortgage Company, an affiliate of Goldman Sachs & Co. This facilityhas an initial term of three years expiring in January 2008 with one six-monthextension option. This facility bears interest at spreads of 1.00% to 2.75%over a 30-day LIBOR and, based on our expected investment activities, providesfor advance rates that vary from 40% to 85% based upon the collateral providedunder a borrowing base calculation. As with the Wachovia facility, the lenderhas a consent right to the inclusion of investments in this facility,determines periodically the market value of the investments, and has the rightto require additional collateral if the estimated market value of the includedinvestments declines. We had accrued interest of $163 and borrowings of $49,649under this facility at a weighted average spread to LIBOR of 1.71% at December31, 2005.

 

Borrowings under the Goldman facility atDecember 31, 2005 and 2004 were secured by the following investments:

 

| ** **          | ** ** | **Carrying Value (1)** | ** ** |
|---------------------|------------|------------------------|------------|
| **Investment Type** | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Whole loans         |       | $                      | 59,457     |   | $ | — |   |
|                |       | $                      | 59,457     |   | $ | — |   |

 

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**(1)**          Approximates fair value.

** **

The terms of both of our repurchase facilities and our credit facilityinclude covenants that****(a) limitour maximum total indebtedness to no more than 85% of total assets, (b) requireus to maintain minimum liquidity of at least $10,000 for the first two yearsand $15,000 thereafter, (c) our fixed charge coverage ratio shall at no time beless than 1.50 to 1.00, (d) our minimum interest coverage ratio shall at no timebe less than 1.75 to 1.00, (e) require us to maintain minimum tangible networth of not less than the greater of (i) $129,750, or (i) plus (ii) 75% of theproceeds of our subsequent equity issuances and (f) restrict the maximum amountof 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 

 

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distributions necessary to maintain our REIT status. Under our facility with Wachovia an event ofdefault will be triggered if GKK Manager LLC ceases to be the Manager. As ofDecember 31, 2005, we were in compliance with all such covenants.

 

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

 

In certain circumstances, we have purchased debt investments from acounterparty and subsequently financed the acquisition of those debtinvestments through repurchase agreements with the same counterparty. Wecurrently record the acquisition of the debt investments as assets and therelated repurchase agreements as financing liabilities gross on theconsolidated balance sheets. Interest income earned on the debt investments andinterest expense incurred on the repurchase obligations are reported gross onthe consolidated income statements. However, under a certain technicalinterpretation of FAS 140, such transactions may not qualify as a purchase by us. We believe, and it is industry practice,that we are accounting for these transactions in an appropriate manner.  However, the result of this technicalinterpretation would prevent us from presenting the debt investments andrepurchase agreements and the related interest income and interest expense on agross basis on our financial statements. Instead, we would present the netinvestment in these transactions with the counterparty and a derivative withthe corresponding change in fair value of the derivative being recorded throughearnings. The value of the derivative would reflect changes in the value of theunderlying debt investments and changes in the value of the underlying creditprovided by the counterparty.

 

#### **Mortgage Loan**

 

We have one consolidated interest-only mortgage loan of $41,000 thatbears interest at a fixed rate of 4.90% and has a term of ten years, resultingin a balloon payment in 2015. This mortgage was used to finance our acquisitionof 200 Franklin Square Drive for approximately $50,250, excluding closingcosts, in September 2005.

 

Combined aggregateprincipal maturities of our CDO, repurchase facilities, trust preferredsecurities, mortgage note payable and revolving credit facility as of December31, 2005 are as follows:

 
| ** ** | ** ** | **Collateralized  Debt Obligations** | ** ** | **Repurchase Facilities** | ** ** | **Trust Preferred Securities** | ** ** | **Mortgage  Note  Payable** | ** ** | **Revolving  Credit  Facility** | ** ** | **Total** | ** ** |
|------------|------------|--------------------------------------|------------|---------------------------|------------|--------------------------------|------------|-----------------------------|------------|---------------------------------|------------|-----------|------------|
| 2006       |       | $                                    | —     |                      | $          | —                         |       | $                           | —     |                            | $          | —    |       | $ | — |   | $ | — |   |
| 2007       |       | —                               |       | 67,717                    |       | —                         |       | —                      |       | —                          |       | 67,717    |       |
| 2008       |       | —                               |       | 49,649                    |       | —                         |       | —                      |       | —                          |       | 49,649    |       |
| 2009       |       | —                               |       | —                    |       | —                         |       | —                      |       | —                          |       | —    |       |
| 2010       |       | —                               |       | —                    |       | —                         |       | —                      |       | —                          |       | —    |       |
| Thereafter |       | 810,500                              |       | —                    |       | 100,000                        |       | 41,000                      |       | —                          |       | 951,500   |       |
|       |       | $                                    | 810,500    |                      | $          | 117,366                        |       | $                           | 100,000    |                            | $          | 41,000    |       | — |   | $ | 1,068,866 |   |
|            |            |                                      |            |                           |            |                                |            |                             |            |                                 |            |           |            |  |  |  |  |  |  |

 

**9.**Operating PartnershipAgreement / Manager

 

At December 31, 2005, weowned all of the Class A limited partnership interests in our OperatingPartnership. At December 31, 2005, the majority of the Class B limitedpartnership interests were owned by our Manager and SL Green OperatingPartnership, L.P. Interests were also held by certain officers and employees ofSL Green Realty Corp., including some of whom are among our executive officers,which interests are subject to performance thresholds.

 

At December 31, 2005, the majority of the interests inour Manager were held by SL Green Operating Partnership, L.P. Interests werealso held by certain officers and employees of SL Green Realty Corp., includingsome of whom are among our executive officers, which interests are subject toperformance thresholds.

 

**10. Related PartyTransactions**

 

In connection with ourinitial public offering, we entered into a management agreement with ourManager, which provides for an initial 

 

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term through December2007 with automatic one-year extension options and is subject to certaintermination rights. We pay the Manager an annual management fee equal to 1.75%of our gross stockholders equity (as defined in the management agreement)inclusive of the trust preferred securities issued on May 20, 2005 and August9, 2005. We realized expense to the Manager under this agreement of an aggregateof approximately $6,337 for the year ended December 31, 2005 and approximately$1,349 for the period from April 12, 2004 (formation) through December 31,2004.

 

At December 31, 2005, the majority of the Class Blimited partnership interests were owned by our Manager and SL Green OperatingPartnership, L.P. Interests were also held by certain officers and employees ofSL Green Realty Corp., including some of whom are among our executive officers,which interests are subject to performance thresholds. To provide an incentivefor the Manager to enhance the value of the common stock, the holders of the ClassB limited partner interests of the Operating Partnership are entitled to anincentive return equal to 25% of the amount by which funds from operations (asdefined in the partnership agreement of the Operating Partnership) plus certainaccounting gains exceed the product of our weighted average stockholders equity(as defined in the partnership agreement of the Operating Partnership)multiplied by 9.5% (divided by 4 to adjust for quarterly calculations). We willrecord any distributions on the Class B limited partner interests as anincentive distribution expense in the period when earned and when payments ofsuch amounts have become probable and reasonably estimable in accordance withthe partnership agreement. We realized approximately $2,276 of incentivedistribution expense for the year ended December 31, 2005.

 

We are obligated to reimburse the Manager for its costs incurred underan asset servicing agreement between our Manager and an affiliate of SL GreenOperating Partnership, L.P. and a separate outsourcing agreement between ourManager and SL Green Operating Partnership, L.P. The asset servicing agreementprovides for an annual fee payable to SL Green Operating Partnership, L.P. byus of 0.15% of the carrying value of our investments, which amount SL GreenOperating Partnership, L.P. has agreed to reduce for certain investments and whichfee may be further reduced by SL Green Operating Partnership, L.P. for feespaid directly to outside servicers by us. The outsourcing agreement currently providesfor a fee payable by us of $1,288 per year, increasing 3% annually over theprior year. For the year ended December 31, 2005 and the period from April 12,2004 (formation) through December 31, 2004, we realized expense of an aggregateof $1,266 and $521, respectively, to our Manager under the outsourcingagreement. For the year ended December 31, 2005 and the period from April 12,2004 (formation) through December 31, 2004, we realized expense of an aggregateof $1,037 and $95 to our Manager under the asset servicing agreement,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 managementagreement provides for a senior collateral management fee, payable quarterly inaccordance with the priority of payments as set forth in the indenture, equalto 0.15% per annum of the net outstanding portfolio balance, and an additionalsubordinate collateral management fee, payable quarterly in accordance with thepriority of payments as set forth in the indenture, equal to 0.25% per annum ofthe net outstanding portfolio balance. Net outstanding portfolio balance is thesum of the (i) aggregate principal balance of the collateral debt securities,excluding defaulted securities, (ii) aggregate principal balance of allprincipal proceeds held as cash and eligible investments in certain accounts,and (iii) with respect to the defaulted securities, the calculation amount ofsuch defaulted securities. As compensation for the performance of itsobligations as collateral manager, our Board of Directors has allocated to theManager the portion of the subordinate collateral management fee paid on securitiesnot held by us. Thesenior collateral management fee and balance of the subordinate collateralmanagement fee is allocated to us. For the year ended December 31, 2005 werealized expense of $944 to the Manager under the collateral managementagreement.

 

In connection with the5,500 shares of common stock that were sold on December 3, 2004 and settled onDecember 31, 2004 and January 3, 2005 in a private placement, we agreed to paythe Manager a fee of $1,000 as compensation for financial advisory, structuringand costs incurred on our behalf. This fee was recorded as a reduction in theproceeds of the private placement. Apart from legal fees and stock clearingcharges totaling $245, no other fees were paid by us to an investment bank,broker/dealer or other financial advisor in connection with the privateplacement, resulting in total costs of 1.3% of total gross proceeds.

 

**On April 29, 2005, we closed on a $57,503 initial investment in a jointventure with SL Green to acquire, own and operate the South Building located atOne Madison Avenue, New York, New York, or the Property. The joint venture,which was created to acquire, own and operate the Property, is owned 45% by awholly-owned subsidiary of us and 55% by a wholly-owned subsidiary of SL Green.The joint venture interests are *pari passu*. Alsoon April 29, 2005, the joint venture completed the acquisition of the Propertyfrom**

 

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**Metropolitan Life Insurance Company for the purchase price of approximately$802,800 plus closing costs, financed in part through a $690,000 first mortgageloan on the Property. The Property comprises approximately 1.2 million squarefeet and is almost entirely net leased to CS pursuant to a lease with a 15-yearremaining 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 for approximately five thousand square feet withan option to lease an additional approximately two thousand square feet andcarries a term of ten years with rents on the entire seven thousand square feetof approximately $249 per annum for year one rising to $315 per annum in yearten. For the year ended December 31, 2005 we paid $90 under this lease.

 

**Bright Star Couriers LLC, or Bright Star, provides messenger services tous. Bright Star is owned by Gary Green, a son of Stephen L. Green, our Chairman.The aggregate amount of fees paid by us for such services for the year endedDecember 31, 2005 was approximately $3, and less than $1 for the period fromApril 12, 2004 (formation) through December 31, 2004.**

** **

**SL Green Operating Partnership, L.P. has invested $75,000 and $6,100 inpreferred equity interests that are subordinate to two of our investments withbook values of $29,026 and $6,441, respectively, as of December 31, 2005. SLGreen Operating Partnership, L.P. had invested $75,000 in a preferred equityinterest that was subordinate to our investment with a book value of $68,879 asof December 31, 2004.**

** **

**On July 14, 2005, we closed on the purchase from an SL Green affiliate ofa $40,000 mezzanine loan which bears interest at 11.20%. As part of that sale,the seller retained an interest-only participation. We have determined that theyield on our mezzanine loan after giving effect to the interest-onlyparticipation retained by the seller is at market. The mezzanine loan issecured by the equity interests in an office property in New York, New York.**

** **

**11. Deferred Costs**

** **

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

 

| ** **                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Deferred  financing            |       | $        | 20,553     |     | $          | 2,334 |   |
| Deferred  acquisition          |       | 2,210    |       | 215      |       |
|                           |       | 22,763   |       | 2,549    |       |
| Less  accumulated amortization |       | (3,381   | )          | (316     | )          |
|                           |       | $        | 19,382     |     | $          | 2,233 |   |

 

Deferred financing costsrelate to our existing repurchase and credit facilities with Wachovia andGoldman Sachs, our CDO, the trust preferred securities and our mortgage note. Thesecosts are amortized on a straight-line basis to interest expense based on theremaining term of the related financing.

 

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

 

**12. Fair Value of FinancialInstruments**

** **

Thefollowing discussion of fair value was determined by our Manager, usingavailable market information and appropriate valuation methodologies. Considerablejudgment is necessary to interpret market data and develop estimated fair value.Accordingly, fair values are not necessarily indicative of the amounts we couldrealize on disposition of the financial instruments. The use of differentmarket assumptions and/or estimation methodologies may have a material effecton estimated fair value amounts.

 

Cashequivalents, accrued interest, and accounts payable balances reasonablyapproximate their fair values due to the short maturities of these items. Thecarrying value of our CDO, repurchase and credit facilities approximate fairvalue because they bear interest at floating rates, which we believe, forfacilities with a similar risk profile, reasonably approximate market rates. Ourjunior subordinated debentures reasonably approximate fair value based upon theamount at which similarly issued instruments have been valued. Our 

 

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fixedrate mortgage payable is carried at its unpaid principal balance, whichapproximates fair value due to the short period of time the note has beenoutstanding. Loans and commercial mortgage backed securities are carried atamounts, which reasonably approximate their fair value as determined by ourManager.

 

Thefair value of our fixed-rate debt investments as determined by our Manager inconsultation with market dealers of such instruments as of December 31, 2005are as follows:

 

| ** **                   | ** ** | **Carrying  Value** | ** ** | **Fair Value** | ** ** |
|------------------------------|------------|---------------------|------------|----------------|------------|
| Fixed-rate  debt investments |       | $                   | 186,786    |           | $          | 192,246 |   |
|                              |            |                     |            |                |            |  |  |

 

Disclosureabout fair value of financial instruments is based on pertinent informationavailable to us at December 31, 2005. Although we are not aware of any factorsthat would significantly affect the reasonable fair value amounts, such amountshave not been comprehensively revalued for purposes of these financial statementssince that date and current estimates of fair value may differ significantlyfrom the amounts presented herein.

 

**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. On August 2, 2004 we completedour initial public offering of 12,500,000 shares of common stock resulting innet proceeds of approximately $172,900, which was used to fund investments andcommence our operations. As of December 31, 2005, 338,000 restricted shares hadalso been issued under our 2004 Equity Incentive Plan, or the Equity IncentivePlan. 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, at a price of $17.27per share, resulting in net proceeds of approximately $93,740 under a privateplacement exemption from the registration requirements of Section 5 of theSecurities Act of 1933, as amended. A total of 4,225,000 shares were sold tovarious institutional investors and an additional 1,275,000 shares were sold toSL Green Operating Partnership, L.P. pursuant to its contractual right to chooseto maintain a 25% ownership interest in the outstanding shares of our commonstock. Of the 5,500,000 shares sold, 2,000,000 shares were settled on December31, 2004 and the remaining 3,500,000 shares were settled on January 3, 2005. Thevalue of the shares settled on January 3, 2005 were reflected as a stocksubscription receivable for financial statement purposes as of December 31,2004.

 

OnSeptember 14, 2005 we sold 3,833,333 shares of common stock, at a price of$25.80 per share, resulting in net proceeds of approximately $97,830. A totalof 2,875,000 shares were sold through public offering and an additional 958,333shares were sold to SL Green Operating Partnership, L.P. pursuant to itscontractual right to choose to maintain a 25% ownership interest in ouroutstanding shares of common stock. After this offering, SL Green OperatingPartnership, L.P. owned 5,668,333 shares of our common stock. Net proceeds wereused for acquisitions, repayment of outstanding principal under one of ourrepurchase facilities 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 December 31, 2005, 22,802,642 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 Equity Incentive Plan, as amended, authorizes(i) the grant of stock options that qualify as incentive stock options underSection 422 of the Internal Revenue Code of 1986, as amended, or ISOs, (ii) thegrant of stock options that do not qualify, or NQSOs, (iii) the grant of stockoptions in lieu of cash directors’ fees and (iv) grants of shares of restrictedand unrestricted common stock. The exercise price of stock options will bedetermined by the compensation committee, but may not be less than 100% of thefair market value of the shares of common stock on the date of grant. AtDecember 31, 2005, approximately 1,077,431 shares of common stock wereavailable for issuance under the Equity Incentive Plan.

** **

**Management and outsourcing fees paid to the Manager and SLGreen Operating Partnership, L.P. are sufficient to reimburse the Manager andSL Green Operating Partnership, L.P. for the applicable compensation, includingpayroll taxes, of the employees who provide services to Gramercy pursuant tothe confirmatory addendum to the Management Agreement between Gramercy, theManager and the Operating Partnership. These awardees are considered co-leased employees. Options granted underthe Equity Incentive Plan to awardees who are co-leased employees of Gramercyare exercisable 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 granted under the Equity Incentive Plan to persons who providesignificant services to us or our affiliates, but are not considered co-leasedemployees because compensation for their services is not covered by ourmanagement agreement or outsourcing agreement. Options granted to awardees thatare not co-leased employees have the same terms as those issued to co-leasedemployees except as it relates to any performance-based provisions within thegrant. To the extent there are performance provisions associated with a grantto an awardee who is not a co-leased employee, an estimated expense related tothese options is recognized over the vesting period and the final expense isreconciled at the point performance has been met, or the measurement date. Ifno performance based provision exists, the fair value of the options iscalculated on a quarterly basis and the related expense is recognized over thevesting period.**

 

A summary of the status of our stock options as of December 31, 2005and 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                                                                                                                                                           |       | 236,000                  |       | $                                      | 19.62      |   | 640,500 |   | $ | 15.05 |   |
| Exercised                                                                                                                                                         |       | (131,249                 | )          | $                                      | 15.01      |   | — |   | $ | — |   |
| Lapsed or cancelled                                                                                                                                               |       | (11,667                  | )          | $                                      | 18.20      |   | — |   | $ | — |   |
| Balance at end of period                                                                                                                                          |       | 733,584                  |       | $                                      | 16.47      |   | 640,500 |   | $ | 15.05 |   |
|                                                                                                                                                              |       |                     |       |                                   |       |   |   |   |   |
| Options exercisable at end of year                                                                                                                                |       | 61,830                   |       | $                                      | 15.13      |   | — |   | $ | — |   |
| Weighted average fair value of options  granted during the year ended December 31, 2005 and the period from April 12,  2004 (formation) through December 31, 2004 |       | $                        | 249        |                                   |       |   |   | $ | 262 |   |   |   |
|                                                                                                                                                                   |            |                          |            |                                        |            |  |  |  |  |  |  |  |  |

 

Alloptions were granted within a price range of $15.00 to $23.53. The remainingweighted average contractual life of the options was 8.83 years. Compensationexpense of $172 and $23 was recorded for the year ended December 31, 2005 andthe period from April 12, 2004 (formation) through December 31, 2004,respectively, related to the issuance of stock options.

 

ThroughDecember 31, 2005, 338 restricted shares had been issued under the EquityIncentive Plan, of which 32% have vested. Of the 338 restricted shares issued,313 shares were issued in 2004 and 25 shares were issued in 2005 at a weightedaverage fair value of $2,838 and $523, respectively. The unvested shares arenot currently entitled to receive distributions declared by us on our commonstock until such time as the shares have vested. Unvested shares may beentitled to receive dividends at the discretion of the Compensation Committeeof our Board of Directors. Holders of restricted shares are prohibited fromselling such shares until they vest but are provided the ability to vote suchshares beginning on the date of grant. Compensation expense of $1,577 and $381was recorded for the year ended December 31, 2005 and the period from April 12,2004 (formation) through December 31, 2004, respectively, related to theissuance of restricted shares.

 

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**Outperformance Plan**

 

InJune 2005, the compensation committee of our board of directors approved along-term incentive compensation program, the 2005 Outperformance Plan. Participantsin the 2005 Outperformance Plan, all of whom are co-leased employees, willshare in a “performance pool” if our total return to stockholders for theperiod from June 1, 2005 through May 31, 2008 exceeds a cumulative total returnto stockholders of 30% during the measurement period over a base share price of$20.21 per share. The size of the pool will be 10% of the outperformance amountin excess of the 30% benchmark, subject to a maximum limit equal to the lesserof 4% of our outstanding shares and units of limited partnership interest as ofthe end of the performance period or 1,200,000 shares. If our total return tostockholders from June 1, 2005 to any subsequent date exceeds 80% and remainsat that level or higher for 30 consecutive days, then a minimum performancepool will be established. In the event the potential performance pool reachesthe maximum dilution cap before May 31, 2008 and remains at that level orhigher for 30 consecutive days, the performance period will end early and thepool will be formed on the last day of such 30 day period. Each participant’saward under the 2005 Outperformance Plan is designated as a specifiedpercentage of the aggregate performance pool to be allocated to suchparticipant assuming the 30% benchmark is achieved. Individual awards under the2005 Outperformance Plan will be made in the form of partnership units, or LTIPUnits, that may ultimately become exchangeable for shares of our common stockor cash, at our election. LTIP Units will be granted prior to the determinationof the performance pool; however, they will only vest upon satisfaction ofperformance and other thresholds, and will not be entitled to distributionsuntil after the performance pool, or minimum performance pool, is established. The2005 Outperformance Plan provides that if a pool is established, eachparticipant will also be entitled to the distributions that would have beenpaid on the number of LTIP Units earned, had they been issued at the beginningof the performance period. Those distributions will be paid in the form ofadditional LTIP Units. Once a performance pool has been established, the earnedLTIP Units will receive regular quarterly distributions on a per unit basisequal to the dividends per share paid on our common stock, whether or not theyare vested. Any LTIP Units that are not earned upon the establishment of theperformance pool will be automatically forfeited, and the LTIP Units that areearned will be subject to time-based vesting, with 50% of the LTIP Units earnedvesting in May 2009 and the balance vesting one year later based on continuedemployment with the Manager or SL Green.  We will record the expense of the restricted stock award in accordancewith FASB Statement No. 123, or SFAS 123, “Accounting for Stock-BasedCompensation.”  Compensation expense of$1.2 million was recorded for the year ended December 31, 2005 related to the2005 Outperformance Plan.

 

**Deferred Stock Compensation Plan for Directors**

 

Under our IndependentDirector’s Deferral Program, which commenced April 2005, our independent 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 ofcommon stock upon such directors’ termination of service from the Board ofDirectors or a change in control by us, as defined by the program. Phantom stock units are credited to each independent director quarterly usingthe closing price of our common stock on the applicable dividend record datefor the respective quarter.  Each participating independent director whoelects to receive fees in the form of phantom stock units has the option tohave their account credited for an equivalent amount of phantom stock unitsbased on the dividend rate for each quarter or have dividends paid in cash.

 

As of December 31, 2005there were approximately 2,228 phantom stock units outstanding.

 

77

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**Earnings per Share**

** **

Earningsper share year ended December 31, 2005 and the period from April 12, 2004(formation) through December 31, 2004 is computed as follows:

 

| **Numerator (Income)**                      | ** ** | **For the Year  Ended  December 31,  2005** | ** ** | **For the Period  April 12, 2004  (formation)  through  December 31,**

**2004** | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
|                                        |       |                                        |
| Basic Earnings:                             |       |                                        |       |                                                                             |       |
| Net income available to common stockholders |       | $                                           | 31,371     |                                                                             | $          | 2,052 |   |
| Effect of dilutive securities               |       | —                                      |       | —                                                                           |       |
| Diluted Earnings:                           |       |                                        |       |                                                                             |       |
| Net income available to common stockholders |       | $                                           | 31,371     |                                                                             | $          | 2,052 |   |
|                                        |       |                                        |       |                                                                             |       |
| **Denominator (Weighted Average Shares)**   |       |                                        |       |                                                                             |       |
| Basic                                       |       |                                        |       |                                                                             |       |
| Shares available to common stockholders     |       | 20,027                                      |       | 13,348                                                                           |       |
| Effect of Diluted Securities:               |       |                                        |       |                                                                             |       |
| Stock-based compensation plans              |       | 752                                         |       | 63                                                                               |       |
| Phantom stock units                         |       | 2                                           |       | —                                                                           |       |
| Diluted Shares                              |       | 20,781                                      |       | 13,411                                                                           |       |

 

**14. Minority Interest**

 

At December 31, 2005, we owned all of the Class A limited partnershipinterests in our Operating Partnership. At December 31, 2005, the majority ofthe 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 among ourexecutive officers, which interests are subject to performance thresholds.

 

**15. Benefit Plans**

 

**We do not maintain a defined benefit pension plan,post-retirement health and welfare plan, 401(k) plan or other benefits plans aswe do not have any employees. These benefits are provided to its employees byour 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 ourOperating Partnership related to litigation will not materially affect ourfinancial 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 for approximately five thousand square feetwith an option to lease an additional approximately two thousand square feetand carries a term of ten years with rents on the entire seven thousand squarefeet of approximately $249 per annum for year one rising to $315 per annum inyear ten.

 

78

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

 

| ** **                   | ** ** | **Operating Lease** | ** ** |
|------------------------------|------------|---------------------|------------|
| 2006                         |       | $                   | 252        |   |
| 2007                         |       | 256                 |       |
| 2008                         |       | 261                 |       |
| 2009                         |       | 265                 |       |
| 2010                         |       | 283                 |       |
| Thereafter                   |       | 1,351               |       |
| Total minimum lease payments |       | $                   | 2,668      |   |

 

**17.**       Financial Instruments: Derivatives andHedging

 

FASB No. 133, or SFAS 133, “Accounting for Derivative Instruments andHedging Activities,” which became effective January 1, 2001, requires Gramercyto recognize all derivatives on the balance sheet at fair value. Derivativesthat are not hedges must be adjusted to fair value through income. If aderivative is a hedge, depending on the nature of the hedge, changes in thefair value of the derivative will either be offset against the change in fairvalue of the hedged asset, liability, or firm commitment through earnings, orrecognized in other comprehensive income until the hedged item is recognized inearnings. The ineffective portion of a derivative’s change in fair value willbe immediately recognized in earnings. SFAS 133 may increase or decreasereported net income and stockholders’ equity prospectively, depending on futurelevels of 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 following table summarizes the notional and fair value of ourderivative financial instrument at December 31, 2005. All derivativeinstruments with the exception of the $15,500 swap which was entered incontemplation of a future sale transaction, have been designated as cash flowhedges. The notional value is an indication of the extent of our involvement inthis instrument at that time, but does not represent exposure to credit,interest rate or market risks (in thousands):

 
| ** **         | ** ** | **Benchmark  Rate** | ** ** | **Notional  Value** | ** ** | **Strike  Rate** | ** ** | **Effective  Date** | ** ** | **Expiration  Date** | ** ** | **Fair  Value** | ** ** |
|--------------------|------------|---------------------|------------|---------------------|------------|------------------|------------|---------------------|------------|----------------------|------------|-----------------|------------|
| Interest Rate Swap |       | 3 month LIBOR       |       | $                   | 40,000     |             | 4.42       | %                   | 7/2005     |                 | 2/2014     |            | $          | 905 |   |
| Interest Rate Swap |       | 1 month LIBOR       |       |                | 26,235     |             | 4.188      | %                   | 6/2005     |                 | 6/2010     |            | 588        |   |
| Interest Rate Swap |       | 1 month LIBOR       |       |                | 3,465      |             | 3.30       | %(1)                | 7/2005     | (1)                  | 2/2006     | (1)             | 60         |   |
| Interest Rate Swap |       | 1 month LIBOR       |       |                | 31,686     |             | 3.855      | %                   | 7/2005     |                 | 11/2009    |            | 996        |   |
| Interest Rate Swap |       | 1 month LIBOR       |       |                | 19,800     |             | 3.625      | %                   | 7/2005     |                 | 2/2006     |            | 13         |   |
| Interest Rate Swap |       | 3 month LIBOR       |       |                | 15,500     |             | 5.135      | %                   | 12/2005    |                 | 12/2015    |            | (265       | ) |
| Interest Rate Swap |       | 1 month LIBOR       |       |                | 3,960      |             | 4.959      | %                   | 12/2005    |                 | 12/2015    |            | (48        | ) |
| Interest Rate Cap  |       | 3 month LIBOR       |       |                | 23,713     |             | 5.70       | %                   | 11/2005    |                 | 12/2007    |            | 20         |   |
| Interest Rate Cap  |       | 1 month LIBOR       |       |                | 14,120     |             | 5.50       | %                   | 12/2005    |                 | 1/2007     |            | 2          |   |
|               |       |                |       | $                   | 178,479    |             |       |                |       |                 |       |            | $          | 2,271 |   |

 

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

 

AtDecember 31, 2005, the derivative instruments were reported as an asset attheir fair value of $2,271. Offsetting adjustments are represented as deferredgains or losses in Accumulated Other Comprehensive Income of $2,851. For theyear ended December 31, 2005 we recognized in interest expense $58 attributableto the ineffective component of our derivative instruments designated as cashflow hedges. For the same period we reclassified through earnings (i) $376representing the gains and losses previously reported in Accumulated OtherComprehensive Income, which were reclassified into earnings at the same timethat the forecasted transactions affect earnings and (ii) a $280 reduction inearnings representing the change in value of undesignated derivatives which arenot speculative for economic purposes. Currently, all derivative instrumentsare designated as effective hedging instruments with the exception of the$15,500 swap, which has not been designated. Over time, the realized andunrealized gains and losses held in Accumulated Other Comprehensive Income willbe reclassified into earnings in the same periods in which the hedged interest 

 

79

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paymentsaffect earnings. We estimate that approximately $540 of the current balanceheld in Accumulated Other Comprehensive Loss will be reclassified into earningswithin the next 12 months.

 

We are hedgingexposure to variability in future interest payments on our debt facilities andcash flows for future transactions except in the case of swaps we may enterinto from time to time, including TROR swaps, which are intended to hedge ourexposure to variability in the rate of return in excess of anticipated futureinterest payments on that portion of our debt facilities used to fund fixedrate mortgage loan assets held as available for sale.

 

**18. Income Taxes**

 

We have elected to betaxed as a REIT, under Sections 856 through 860 of the Internal Revenue Codebeginning with our taxable year ending December 31, 2004. To qualify as a REIT,we must meet certain organizational and operational requirements, including arequirement to distribute at least 90% of our ordinary taxable income tostockholders. As a REIT, we generally will not be subject to federal income taxon taxable income that we distribute to our stockholders. If we fail to qualifyas a REIT in any taxable year, we will then be subject to federal income taxeson our taxable income at regular corporate rates and we will not be permittedto qualify for treatment as a REIT for federal income tax purposes for fouryears following the year during which qualification is lost unless the InternalRevenue Service grants us relief under certain statutory provisions. Such anevent could materially adversely affect our net income and net cash availablefor distributions to stockholders. However, we believe that we are organizedand will 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 subjectto certain state and local taxes.

 

For the year ended December 31, 2005, we recorded $900 of income taxexpense in income from continuing operations for income attributable ourwholly-owned taxable REIT subsidiaries. We have assumed an effective tax ratefor the year ended December 31, 2005 of 40% taking into consideration theanticipated applicable U.S. federal statutory tax rate at December 31, 2005 of34% and state 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 anyenvironmental liability that it believes would have a materially adverse impacton 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 report informationabout operating segments in their annual financial statements. We are a REITfocused primarily on originating and acquiring loans and securities related toreal estate and under the provisions of SFAS No. 131 currently operate in onlyone segment.**

** **

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

 

The following table represents non-cash investingand financing activities:

 
| ** **                                                                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Derivative instruments at fair value                                             |       | $        | 2,271      |     | $          | 249 |   |
| Fair value of below market leases (SFAS  No.141) in connection with acquisitions |       | $        | 872        |     | —     |   |
|                                                                                  |            |          |            |          |            |  |  |

 

80

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**22.**       Quarterly Financial Data (unaudited)

 

Quarterly data for the quarters since our initial public offering arepresented below.

 
| **2005 Quarter Ended**                                                                                  | ** ** | **December 31** | ** ** | **September 30** | ** ** | **June 30** | ** ** | **March 31** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-----------------|------------|------------------|------------|-------------|------------|--------------|------------|
| Total revenues                                                                                          |       | $               | 32,045     |             | $          | 26,592      |       | $            | 18,758     |   | $ | 10,690 |   |
| Income from continuing operations before  equity in net loss of unconsolidated joint ventures and taxes |       | 11,247          |       | 9,587            |       | 8,361       |       | 4,566        |       |
| Equity in net loss of unconsolidated joint  ventures                                                    |       | (575            | )          | (510             | )          | (404        | )          | —       |       |
| Income from continuing operations before  provision for taxes and GKK formation costs                   |       | 10,672          |       | 9,077            |       | 7,957       |       | 4,566        |       |
| Provision for taxes                                                                                     |       | 100             |       | (500             | )          | (500        | )          | —       |       |
| GKK formation costs                                                                                     |       | —          |       | —           |       | —      |       | —       |       |
| Net income available to common stockholders                                                             |       | $               | 10,772     |             | $          | 8,577       |       | $            | 7,457      |   | $ | 4,566 |   |
| Net income per common share - Basic                                                                     |       | $               | 0.47       |             | $          | 0.44        |       | $            | 0.40       |   | $ | 0.24 |   |
| Net income per common share - Diluted                                                                   |       | $               | 0.45       |             | $          | 0.41        |       | $            | 0.39       |   | $ | 0.24 |   |
|                                                                                                         |            |                 |            |                  |            |             |            |              |            |  |  |  |  |  |  |  |

 

| **2004 Quarter Ended**                   | ** ** | **December 31** | ** ** | **September 30** | ** ** |
|------------------------------------------|------------|-----------------|------------|------------------|------------|
| Total  revenues                          |       | $               | 5,679      |             | $          | 1,472 |   |
| Income  available to common stockholders |       | $               | 2,041      |             | $          | 11 |   |
| Net income  per common share-Basic       |       | $               | 0.15       |             | $          | 0.00 |   |
| Net income  per common share-Diluted     |       | $               | 0.15       |             | $          | 0.00 |   |

 

**23.**                               Subsequent Events

 

**On January 27,2006 we completed a third issuance of $50,000 in unsecured trust preferredsecurities through a separate newly formed Delaware statutory trust, GramercyCapital Trust III, or GCTIII, that is a wholly-owned subsidiary of theOperating Partnership. The securities bear interest at a fixed rate of 7.65%for the first ten years ending January 2016, with an effective rate of 7.43%when giving effect to the swap arrangement previously entered into incontemplation of this financing. Thereafter the rate will float based on thethree-month LIBOR plus 270 basis points. The trust preferred securities requirequarterly interest distributions; however, payments may be deferred while theinterest expense is accrued for a period of up to four consecutive quarters ifthe Operating Partnership exercises its right to defer such payments. The trustpreferred securities are redeemable, at the option of the OperatingPartnership, in whole or in part, with no prepayment premium any time afterJanuary 30, 2011.**

** **

**GCTIII issued $1,550 aggregate liquidation amount of common securities,representing 100% of the voting common stock of GCTIII to the OperatingPartnership for a total purchase price of $1,550. GCTIII used the proceeds fromthe sale of the trust preferred securities and the common securities topurchase the Operating Partnership’s junior subordinated notes. The terms ofthe junior subordinated notes match the terms of the trust preferred securities.The notes are subordinate and junior in right of payment to all present andfuture senior indebtedness and certain other of our financial obligations. Werealized net proceeds from the offering of approximately $48,956.**

 

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**GramercyCapital Corp.**

**Schedule IV – Mortgage Loans on Real Estate**

**December31, 2005**

(Dollars in thousands)

 
| **Description**                                | ** ** | **Location**                     | ** ** | **Interest  Rate****(1)**     | ** ** | **Final  Maturity  Date****(2)** | ** ** | **Periodic  Payment  Terms** | ** ** | **Prior  Liens** | ** ** | **Face  Amount  of Loans** | ** ** | **Carrying  Amount  of Loans****(3)** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|-------------------------------|------------|----------------------------------|------------|------------------------------|------------|------------------|------------|----------------------------|------------|---------------------------------------|------------|
| Whole Loans:                                   |       |                             |       |                          |       |                             |       |                         |       |             |       |                       |       |                                  |       |
| Hotel                                          |       | Atlanta, GA                      |       | LIBOR + 3.75%                 |       | February 2007                    |       | Interest only                |       | $                | —     |                       | $          | 43,000                                |       | $ | 42,415 |   |
| Multi-family                                   |       | New York, NY                     |       | LIBOR + 3.50 - LIBOR +  3.80% |       | November 2006                    |       | Interest only                |       | —           |       | 43,137                     |       | 43,068                                |       |
| Multi-family                                   |       | Rancho Cucamonga, CA             |       | LIBOR + 2.62%                 |       | July 2007                        |       | Interest only                |       | —           |       | 49,435                     |       | 49,435                                |       |
| Office                                         |       | Santa Clara, CA and Milpitas, CA |       | LIBOR + 3.00%                 |       | August 2008                      |       | Interest only                |       | —           |       | 51,850                     |       | 51,371                                |       |
| Hotel                                          |       | Various cities, CA               |       | LIBOR + 3.50%                 |       | July 2006                        |       | Interest only                |       | —           |       | 55,900                     |       | 55,900                                |       |
| Whole loans <  3%                           |       |                             |       |                          |       |                             |       |                         |       | —           |       | 418,102                    |       | 413,647                               |       |
|                                           |       |                             |       |                          |       |                             |       |                         |       | —           |       | 661,424                    |       | 655,836                               |       |
|                                           |       |                             |       |                          |       |                             |       |                         |       |             |       |                       |       |                                  |       |
| Subordinate  Interests in Whole Loans:         |       |                             |       |                          |       |                             |       |                         |       |             |       |                       |       |                                  |       |
| Office:                                        |       |                             |       |                          |       |                             |       |                         |       |             |       |                       |       |                                  |       |
| B Note                                         |       | New York, NY                     |       | LIBOR + 4.25%                 |       | August 2007                      |       | Interest only                |       | 80,000           |       | 50,000                     |       | 49,583                                |       |
| Multi-family:                                  |       |                             |       |                          |       |                             |       |                         |       |             |       |                       |       |                                  |       |
| B Note                                         |       | Various states                   |       | LIBOR + 2.00% (4)             |       | August 2007                      |       | Interest only                |       | 345,000          |       | 75,000                     |       | 74,689                                |       |
| Subordinate  interests in whole loans  < 3% |       |                             |       |                          |       |                             |       |                         |       | 1,475,714        |       | 282,313                    |       | 275,815                               |       |
|                                           |       |                             |       |                          |       |                             |       |                         |       | 1,900,714        |       | 407,313                    |       | 400,087                               |       |
|                                           |       |                             |       |                          |       |                             |       |                         |       |             |       |                       |       |                                  |       |
| Mezzanine Loans:                               |       |                             |       |                          |       |                             |       |                         |       |             |       |                       |       |                                  |       |
| Office (5)                                     |       | New York, NY                     |       | 8.42%                         |       | February 2014                    |       | Interest only                |       | 184,000          |       | 40,000                     |       | 40,029                                |       |
| Mezzanine loans  < 3%                       |       |                             |       |                          |       |                             |       |                         |       | 2,917,000        |       | 86,311                     |       | 86,116                                |       |
|                                           |       |                             |       |                          |       |                             |       |                         |       | 3,101,000        |       | 126,311                    |       | 126,145                               |       |
|                                           |       |                             |       |                          |       |                             |       |                         |       |             |       |                       |       |                                  |       |
| Preferred equity  < 3%                      |       |                             |       |                          |       |                             |       |                         |       | 46,331           |       | 24,000                     |       | 23,677                                |       |
|                                           |       |                             |       |                          |       |                             |       |                         |       |             |       |                       |       |                                  |       |
|                                           |       |                             |       |                          |       |                             |       |                         |       | $                | 5,048,045  |                       | $          | 1,219,048                             |       | $ | 1,205,745 |   |

 

----

(1) All variable-rate loans are basedon 30-day LIBOR and reprice monthly.

(2)Reflects the initial maturity of the investment and does not consider anyoptions to extend that are at the discretion of the borrower.

(3)No mortgage loans are delinquent with respect to principal or interest.

(4)The effective yield of the investment is LIBOR + 2.60% taking intoconsideration our purchase discount.

(5)Purchased from an SL Green affiliate.

 

82

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**ITEM  9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE**

 

None.

 

**ITEM 9A. CONTROLS AND PROCEDURES**

 

**Evaluation of Disclosure Controls andProcedures**

 

We maintain disclosure controls and procedures that are designed to ensurethat information required to be disclosed in our Exchange Act reports isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms, and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosure based closely on the definition of “disclosure controls andprocedures” in Rule 13a-15(e). In designing and evaluating the disclosurecontrols and procedures, management recognized that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures. Also, we haveinvestments in certain unconsolidated entities. As we do not control theseentities, our disclosure controls and procedures with respect to such entitiesare necessarily substantially more limited than those we maintain with respectto 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 ChiefFinancial Officer concluded that our disclosure controls and procedures wereeffective as of the end of the period covered by this report.

 

**Management’sAnnual Report on Internal Control over Financial Reporting**

 

We are responsible forestablishing and maintaining adequate internal control over financialreporting, as such term is defined in Exchange ActRules 13a-15(f) and 15d-15(f).  Under the supervision and withthe participation of our management, including our Chief Executive Officer andChief Financial Officer, we conducted an evaluation of the effectiveness of ourinternal control over financial reporting as of December 31, 2005 based onthe framework in Internal Control-Integrated Framework issued by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO).  Based onthat evaluation, we concluded that our internal control over financialreporting was effective as of December 31, 2005.

 

Management’s assessmentof the effectiveness of our internal control over financial reporting as ofDecember 31, 2005 has been audited by Ernst & Young LLP, anindependent registered public accounting firm, as stated in their report whichis included elsewhere herein.

 

**Changes inInternal Control over Financial Reporting**

 

There have been nosignificant changes in our internal control over financial reporting during theyear ended December 31, 2005 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreports.

 

**ITEM 9B. OTHER INFORMATION**

 

None.

 

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#### **PARTIII**

 

**ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OFTHE REGISTRANT**

 

The information set forth under the captions “Election of Directors”and “Security Ownership of Certain Beneficial Owners and Management – Section16(a) Beneficial Ownership Reporting Compliance” and the information regardinga code of ethics in our Definitive Proxy Statement for our 2006 Annual Meetingof Stockholders, to be filed pursuant to Regulation 14A under the Securitiesand Exchange Act of 1934, as amended, prior to April 30, 2006 (the “2006Proxy Statement”), is incorporated herein by reference.

 

**ITEM 11. EXECUTIVE AND DIRECTOR COMPENSATION**

 

Theinformation set forth under the captions “Election of Directors – DirectorCompensation” and “Executive Compensation” in the 2006 Proxy Statement isincorporated herein by reference.

 

**ITEM 12. SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT**

 

The information set forth under the captions “Security Ownership of CertainBeneficial Owners and Management” and “Equity Compensation Plan Information” inthe 2006 Proxy Statement is incorporated herein by reference.

 

**ITEM 13. CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

The information set forth under the caption “Certain Relationships andRelated Transactions” in the 2006 Proxy Statement is incorporated herein byreference.

 

**ITEM 14. PRINCIPAL ACCOUNTING FEES ANDSERVICES**

 

The information regarding principal accounting fees and services andthe audit committee’s pre-approval policies and procedures required by thisItem 14 is incorporated herein by reference to the 2006 Proxy Statement.

 

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## **PART IV**

 

**ITEM 15. EXHIBITS, FINANCIAL STATEMENTS ANDSCHEDULES, AND REPORTS ON FORM 8-K**

 

(a)(1) Consolidated Financial Statements

 
| **GRAMERCY CAPITAL CORP.**                                                                                                                                                           | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                                                                                                                                                 |       |
| Report of Independent Registered Public  Accounting Firm                                                                                                                             |       |
| Consolidated Balance Sheets as of  December 31, 2005 and 2004                                                                                                                   |       |
| Consolidated Statements of Income for the  year ended December 31, 2005 and the period from April 12, 2004  (formation) through December 31, 2004                               |       |
| Consolidated Statements of Stockholders’  Equity for the year ended December 31, 2005 and the period from April  12, 2004 (formation) through December 31, 2004            |       |
| Consolidated Statements of Cash Flows for  the year ended December 31, 2004 and the period from April 12, 2004  (formation) through December 31, 2004                           |       |
| **Notes to Consolidated  Financial Statements**                                                                                                                                      | ** ** |
|                                                                                                                                                                                 |       |
| (a)(2)  Financial Statement Schedules                                                                                                                                                |       |
|                                                                                                                                                                                 |       |
| Schedule IV-Mortgage Loans on Real  Estate as of December 31, 2005                                                                                                         |       |
|                                                                                                                                                                                 |       |
| Schedules other than those listed are  omitted as they are not applicable or the required or equivalent information  has been included in the financial statements or notes thereto. |       |
|                                                                                                                                                                                 |       |
| (a)(3)  Exhibits                                                                                                                                                                     |       |
| See Index to  Exhibits on following page                                                                                                                                             |       |

 

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**INDEX TO EXHIBITS**

 

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

** **

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

** **

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

** **

**10.1 Second Amended and Restated Agreement of Limited Partnership of GKKCapital LP, dated December 14, 2005.**

** **

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

** **

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

** **

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

** **

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

** **

**10.6 Form of Collateral Management Agreement by and between Gramercy RealEstate CDO 2005-1, Ltd., as issuer and GKK Manager LLC, as collateral manager,incorporated by reference to the Company’s Quarterly Report on Form 10-Q forthe fiscal quarter ended June 30, 2005.**

** **

**10.7 Form of Second Amended and Restated Master Repurchase Agreement, byand between the Company and Wachovia Capital Markets, LLC, incorporated byreference to the Company’s Quarterly Report on Form 10-Q for the fiscal quarterended March 31, 2005.**

** **

**10.8 Form of Credit Agreement, by and between the Company and WachoviaCapital Markets, LLC, 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 Master Repurchase Agreement dated as of January 3, 2005, byand between the Company and Goldman Sachs Mortgage Company, incorporated byreference to the Company’s Annual Report on Form 10-K for the fiscal year endedDecember 31, 2004.**

** **

**10.10 Annex to the Form of Master Repurchase Agreement dated as ofJanuary 3, 2005, by and between the Company and Goldman Sachs Mortgage Company,incorporated by reference to the Company’s Annual Report on Form 10-K for thefiscal year ended December 31, 2004.**

** **

**10.11 Form of Indenture by and among Gramercy Real Estate CDO 2005-1,Ltd., as issuer, Gramercy Real Estate CDO 2005-1 LLC, as co-issuer, GKKLiquidity LLC, as advancing agent and Wells Fargo Bank, National Association,as trustee, paying agent, calculation agent, transfer agent, custodialsecurities intermediary, backup advancing agent, notes registrar, incorporatedby reference to the Company’s Quarterly Report on Form 10-Q for the fiscalquarter ended June 30, 2005.**

** **

**10.12 Form of 2004 Equity Incentive Plan, incorporated by reference tothe Company’s Registration Statement on Form S-11 (No. 333-114673), declaredeffective by the Commission on July 27, 2004.**

** **

**10.13 Form of Gramercy Capital Corp. Director’s Deferral Program,incorporated by reference to the Company’s Quarterly Report on Form 10-Q/A forthe fiscal quarter ended June 30, 2005.**

 

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**10.14 Form of Gramercy Capital Corp. 2005 Long-Term OutperformanceProgram Award Agreement, incorporated by reference to the Company’s Form 8-K,dated December 14, 2005 filed with the Commission on December 20, 2005.**

** **

**10.15 Form of Employment Agreement by and between Hugh Hall and GKKManager LLC, incorporated by reference to the Company’s Annual Report on Form10-K for the fiscal year ended December 31, 2004.**

** **

**10.16 Form of Employment Agreement by and between Robert R. Foley and GKKManager LLC, incorporated by reference to the Company’s Annual Report on Form10-K for the fiscal year ended December 31, 2004.**

** **

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

** **

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

** **

**10.19 Form of Purchase Agreement, by and among the Company and variousinvestors in the Company’s common stock, incorporated by reference to theCompany’s Form 8-K, dated December 3, 2004 filed with the Commission onDecember 3, 2004.**

** **

**10.20 Form of Amended and Restated Trust Agreement by and among GKKCapital LP, as depositor, JPMorgan Chase Bank, National Association, asproperty trustee, Chase Bank USA, National Association, as Delaware trustee,and the administrative trustees named therein, incorporated by reference to theCompany’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30,2005.**

** **

**10.21 Form of Junior Subordinated Indenture between GKK Capital LP andJPMorgan Chase Bank, National Association, as trustee, incorporated byreference to the Company’s Quarterly Report on Form 10-Q for the fiscal quarterended June 30, 2005.**

** **

10.22 Form of Amended and Restated Trust Agreement among GKK CapitalLP, as depositor, JPMorgan Chase Bank, National Association, as propertytrustee, Chase Bank USA, National Association, as Delaware trustee, and theadministrative trustees named therein, incorporated by reference to the Company’sQuarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2005.

 

10.23 Form of Junior Subordinated Indenture between GKK Capital LP andJPMorgan Chase Bank, National Association, as trustee, incorporated by referenceto the Company’s Quarterly Report on Form 10-Q for the fiscal quarter endedSeptember 30, 2005.

 

10.24 Form of Amended and Restated Trust Agreement among GKK CapitalLP, as depositor, JPMorgan Chase Bank, National Association, as propertytrustee, Chase Bank USA, National Association, as Delaware trustee, and theadministrative trustees named therein, dated January 27, 2006.

 

**10.25 Form of Junior SubordinatedIndenture between GKK Capital LP and JPMorgan Chase Bank, National Association,as trustee, dated January 27, 2006.**

** **

10.26 Form of Underwriting Agreement among Gramercy Capital Corp., GKKCapital LP and Wachovia Capital Markets, LLC, as underwriter, dated September8, 2005, incorporated by reference to the Company’s Form 8-K, dated September7, 2005.

 

**10.27 Form of LLC Agreement, by and between GKK Madison Investment LLC, awholly-owned subsidiary of the Company, and SLG Madison Investment LLC, awholly-owned subsidiary of SL Green Realty Corp., incorporated by reference tothe Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended March31, 2005.**

 

21.1 Subsidiaries of the Registrant.

 

23.1 Consent of Independent Registered Public Accounting Firm.

 

24.1 Power of Attorney (included on signature page)

 

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

 

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

 

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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.

 

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**SIGNATURES**

 

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

 
|                  | GRAMERCY CAPITAL CORP. |
|-----------------------|------------------------|
|                  |                   |
| Dated: March 13, 2006 | By:                    |  /s/ Robert R. Foley |   |
|                  |                   | Robert R.  Foley |
|                  |                   | Chief  Financial Officer |

 

KNOWALL MEN BY THESE PRESENTS, that we, the undersigned officers and directors ofGramercy Capital Corp. hereby severally constitute Marc Holliday and Robert R.Foley, and each of them singly, our true and lawful attorneys and with fullpower to them, and each of them singly, to sign for us and in our names in thecapacities indicated below, the Annual Report on Form 10-K filed herewith andany and all amendments to said Annual Report on Form 10-K, and generally to doall such things in our names and in our capacities as officers and directors toenable Gramercy Capital Corp. to comply with the provisions of the SecuritiesExchange Act of 1934, and all requirements of the Securities and ExchangeCommission, hereby ratifying and confirming our signatures as they may besigned by our said attorneys, or any of them, to said Annual Report on Form10-K and any and all amendments thereto.

 

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

 
| **Signatures**         | ** ** | **Title**                            | ** **     | **Date** |
|------------------------|------------|--------------------------------------|----------------|----------|
|                   |       |                                 |
| /s/ Stephen L. Green   |       | Chairman of the Board of Directors   | March 13, 2006 |
| Stephen L. Green       |       |                                 |           |
|                   |       |                                 |           |
| /s/ Marc Holliday      |       | Chief Executive Officer, President   | March 13, 2006 |
| Marc Holliday          |       | and Director                         |           |
|                   |       |                                 |           |
| /s/ Robert R. Foley    |       | Chief Financial Officer              | March 13, 2006 |
| Robert R. Foley        |       |                                 |           |
|                   |       |                                 |           |
| /s/ Hugh F. Hall       |       | Chief Operating Officer and Director | March 13, 2006 |
| Hugh Hall              |       |                                 |           |
|                   |       |                                 |           |
| /s/ Allan J. Baum      |       | Director                             | March 13, 2006 |
| Allan J. Baum          |       |                                 |           |
|                   |       |                                 |           |
| /s/ Jeffrey E. Kelter  |       | Director                             | March 13, 2006 |
| Jeffrey E. Kelter      |       |                                 |           |
|                   |       |                                 |           |
| /s/ Paul J. Konigsberg |       | Director                             | March 13, 2006 |
| Paul J. Konigsberg     |       |                                 |           |
|                   |       |                                 |           |
| /s/ Charles S. Laven   |       | Director                             | March 13, 2006 |
| Charles S. Laven       |       |                                 |
|                        |            |                                      |                |          |  |

 

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