SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________
 
FORM 10-Q
 
(Mark One)
 
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2007
 
OR
 
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________to _____________
 
Commission file number 001-32039
 
Capital Lease Funding, Inc.
(Exact name of registrant as specified in its charter)

Maryland
  
52-2414533
(State or Other Jurisdiction of
Incorporation or Organization)
  
(I.R.S. Employer Identification No.)
     
1065 Avenue of the Americas, New York, NY
  
10018
(Address of Principal Executive Offices)
  
(ZIP Code)
     
Registrant’s Telephone Number, Including Area Code:
  
(212) 217-6300
 
_______________
 
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes xNo o
    
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o    Accelerated filer x     Non-accelerated filer o
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
 
As of May 1, 2007, there were 34,504,193 shares of common stock of Capital Lease Funding, Inc., $0.01 par value per share, outstanding (“Common Stock”).
 

Capital Lease Funding, Inc.
 
Index to Form 10-Q

 
Page
   
PART I. FINANCIAL INFORMATION
2
Item 1.
Financial Statements
2
 
Consolidated Balance Sheets as of March 31, 2007 (unaudited) and December 31, 2006
2
 
Consolidated Income Statements (unaudited) for the Three Months Ended March 31, 2007 and 2006
3
 
Consolidated Statement of Changes in Stockholders’ Equity (unaudited) for the Three Months Ended March 31, 2007
4
 
Consolidated Statements of Cash Flows (unaudited) for the Three Months Ended March 31, 2007 and 2006
5
 
Notes to Consolidated Financial Statements (unaudited)
7
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
29
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
36
Item 4.
Controls and Procedures
38
PART II. OTHER INFORMATION
39
Item 1.
Legal Proceedings
39
Item 1A.
Risk Factors
39
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
40
Item 3.
Defaults Upon Senior Securities
41
Item 4.
Submission of Matters to a Vote of Security Holders
41
Item 5.
Other Information
41
Item 6.
Exhibits
41
     
SIGNATURES
  
 
i
PART I.  
FINANCIAL INFORMATION
 
Item 1.  
Financial Statements
 
Capital Lease Funding, Inc. and Subsidiaries
Consolidated Balance Sheets
As of March 31, 2007 (unaudited) and December 31, 2006

(Amounts in thousands, except share and per share amounts)
  
As Of
March 31,
2007
  
As Of
December 31,
2006
  
Assets
          
Real estate investments, net
  
$
1,160,110
  
$
1,115,001
  
Loans held for investment
    
269,273
   
273,170
 
Securities available for sale
   
182,334
   
183,066
 
Cash and cash equivalents
    
10,044
   
4,425
 
Asset held for sale
    
5,413
   
2,942
 
Structuring fees receivable
    
3,093
   
3,253
 
Other assets
    
71,538
   
62,443
 
Total Assets
  
$
1,701,805
  
$
1,644,300
  
Liabilities and Stockholders' Equity
              
Mortgages on real estate investments
  
$
829,580
  
$
794,773
  
Collateralized debt obligations
    
268,199
   
268,190
 
Repurchase agreement and other short-term financing obligations
    
224,427
   
195,485
 
Other long-term debt
    
30,930
   
30,930
 
Intangible liabilities on real estate investments
    
19,766
   
19,693
 
Accounts payable, accrued expenses and other liabilities
    
17,296
   
17,132
 
Dividends and distributions payable
    
7,646
   
7,582
 
Total liabilities
    
1,397,844
   
1,333,785
 
Minority interest
    
2,806
   
2,859
 
Commitments and contingencies
              
Stockholders' equity:
              
Preferred stock, $0.01 par value, 100,000,000 shares authorized, Series A cumulative redeemable preferred, liquidation preference $25.00 per share, 1,400,000 shares issued and outstanding
    
33,657
   
33,657
 
Common stock, $0.01 par value, 500,000,000 shares authorized, 34,413,061 and 34,091,829 shares issued and outstanding, respectively
    
344
   
341
 
Additional paid in capital
    
271,268
   
277,918
 
Accumulated other comprehensive loss
    
(4,114
)
  
(4,260
)
Total Stockholders' Equity
    
301,155
   
307,656
 
Total Liabilities and Stockholders' Equity
  
$
1,701,805
  
$
1,644,300
  
 
See notes to consolidated financial statements.
 
2

Capital Lease Funding, Inc. and Subsidiaries
Consolidated Income Statements
(Unaudited)

   
For the Three Months
Ended March 31
  
(Amounts in thousands, except per share amounts)
  
2007
  
2006
  
Revenues:
          
Rental revenue
  
$
24,122
  
$
17,022
  
Interest income from loans and securities
    
8,401
   
8,214
 
Property expense recoveries
    
2,492
   
1,910
 
Gains on sale of mortgage loans and securities
    
–
   
645
 
Other revenue
    
149
   
557
 
Total revenues
    
35,164
   
28,348
 
Expenses:
              
Interest expense
    
19,051
   
14,025
 
Property expenses
    
4,320
   
3,565
 
(Gain) loss on derivatives
    
11
   
(4
)
General and administrative expenses
    
2,610
   
2,343
 
General and administrative expenses-stock based compensation
    
323
   
671
 
Depreciation and amortization expense on real property
    
8,203
   
5,378
 
Loan processing expenses
    
73
   
67
 
Total expenses
    
34,591
   
26,045
 
Income before minority interest and taxes
    
573
   
2,303
 
Minority interest in consolidated entities
    
1
   
–
 
Income from continuing operations
    
574
   
2,303
 
Income from discontinued operations
    
44
   
49
 
Net income
    
618
   
2,352
 
Dividends allocable to preferred shares
    
(711
)
  
(711
)
Net income (loss) allocable to common stockholders
  
$
(93
)
$
1,641
  
               
Earnings per share:
              
Net income (loss) per common share, basic and diluted
  
$
(0.00
)
$
0.06
  
Weighted average number of common shares outstanding, basic and diluted
    
34,122
   
27,893
 
Dividends declared per common share
  
$
0.20
  
$
0.20
  
Dividends declared per preferred share
  
$
0.51
  
$
0.51
  
 
See notes to consolidated financial statements.

3

Capital Lease Funding, Inc. and Subsidiaries
Consolidated Statement of Changes in Stockholders’ Equity
(Unaudited)
(in thousands)
 
   
Preferred
Stock
 
Common
Stock
at Par
 
Additional
Paid-In
Capital
 
Accumulated
Other
Comprehensive
Income
(Loss)
 
Retained
Earnings
 
Total
  
Balance at December 31, 2006
  
$
33,657
  
$
341
  
$
277,918
  
$
(4,260
)
$
–
  
$
307,656
  
Incentive stock plan compensation expense
    
–
   
–
   
323
   
–
   
–
   
323
 
Incentive stock plan grants issued
    
–
   
3
   
(3
)
  
–
   
–
   
–
 
Net income
    
–
   
–
   
–
   
–
   
618
   
618
 
Issuance of common stock
    
–
   
–
   
5
   
–
   
–
   
5
 
Dividends declared-preferred
    
–
   
–
   
–
   
–
   
(711
)
  
(711
)
Dividends declared-common
    
–
   
–
   
(6,975
)
  
–
   
93
   
(6,882
)
Unrealized change in value of securities available for sale
    
–
   
–
   
–
   
(253
)
  
–
   
(253
)
Unrealized change in value of derivatives
    
–
   
–
   
–
   
(110
)
  
–
   
(110
)
Realized gains (losses) on derivatives, net of amortization of $302
    
–
   
–
   
–
   
509
   
–
   
509
 
Balance at March 31, 2007
  
$
33,657
  
$
344
  
$
271,268
  
$
(4,114
)
$
–
  
$
301,155
  
 
 
See notes to consolidated financial statements.
 
4
 
Capital Lease Funding, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)
(in thousands)


   
For the Three Months
Ended March 31,
  
   
2007
 
2006
  
Operating activities
          
Net income
  
$
618
  
$
2,352
  
Adjustments to reconcile net income to cash provided by (used in) operating activities:
              
Depreciation and amortization
    
8,334
   
5,413
 
Amortization of stock based compensation
    
323
   
671
 
Amortization of above and below market leases
    
(220
)
  
(166
)
Minority interest in consolidated entities
    
(1
)
  
–
 
Gain on sale of loans and securities
    
–
   
(645
)
Loss on sale of real estate properties
    
55
   
–
 
(Gain) loss on derivatives
    
11
   
(4
)
Straight-lining of rents
    
(2,059
)
  
(2,971
)
Amortization of discounts/premiums, and origination fees/costs
    
(109
)
  
(138
)
Amortization of debt issuance costs and fair market value of debt assumed
    
378
   
380
 
Changes in operating assets and liabilities:
              
Structuring fees receivable
    
160
   
148
 
Other assets
    
(3,094
)
  
(7,595
)
Accounts payable, accrued expenses and other liabilities
    
377
   
(905
)
Deposits and escrows
    
(70
)
  
(1,683
)
Amounts due to servicer
    
(172
)
  
–
 
Net cash provided by (used in) operating activities
    
4,531
   
(5,143
)
Investing activities
              
Proceeds from sale of loans
    
–
   
78,645
 
Additions to loans held for investment
    
(164
)
  
(98,020
)
Principal received from borrowers
    
4,076
   
46,944
 
Origination costs on lending investments
    
–
   
85
 
Principal amortization on securities available for sale
    
572
   
377
 
Proceeds from sale of real estate investments
    
2,887
   
–
 
Purchases of real estate investments
    
(58,308
)
  
(160,609
)
Real estate improvements, additions and construction in progress
    
(169
)
  
(4,750
)
Deposits on potential equity investments
    
(5,500
)
  
(4,000
)
Return of deposits on potential equity investments
    
1,500
   
4,000
 
Purchases of furniture, fixtures, equipment and leasehold improvements
    
(32
)
  
(13
)
Net cash used in investing activities
    
(55,138
)
  
(137,341
)
Financing activities
              
Borrowing under repurchase agreement and other short-term financing obligations
    
30,420
   
84,893
 
Repayment of repurchase agreement and other short-term financing obligations
    
(1,478
)
  
(22,363
)
Borrowings from mortgages on real estate investments
    
35,952
   
71,700
 
Repayments of mortgages on real estate investments
    
(1,059
)
  
(304
)
Debt issuance costs
    
(228
)
  
(182
)
Escrows held with mortgage lender
    
–
   
6,144
 
Funds provided by (used in) hedging and risk management activities
    
196
   
(18
)
Common stock issued, net of offering costs
    
5
   
–
 
Cash distributions to minority limited partners
    
(53
)
  
–
 
Dividends paid on common and preferred stock
    
(7,529
)
  
(6,253
)
Changes in amounts due from affiliates
    
–
   
19
 
Net cash provided by financing activities
    
56,226
   
133,636
 
Net increase (decrease) in cash and cash equivalents
    
5,619
   
(8,848
)
Cash and cash equivalents at beginning of period
    
4,425
   
19,316
 
Cash and cash equivalents at end of period
  
$
10,044
  
$
10,468
  
 
See notes to consolidated financial statements.

5

Capital Lease Funding, Inc. and Subsidiaries
Consolidated Statements of Cash Flows - continued
(Unaudited)
(in thousands)

   
For the Three Months
Ended March 31,
 
 
 
2007
 
2006
  
Supplemental disclosure of cash flow information
          
Cash paid for interest expense (excluding capitalized interest)
  
$
18,080
  
$
12,496
  
Distributions declared but not paid
    
53
   
–
 
Dividends declared but not paid
    
7,593
   
6,347
 
               
Supplemental disclosure of noncash operating, investing and financing information
              
Unrealized gain (loss) on cash flow hedges
  
$
(110
)
$
3,559
  
Unrealized gain (loss) on available-for-sale securities
    
(253
)
  
(3,218
)
Value of in-place leases and above-market leases acquired
    
4,840
   
14,000
 
Value of below-market leases acquired
    
434
   
1,878
 
 
See notes to consolidated financial statements.
 
6

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)

1.  
Organization
 
Capital Lease Funding, Inc. (“CLF, Inc.” and collectively with its majority-owned subsidiaries, the “Company”) is a diversified real estate investment trust, or REIT, that invests primarily in single tenant commercial real estate assets subject to long-term leases to high credit quality tenants. The Company focuses on properties that are subject to a net lease, or a lease that requires the tenant to pay all or substantially all expenses normally associated with the ownership of the property (such as utilities, taxes, insurance and routine maintenance) during the lease term. The Company also has made and expects to continue to make investments in single tenant properties where the owner has exposure to property expenses when it determines it can sufficiently underwrite that exposure and isolate a predictable cash flow.
 
The Company invests at all levels of the capital structure of net lease or other single tenant properties, including equity investments in real estate (owned real properties), debt investments (mortgage loans and net lease mortgage backed securities) and mezzanine investments secured by net leased or other single tenant real estate collateral.
 
CLF, Inc. is organized and conducts its operations to qualify as a REIT for federal income tax purposes. As such, it generally will not be subject to federal income tax on that portion of its income that is distributed to stockholders if it distributes at least 90% of its REIT taxable income to its stockholders by prescribed dates and complies with various other requirements.
 
CLF, Inc. conducts its business through a variety of subsidiaries, including its predecessor and operating partnership, Caplease, LP. CLF, Inc. is the indirect sole general partner of, and owns approximately 98.5% of the common equity of, Caplease, LP.
 
The accompanying consolidated financial statements and related notes of the Company have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in the financial statements prepared under accounting principles generally accepted in the United States have been condensed or omitted. In the opinion of management, all adjustments considered necessary for a fair presentation of the Company’s financial position, results of operations and cash flows have been included and are of a normal and recurring nature. The operating results presented for interim periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. These financial statements should be read in conjunction with the Company’s consolidated financial statements for the fiscal year ended December 31, 2006 and notes thereto, included in the Company’s Form 10-K filed with the SEC on March 7, 2007.
 
2.  
Summary of Significant Accounting Policies
 
Basis of Presentation and Principles of Consolidation
 
The accompanying consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and include the assets, liabilities, and results of operations of CLF, Inc. Results of operations of properties acquired are included in the Consolidated Income Statements from the date of acquisition. All significant intercompany transactions, balances and accounts have been eliminated in consolidation.
 
Loan Investments
 
The Company classifies its loans as long-term investments, as its strategy is to hold the loans for the foreseeable future or until maturity. Loan investments are carried on the Company’s Balance Sheet at cost (unpaid principal balance adjusted for unearned discount or premium and loan origination fees). Unearned discounts or premiums and loan origination fees are amortized as a component of interest income using the effective interest method over the life of the loan.
 
The Company periodically evaluates each of its loans held for investment for possible impairment. Impairment is indicated when it is deemed probable that the Company will be unable to collect all amounts due according to the contractual terms of the asset. Upon determination of impairment, the Company must establish a specific valuation allowance with a corresponding charge to earnings. Significant judgment is required both in determining impairment and in estimating the resulting loss allowance. In determining impairment and any loan loss allowance, the Company evaluates factors such as the present value of future cash flows on the loans, the fair market value of any collateral, and the amount and status of any senior debt. As of March 31, 2007, the Company had no loss allowances on any of the loans in its portfolio.
 
7

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
Purchase Accounting for Acquisition of Real Estate
 
The Company’s purchase price of rental real estate acquired is allocated to the following based on fair values:
 
·  
acquired tangible assets, consisting of land, building and improvements; and
 
·  
identified intangible assets and liabilities, consisting of above-market and below-market leases, in-place leases and tenant relationships.
 
In estimating the fair value of the tangible and intangible assets acquired, the Company considers information obtained about each property as a result of its due diligence activities and other market data, and utilizes various valuation methods, such as estimated cash flow projections utilizing appropriate discount and capitalization rates, estimates of replacement costs, and available market information. The fair value of the tangible assets of an acquired property considers the value of the property as if it were vacant.
 
Above-market and below-market lease values for acquired properties are recorded based on the present value of the differences between (i) the contractual amounts to be paid pursuant to each in-place lease and (ii) management’s estimate of fair market lease rates for each corresponding in-place lease. Fair market lease rates are measured over a period equal to the remaining term of the lease for above-market leases and the initial term plus the term of any below-market rate renewal options for below-market leases. In computing present value, the Company uses a discount rate which reflects the risks associated with the leases acquired. The capitalized above-market lease values are amortized as a reduction of base rental revenue over the remaining term of the respective leases, and the capitalized below-market lease values are amortized as an increase to base rental revenue over the remaining initial terms plus the terms of any below-market renewal options of the respective leases.
 
Other intangible assets acquired include amounts for in-place lease values and tenant relationship values which are based on management’s evaluation of the specific characteristics of each tenant’s lease and the Company’s overall relationship with the respective tenant. Factors considered by management in its analysis of in-place lease values include an estimate of carrying costs during the hypothetical expected time it would take management to find a tenant to lease the space for the existing lease term (a “lease-up period”) considering current market conditions, and costs to execute similar leases. Management estimates carrying costs, including such factors as real estate taxes, insurance and other operating expenses during the expected lease-up period, considering current market conditions and costs to execute similar leases. In estimating costs to execute similar leases, management considers leasing commissions and other related expenses. Characteristics considered by management in valuing tenant relationships include the nature and extent of the Company’s existing business relationships with the tenant, growth prospects for developing new business with the tenant, the tenant’s credit quality and expectations of lease renewals. The value of in-place leases is amortized to expense over the remaining initial terms of the respective leases. The value of tenant relationship intangibles is amortized to expense over the anticipated life of the relationships. Through March 31, 2007, the Company has assigned no value to tenant relationships on any of its acquisitions.
 
For property acquisitions where the Company assumes existing mortgage debt, the debt is recorded at its fair value, based on management’s estimate of current market yields available for comparable financing. The Company amortizes any discount or premium as part of interest expense on the related debt using the effective interest method.
 
Real estate taxes, insurance and interest expense on properties that are under development are capitalized in accordance with the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 34, Capitalization of Interest Cost and SFAS No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects.
 
8

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
Depreciation is determined by the straight-line method over the remaining estimated economic useful lives of the properties. The Company generally depreciates buildings and building improvements over periods not exceeding 40 years. Direct costs incurred in acquiring properties are capitalized. Expenditures for maintenance and repairs are charged to operations as incurred. Significant renovations which extend the useful life of the properties are capitalized.
 
Securities Available for Sale
 
In accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, the Company classifies securities which it intends to hold for an indefinite period of time as securities available for sale. These securities are reported at fair value on the Company’s Consolidated Balance Sheets, with unrealized gains and losses included in other comprehensive income, and other than temporary impairments included in current earnings on the Consolidated Income Statement. Purchase premiums and discounts are amortized as a component of interest income using the effective interest method over the terms of the securities. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been below cost, (2) the financial condition and near-term prospects of the underlying credit and (3) the intent and ability of the Company to retain its investment in the underlying credit for a period of time sufficient to allow for anticipated recovery in fair value. The Company had no losses on securities charged to the Income Statement during the quarters ended March 31, 2007 and March 31, 2006.
 
Deferred Origination Fees and Costs
 
In accordance with SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, the Company defers the recognition of fees and expenses associated with the origination of its loans held for investment. These items include lender fee income, rate lock income, direct loan origination costs, certain legal fees, insurance costs, rating agency fees and certain other expenses. Deferred fees and costs are recognized as an adjustment to the effective yield over the life of the related asset.
 
Cash and Cash Equivalents
 
The Company defines cash equivalents as highly liquid investments purchased with maturities of three months or less at date of purchase. From time to time, the Company’s account balance held at financial institutions exceeds Federal Depository Insurance Corporation (“FDIC”) insurance coverage and, as a result, there is a concentration of credit risk related to the balance on deposit in excess of FDIC insurance coverage. The Company believes that the risk of loss is not significant.
 
Revenue Recognition
 
Rental revenue on real estate is recognized in accordance with SFAS No. 13, Accounting for Leases. Rental revenue is recognized on a straight-line basis over the non-cancelable term of the lease unless another systematic and rational basis is more representative of the time pattern in which the use benefit is derived from the leased property. This includes the effects of rent steps and rent abatements under the leases.
 
Interest income from loans, securities, and structuring fees receivable, is recognized on the accrual basis of accounting. Interest income from securities (including interest-only strips) is recognized over the life of the investment using the effective interest method. The cost basis of interest-only strips is adjusted to reflect any prepayments from underlying assets, using the initial yield-to-maturity at the purchase date.
 
Gains are recognized on the sale of loans and securities in accordance with the requirements of SFAS No. 140. The Company may from time to time split its mortgage loan investments into two notes-a real estate note and a corporate credit note. In these instances, the Company will generally sell the real estate note to a third party and retain the corporate credit note in portfolio. The Company computes gain on these sales by comparing the sales proceeds on the note sold to its cost basis. The Company computes its cost basis on the note sold by allocating the entire basis in the loan between the two notes based on the present value of expected cash flows on each note. In computing present values, management estimates a discount rate based on a benchmark rate plus a market spread based on the credit of the underlying tenant. These estimates reflect market rates that management believes are reasonable. However, the use of different estimates could have an impact on the calculation of gain on sale revenue.
 
9

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
The Company may periodically receive breakup fees on contracts in connection with its investments in real estate. The Company recognizes revenues from contract breakup fees when the contractual conditions have occurred to trigger the receipt of such a fee, when the amounts of such revenue can be reasonably determined, and when collection is probable.
 
Impairment of Long-Lived Assets
 
In accordance with SFAS No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets, the Company reviews its investment in long-lived assets (owned real properties) for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company began acquiring owned real properties in the third quarter of 2004. The Company recognized no impairment losses on long-lived assets during the quarters ended March 31, 2007 and March 31, 2006.
 
Income Taxes
 
CLF, Inc. is subject to federal income taxation at corporate rates on its “REIT taxable income.” However, CLF, Inc. is allowed a deduction for the amount of dividends paid to its stockholders, thereby subjecting the distributed net income of CLF, Inc. to taxation at the stockholder level only. CLF, Inc. intends to continue to operate in a manner consistent with and it has elected to be treated as a REIT for tax purposes. From time to time, the Company may conduct a portion of its business through a taxable REIT subsidiary (“TRS”), and the income from the activities of the TRS is subject to federal and state taxation at the applicable corporate rates.
 
Earnings per Share
 
In accordance with SFAS No. 128, Earnings per Share, the Company presents both basic and diluted earnings per share (“EPS”). Basic EPS excludes dilution and is computed by dividing net income allocable to common stockholders by the weighted average number of shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock, where such exercise or conversion would result in a lower EPS amount.
 
The following summarizes the Company’s EPS computations for the quarters ended March 31, 2007 and March 31, 2006 (in thousands, except per share amounts):
 
   
For the three months
ended March 31,
  
   
2007
  
2006
  
Net income (loss) allocable to common stockholders
  
$
(93
)
$
1,641
  
Weighted average number of common shares outstanding, basic and diluted
    
34,122
   
27,893
 
Earnings (loss) per share, basic and diluted
  
$
(0.00
)
$
0.06
  
Non-vested shares included in weighted average number of shares outstanding above
    
700
   
581
 
 
Recently Issued Accounting Pronouncements
 
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on description, classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company’s adoption of FIN 48 on January 1, 2007 did not have a material effect on its consolidated financial statements.
 
10

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
Reclassifications
 
Certain prior year amounts have been reclassified to conform to the current presentation. There was no effect on net income or equity related to these reclassifications.
 
3.  
Loans Held for Investment
 
Loans held for investment at March 31, 2007 and December 31, 2006, are summarized in the following table. These investments consist predominantly of mortgage loans on properties subject to leases to investment grade tenants. As of March 31, 2007, the weighted average credit rating of the underlying tenants was BBB+ from Standard & Poor’s. As of March 31, 2007, none of the Company’s loans held for investment were on non-accrual status or past due 90 days or more.
 
   
Mar 31, 2007
  
Dec 31, 2006
  
   
Unaudited
      
Principal
  
$
268,358
  
$
272,271
  
Premium
    
1,794
   
1,814
 
Carrying amount of loans
    
270,152
   
274,085
 
Deferred origination fees, net
    
(879
)
  
(915
)
Total
  
$
269,273
  
$
273,170
  
From time to time, the Company makes mezzanine loan and other investments. These investments are typically shorter-term in nature and are often subordinate to other financing. As of March 31, 2007, these investments aggregated $7,027, and are included in the table above.
 
During June 2006, the Company entered into a revolving credit agreement with a third party borrower. The Company agreed to fund loans from time to time of up to $12,000 to support the borrower’s capital contributions to a joint venture that makes franchise loans to franchisees of YUM! Brands, Inc. restaurant concepts such as Taco Bell, Kentucky Fried Chicken and Pizza Hut. During August 2006, the Company also made a $6,648 bridge loan to an affiliated entity of the credit agreement borrower to support a franchise loan made outside the joint venture. The bridge loan matured and was paid off in March 2007. As of March 31, 2007, the Company had advanced $5,879 under the revolving credit agreement. Loans made under these programs have been classified as mezzanine loans by the Company.
 
At each of March 31, 2007, and December 31, 2006, the Company’s loan investments carried interest rates ranging from 5.28% to 10.00%. At March 31, 2007 and December 31, 2006, the weighted average effective interest rate on the Company’s loan investments, as measured against its cost basis, was 6.78% and 6.85%, respectively. 
 
4.  
Real Estate Investments
 
Real estate held for investment and related intangible liabilities on real estate investments consisted of the following at March 31, 2007 and December 31, 2006:
 
11

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
 
   
Mar 31, 2007
 
Dec 31, 2006
  
   
Unaudited
      
Real estate investments, at cost:
          
Land
  
$
189,096
  
$
177,726
  
Building and improvements
    
890,776
   
852,495
 
Intangible assets under SFAS 141
    
126,210
   
122,481
 
Less: Accumulated depreciation and amortization
    
(45,972
)
  
(37,701
)
Real estate investments, net 
  
$
1,160,110
  
$
1,115,001
  
Intangible liabilities on real estate investments:
              
Intangible liabilities under SFAS 141
  
$
22,107
  
$
21,674
  
Less: Accumulated amortization
    
(2,341
)
  
(1,981
)
Intangible liabilities on real estate investments, net 
  
$
19,766
  
$
19,693
  
 
Acquisition costs capitalized as part of buildings and improvements were $95 for the quarter ended March 31, 2007, and $1,116 for the quarter ended March 31, 2006. Interest capitalized as part of buildings and improvements was $0 for the quarter ended March 31, 2007, and $0 for the quarter ended March 31, 2006.
 
Amounts for accrued rental income and deferred rental income as of March 31, 2007 and December 31, 2006, were as follows:
 
 
 
Mar 31, 2007
 
Dec 31, 2006
 
 
 
Unaudited
 
 
  
Accrued Rental Income
  
$
17,013
  
$
15,069
  
Deferred Rental Income
    
45
   
160
 
 
Accrued rental income is included in other assets on the Company’s Consolidated Balance Sheet. Deferred rental income is included in accounts payable, accrued expenses and other liabilities on the Company’s Consolidated Balance Sheet.
 
Depreciation expense and amortization of intangible assets and liabilities on real estate investments for the quarters ended March 31, 2007 and March 31, 2006, were as follows:

   
For the three months
ended March 31,
  
   
2007
  
2006
  
Depreciation on real estate (included in
depreciation and amortization expense)
  
$
5,645
  
$
3,635
  
Amortization of in-place leases (included in
depreciation and amortization expense)
    
2,601
   
1,743
 
Amortization of above-market leases (included
as a reduction of rental revenue)
    
140
   
106
 
Amortization of below-market leases (included
as a component of rental revenue)
    
360
   
273
 
 
As of March 31, 2007, the Company’s weighted average amortization period on intangible assets was 11.5 years, and the weighted average amortization period on intangible liabilities was 19.1 years.
 
12

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
Scheduled amortization on existing intangible assets and liabilities on real estate investments as of March 31, 2007 is as follows:
 
   
Intangible
Assets
 
Intangible
Liabilities
  
9 Months Ending December 31, 2007
  
$
8,252
  
$
1,087
  
2008
    
11,003
   
1,450
 
2009
    
11,003
   
1,450
 
2010
    
11,003
   
1,450
 
2011
    
11,003
   
1,450
 
Thereafter
    
59,453
   
12,879
 
   
$
111,717
  
$
19,766
  
 
The Company’s analysis of intangible assets and liabilities in connection with the acquisition of real estate properties acquired during the three months ended March 31, 2007 is preliminary.
 
All of the Company’s owned properties are pledged as collateral for its related long-term financings of those assets, with the exception of the Cott Corporation property in Reading, Pennsylvania, which was not financed as of March 31, 2007. The Company owns and finances each owned property through a separate and distinct single purpose entity, or SPE, with each property and the related lease or leases on the property generally representing the sole assets of the SPE and the sole collateral available to the Company’s lender in the event the Company defaults on the debt that finances the property. Also see Note 11.
 
During the quarter ended March 31, 2007, the Company completed the following real estate acquisitions:

Month Acquired
  
Tenant or Guarantor
  
Location
  
Purchase Price
 
Lease Expires
  
Net Rentable Square Feet
  
January
    County of Yolo, California    25 North Cottonwood Street, Woodland, CA  
$
16,400
    
June 2023
    
63,000
 
January
    Farmers Group, Inc.    3039-3041 Cochran Street, Simi Valley, CA    
41,812
   
January 2017
    
271,000
 
           
$
58,212
              
 
5.  
Asset Held for Sale
 
During the fourth quarter of 2005, the Company acquired a portfolio of three office properties from Allstate Insurance Company in a sale/leaseback transaction. The smallest of the three buildings is an approximately 19,500 square foot office building located in Pittsburgh, Pennsylvania. Because of the small size of this property, management concluded, prior to completing the acquisition, to resell the property promptly following its acquisition. The Company sold the property in March 2007, at a loss of approximately $55. This loss is included on the Company’s Income Statement as a component of “Income from discontinued operations.”
 
In accordance with SFAS No. 144, the Company reported the carrying value of the Allstate Pittsburgh property as asset held for sale on the December 31, 2006 Consolidated Balance Sheet, and the revenues from the property as income from discontinued operations on the Consolidated Income Statements for the quarters ended March 31, 2007 and March 31, 2006. Revenue and net income for the Allstate Pittsburgh property were $38 and $38, respectively, for the quarter ended March 31, 2007, and $49 and $49, respectively, for the quarter ended March 31, 2006.
 
In accordance with SFAS No. 144, the Company reported the carrying value of the Cott Corporation property it acquired in July 2006 as asset held for sale on the March 31, 2007 Consolidated Balance Sheet, and the revenues from the property as income from discontinued operations on the Consolidated Income Statements for the quarter ended March 31, 2007. The Company so classified this asset as it is in negotiations to sell this asset to a third party. The potential sale follows the tenant’s request to terminate the lease in exchange for a lease termination payment because it determined to discontinue its operations at the property. The Company expects the sale of the property to close within the next twelve months. Any gain or loss on the sale of the property is expected to be de minimis. Revenue and net income for the Cott Corporation property were $104 and $61, respectively, for the quarter ended March 31, 2007.
 
13

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
6.  
Securities Available for Sale and Structuring Fees Receivable
 
Securities available for sale at March 31, 2007 and at December 31, 2006, consisted of the following:

   
Mar 31, 2007
  
Dec 31, 2006
  
   
Unaudited
      
BACM 2006-4, Class H (rated BBB+) Face Amount
  
$
8,000
  
$
8,000
  
BSCMS 1999 CLF1, Class E (rated CCC) Face Amount
    
3,326
   
3,076
 
BSCMS 1999 CLF1, Class F (rated NR) Face Amount
    
274
   
–
 
CALFS 1997-CTL1, Class D (rated BB+) Face Amount
    
6,000
   
6,000
 
CMLBC 2001-CMLB-1, Class E (rated BBB+) Face Amount
    
9,526
   
9,526
 
CMLBC 2001-CMLB-1, Class G (rated BB+) Face Amount
    
9,526
   
9,526
 
CMLBC 2001-CMLB-1, Class H (rated B+) Face Amount
    
11,907
   
11,907
 
CMLBC 2001-CMLB-1, Class J (rated D) Face Amount
    
6,383
   
6,383
 
NLFC 1999-LTL-1, Class E (rated BB) Face Amount
    
11,081
   
11,081
 
NLFC 1999-LTL-1, Class X (IO) (rated AAA) Carry Value
    
7,319
   
7,597
 
WBCMT 2004-C15 180D (rated B+) Face Amount
    
15,000
   
15,000
 
WBCMT 2004-C15 180E (rated B) Face Amount
    
8,000
   
8,000
 
WBCMT 2006-C27, Class C (rated AA-) Face Amount
    
11,000
   
11,000
 
BACMS 2002-2, Class V-1 (7-Eleven, Inc.) (rated BBB) Face Amount
    
437
   
428
 
BACMS 2002-2, Class V-2 (Sterling Jewelers) (rated BBB-) Face Amount
    
669
   
655
 
CVS Corporation (rated BBB+) Face Amount
    
19,485
   
19,603
 
Koninklijke Ahold, N.V. 7.82% Jan 2020 (rated BB+) Face Amount
    
8,932
   
8,980
 
Koninklijke Ahold, N.V. 7.9% May 2026 (rated BB+) Face Amount
    
23,290
   
23,395
 
Yahoo, Inc. (rated BBB-) Face Amount
    
31,932
   
31,953
 
Unearned Discount
    
(16,192
)
  
(15,736
)
Cost Basis
    
175,895
   
176,374
 
Net unrealized appreciation on securities held for sale
    
6,439
   
6,692
 
Total
  
$
182,334
  
$
183,066
  
 
All Standard & Poor’s ratings in the above table are as of March 31, 2007.
 
Unrealized gains and losses on securities available for sale at March 31, 2007 and December 31, 2006, included as a component of other comprehensive income, consisted of the following:

   
Mar 31, 2007
  
Dec 31, 2006
  
   
Unaudited
      
Unrealized gains on securities available for sale
  
$
7,142
  
$
7,582
  
Unrealized losses on securities available for sale
    
(703
)
  
(890
)
 
The unrealized losses on the Company’s securities are primarily the result of market factors, rather than credit impairment, and the Company believes the securities’ carrying values are fully recoverable over their expected holding period.
 
14

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
The following table summarizes the Company’s securities in an unrealized loss position as of March 31, 2007.

   
Aggregate
Fair Value
 
Aggregate
Unrealized
Loss
 
Number of
Securities
  
In unrealized loss position less than 12 months
  
$
26,600
  
$
93
    
2
 
In unrealized loss position 12 or more months
    
41,303
   
610
   
3
 
 
At March 31, 2007, a total of three available for sale securities were in a continuous unrealized loss position for more than 12 months. The securities consist of mortgage backed securities with ratings ranging from B to BBB+. These securities have unrealized losses ranging from 1.1% to 2.2% of amortized cost. The Company believes that none of the unrealized losses on investment securities are other than temporary because substantially all of the unrealized losses in the Company’s investment portfolio relate to market interest rate changes on mortgage-backed securities, which the Company has both the intent and the ability to hold until maturity or until the fair value fully recovers. In addition, management considers the underlying credits to be financially sound and believes the Company will receive all contractual principal and interest related to these investments.
 
At March 31, 2007 and December 31, 2006, the effective interest rate (yield to maturity on adjusted cost basis) on securities available for sale was approximately 7.6% and 7.6%, respectively.
 
Structuring fees receivable of $3,093 and $3,253 at March 31, 2007 and December 31, 2006, respectively, were earned by the Company in conjunction with the structuring and subsequent sale of certain net lease loans. Such fees are payable to the Company monthly without interest through March 2020 and, accordingly, have been discounted based on imputed interest rates estimated by management to approximate market rates. Structuring fees receivable are shown at their amortized cost.
 
7.  
Other Assets
 
Other assets as of March 31, 2007 and December 31, 2006, consisted of the following:

   
Mar 31, 2007
 
Dec 31, 2006
 
 
 
Unaudited
 
 
  
Receivables and accrued interest
  
$
8,176
  
$
8,681
  
Prepaid expenses and deposits
    
6,861
   
2,561
 
Reserve accounts
    
8,859
   
10,652
 
Escrow held with mortgage lender
    
812
   
812
 
Funds with CDO trustee pending distribution or reinvestment
    
11,749
   
9,734
 
Amounts held by servicer
    
5,184
   
2,107
 
Derivative assets
    
2,394
   
2,333
 
Accrued rental income
    
17,013
   
15,069
 
Debt issuance costs, net
    
7,617
   
7,541
 
Investment in statutory trust
    
930
   
930
 
Other
    
1,943
   
2,023
 
Total
  
$
71,538
  
$
62,443
  
 
8.  
Joint Venture Investments
 
In December 2006, the Company entered into an agreement pursuant to which it committed to contribute up to $5,000 of capital to a newly formed management company organized to form and manage real estate investment funds offered and sold to European investors, subject to the satisfaction of certain terms and conditions by the principals of the management company. The Company expects its contributions will comprise less than 50% of the total capital contributed to the management company, and will entitle the Company to a 12% agreed return on its investment. As of March 31, 2007, the Company had deposited $385 toward its aggregate $5,000 commitment.
 
15

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
The Company also expects from time to time to source properties for the management company’s investment funds. The Company intends to retain an interest in any property sourced to any investment fund.
 
9.  
Repurchase Agreements and Other Short-Term Financing Arrangements
 
As of March 31, 2007, the Company had a $250,000 repurchase agreement and a $100,000 real property acquisition facility in place for short-term liquidity requirements with Wachovia Bank, N.A. and its affiliate. Each agreement has a 364-day term, was renewed in August 2006, and is scheduled to expire in August 2007.
 
The Company’s short-term borrowing arrangements are secured by the assets financed and are fully recourse to its other assets.
 
In anticipation of our next CDO issuance, Wachovia Bank has agreed to temporarily expand the Company’s borrowing capacity under the repurchase agreement to $350,000. This additional capacity is scheduled to expire on the earlier of (i) June 30, 2007 and (ii) the closing of the Company’s next CDO issuance.
 
Amounts related to the Company’s repurchase agreement as of March 31, 2007 and December 31, 2006, are as follows:

   
Mar 31, 2007
 
Dec 31, 2006
 
 
 
(unaudited)
 
 
  
Collateral carry value
          
Loans
  
$
184,113
  
$
171,804
  
Securities
    
96,046
   
82,037
 
Total
  
$
280,159
  
$
253,841
  
               
Borrowings
              
Loans
  
$
152,733
  
$
133,076
  
Securities
    
71,694
   
62,409
 
Total
  
$
224,427
  
$
195,485
  

The Company pays interest on amounts borrowed under its repurchase agreement with Wachovia Bank at prevailing short-term rates (30-day London Interbank Offered Rate (“LIBOR”)) plus a pricing spread (determined based upon the class and credit rating of the asset financed). Weighted average interest rates on the Company’s repurchase agreements for the quarter ended March 31, 2007 and March 31, 2006, are as follows:

   
Mar 31, 2007
 
Mar 31, 2006
 
 
 
Unaudited
 
Unaudited
  
Wachovia-mortgage loan repurchase agreements
    
6.31
%
  
5.56
%
Wachovia-CMBS repurchase agreements
    
6.18
%
  
5.25
%
 
As of March 31, 2007 and March 31, 2006, the 30-day LIBOR rate was 5.32% and 4.83%, respectively.
 
The Company is required to pay interest on any borrowings on the real property acquisition facility at prevailing short-term rates (30-day LIBOR) plus a pricing spread (ranging from 95 to 225 basis points). As of March 31, 2007, the Company had no borrowings outstanding on the real property acquisition facility.
 
16

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
The Company is required to comply with the following financial covenants under its short-term financing agreements: minimum liquidity, minimum tangible net worth and maximum leverage.
 
10.  
Risk Management Transactions
 
The Company’s objectives in using derivatives include adding stability to interest expense and managing its exposure to interest rate movements. The Company uses forward starting interest rate swaps to hedge the variability of changes in the interest-related cash outflows on forecasted future borrowings. As of March 31, 2007, the Company was hedging its exposure to such variability through December 2016. In accordance with SFAS 133, the interest rate swaps, to the extent that they have been designated and qualify as part of a hedging relationship, are treated as cash flow hedges for accounting purposes.
 
Interest rate swaps are agreements between two parties to exchange, at particular intervals, payment streams calculated on a specified notional amount. The interest rate swaps that the Company has entered into are single currency interest rate swaps and, as such, do not require the exchange of a notional amount.
 
Amounts related to open positions, as of March 31, 2007 and December 31, 2006, were as follows:

 
 
March 31, 2007
 
 
 
December 31, 2006
 
 
 
 
 
Unaudited
 
 
 
 
 
 
  
Description
  
Notional
Amount
 
Fair value
 
Notional
Amount
 
Fair value
  
Interest rate swaps
  
$
350,329
  
$
(147
)
$
231,719
  
$
(72
)
 
At March 31, 2007 and December 31, 2006, the Company had hedged the following future borrowings:

   
Mar 31, 2007
 
Dec 31, 2006
 
 
 
Unaudited
 
 
  
Future borrowings (principal amount)
  
$
350,329
  
$
231,719
  
 
At March 31, 2007 and December 31, 2006, derivatives with a fair value of $2,542 and $2,405, respectively, were included in accounts payable, accrued expenses and other liabilities on the Company’s Consolidated Balance Sheet. At March 31, 2007 and December 31, 2006, derivatives with a fair value of $2,394 and $2,333, respectively, were included in other assets on the Company’s Consolidated Balance Sheet.
 
Net realized gains and losses on qualifying cash flow hedges are included in other comprehensive income and will be reclassified and amortized as part of interest expense on the Company’s Consolidated Income Statement over the expected term of the Company’s related debt issuances. For the three months ended March 31, 2007 and March 31, 2006, the Company had net realized gains and (losses) of $196 and $(18), respectively, related to cash flow hedges. For the three months ended March 31, 2007 and March 31, 2006, the Company reclassified $302 and $286, respectively, from accumulated other comprehensive loss into interest expense related to the underlying debt issuances.
 
Within the next twelve months, the Company estimates that $1,257 of net losses currently held within Accumulated Other Comprehensive Income will be reclassified to earnings as additional interest expense.
 
The change in net unrealized gains and (losses) of $(110) and $3,559 in the quarters ended March 31, 2007 and March 31, 2006, respectively, for derivatives designated as cash flow hedges is separately disclosed in the Company’s Consolidated Statement of Changes in Stockholders’ Equity.
 
The Company had net income (expense) due to hedge ineffectiveness of $(11) and $4 for the quarters ended March 31, 2007 and March 31, 2006, respectively. These amounts are included in (gain) loss on derivatives on the Consolidated Income Statements.
 
17

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
Consistent with the cash flows of the related financing, the Company classifies the cash flows from derivatives that are accounted for as cash flow hedges as a financing activity on the Consolidated Statements of Cash Flows.
 
11.  
Long-Term Debt
 
Our long-term debt consists of the following:
 
·  
mortgage notes on real estate investments;
 
·  
collateralized debt obligations; and
 
·  
debt related to trust preferred securities.
 
Mortgage Notes on Real Estate Investments
 
The Company has financed most of its owned real properties with third party mortgage debt. The Company’s mortgage notes payable are as follows:

   
Mar 31, 2007
 
Dec 31, 2006
 
 
 
 Effective
 
 
  
Property Level Debt - Fixed Rate
  
Face
 
 Carry Value
 
Face
 
 Carry Value
 
Coupon
 
Rate(1)
 
Maturity
  
   
(unaudited) (unaudited)
                        
Choice Hotels International, Inc., Silver Spring, MD
  
$
31,474
  
$
31,474
  
$
31,653
  
$
31,653
    
5.30
%
  
5.34
%
  
May 2013
  
Omnicom Group, Inc., Irving, TX
    
13,575
    
13,575
    
13,575
    
13,575
    
5.24
%
  
5.30
%
  
May 2013
  
Capital One Financial Corporation, Plano, TX
    
20,925
    
20,925
    
20,925
    
20,925
    
5.24
%
  
5.29
%
  
May 2013
  
Aon Corporation, Glenview , IL
    
64,800
    
64,800
    
64,800
    
64,800
    
5.23
%
  
5.75
%
  
Nov 2014
  
Cadbury Schw eppes Holdings (US), Whippany, NJ
    
35,473
    
35,473
    
35,614
    
35,614
    
5.26
%
  
5.34
%
  
Mar 2015
  
ITT Industries, Inc., Herndon, VA
    
41,700
    
41,700
    
41,700
    
41,700
    
5.33
%
  
5.40
%
  
Jun 2015
  
Low es Companies, Inc., Aliso Viejo, CA
    
42,125
    
42,125
    
42,125
    
42,125
    
5.10
%
  
5.37
%
  
Jul 2015
  
Abbott Laboratories, Waukegan, IL
    
15,244
    
15,244
    
15,244
    
15,244
    
5.11
%
  
5.16
%
  
Aug 2015
  
United States Government (SSA), Austin, TX
    
5,391
    
5,391
    
5,391
    
5,391
    
5.23
%
  
5.46
%
  
Sep 2015
  
United States Government (DEA), Birmingham, AL
    
11,280
    
11,280
    
11,280
    
11,280
    
5.23
%
  
5.42
%
  
Sep 2015
  
United States Government (FBI), Birmingham, AL
    
18,800
    
18,800
    
18,800
    
18,800
    
5.23
%
  
5.31
%
  
Sep 2015
  
United States Government (NIH), N. Bethesda, MD
    
64,565
    
64,565
    
64,883
    
64,883
    
5.32
%
  
5.56
%
  
Sep 2015
  
Tiffany & Co., Parsippany, NJ
    
58,400
    
58,400
    
58,400
    
58,400
    
5.33
%
  
5.34
%
  
Oct 2015
  
Allstate Insurance Company, Charlotte, NC
    
20,209
    
20,209
    
20,209
    
20,209
    
5.68
%
  
5.71
%
  
Jan 2016
  
Allstate Insurance Company, Roanoke, VA
    
21,516
    
21,516
    
21,516
    
21,516
    
5.68
%
  
5.76
%
  
Jan 2016
  
Farmers New World Life Insurance Company, Mercer Island, WA
    
30,200
    
30,200
    
30,200
    
30,200
    
5.69
%
  
5.72
%
  
Jan 2016
  
TJX Companies, Inc., Philadelphia, PA
    
71,537
    
71,537
    
71,625
    
71,625
    
5.57
%
  
5.59
%
  
Mar 2016
  
United States Government (VA), Ponce, PR
    
6,751
    
7,043
    
6,869
    
7,172
    
7.30
%
  
6.41
%
  
Apr 2016
  
Pearson Plc., Law rence, KS
    
16,025
    
16,025
    
16,025
    
16,025
    
5.84
%
  
5.95
%
  
May 2016
  
Koninklijke Ahold, N.V., Levittow n, PA
    
14,748
    
14,748
    
14,794
    
14,794
    
6.05
%
  
6.11
%
  
Jul 2016
  
AMVESCAP PLC, Denver, CO
    
43,700
    
43,700
    
43,700
    
43,700
    
6.03
%
  
6.08
%
  
Jul 2016
  
Walgreen Co., Pennsauken, NJ
    
1,886
    
2,020
    
1,919
    
2,059
    
7.65
%
  
6.04
%
  
Oct 2016
  
United States Government (FBI), Albany, NY
    
10,137
    
10,137
    
10,137
    
10,137
    
5.50
%
  
5.68
%
  
Nov 2016
  
Aetna Life Insurance Company, Fresno, CA
    
16,043
    
16,043
    
16,043
    
16,043
    
5.63
%
  
5.68
%
  
Dec 2016
  
T-Mobile USA, Inc., Nashville, TN
    
10,885
    
10,885
    
10,885
    
10,885
    
5.59
%
  
5.69
%
  
Dec 2016
  
Time Warner Entertainment Company, L.P., Milw aukee, WI
    
17,500
    
17,500
    
17,500
    
17,500
    
5.55
%
  
5.59
%
  
Dec 2016
  
Farmers Group, Inc., Simi Valley, CA
    
25,620
    
25,620
    
-
    
-
    
5.81
%
  
5.85
%
  
Jan 2017
  
Johnson Controls, Inc., Largo, FL
    
16,200
    
16,200
    
16,200
    
16,200
    
5.48
%
  
5.52
%
  
Jan 2017
  
County of Yolo, California, Woodland, CA
    
10,332
    
10,332
    
-
    
-
    
5.68
%
  
5.75
%
  
Feb 2017
  
AmeriCredit Corp., Arlington, TX
    
28,897
    
28,522
    
29,005
    
28,623
    
5.28
%
  
5.51
%
  
Sep 2017
  
Walgreen Co., Portsmouth, VA
    
3,161
    
3,357
    
3,190
    
3,391
    
7.20
%
  
6.18
%
  
Jul 2018
  
United States Government (EPA), Kansas City, KS
    
21,095
    
24,570
    
21,095
    
24,626
    
7.57
%
  
5.74
%
  
Oct 2022
  
United States Government (OSHA), Sandy, UT
    
14,670
    
15,664
    
14,669
    
15,678
    
6.28
%
  
5.52
%
  
Jan 2024
  
Total
  
$
824,864
  
$
829,580
  
$
789,971
  
$
794,773
                    
 
(1)
The effective rate is the Company’s approximate borrowing cost, including the effect of hedge gains or losses and other deferred financing costs associated with the related borrowing.

The mortgage notes are secured by the respective properties and an assignment of the relevant leases on the properties. See Note 4 regarding the separate and distinct nature of the Company’s SPEs. The Company’s book value before accumulated depreciation and amortization on owned properties encumbered with mortgage debt aggregated $1,206,082 at March 31, 2007, and $1,147,232 at December 31, 2006.
 
18

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
Collateralized Debt Obligations
 
In March 2005, the Company completed its first collateralized debt obligation, or CDO. The CDO was an entirely fixed rate financing. The Company aggregated approximately $300,000 of assets into the pool, and created $285,000 face amount of multi-class notes and $15,000 of preferred equity through the CDO trust. The net amount of the debt the Company issued was $268,130, inclusive of a $370 discount to face, as the Company retained the three most junior note classes aggregating a face amount of $16,500 and the full $15,000 of preferred equity. Each of the five note classes of the CDO was rated investment grade. During the first five years of the CDO term, the Company expects to reinvest principal repayments on the underlying assets into qualifying replacement collateral. The CDO notes have a stated maturity in January 2040, but are expected to mature in January 2015 when they become subject to an auction call procedure. The Company’s effective blended financing rate (inclusive of original issue discount and debt issuance and hedge costs) on its CDO is approximately 5.67%. The CDO debt is non-recourse to the Company but is secured by the assets in the pool. The following table summarizes the assets in the Company’s portfolio posted as CDO collateral as of March 31, 2007.

   
Carry Value
  
Long-Term Mortgage Loans
  
$
155,328
  
Corporate Credit Notes
    
11,135
  
CMBS and Other Real Estate Securities
    
78,405
  
Total
  
$
244,868
  
 
The table does not include approximately $46,567 of intercompany mortgage notes that are eliminated from the Company’s balance sheet in consolidation.
 
Trust Preferred Securities
 
In December 2005, the Company’s operating partnership, Caplease, LP, issued $30,000 in aggregate principal amount of fixed/floating rate preferred securities through its wholly-owned subsidiary, Caplease Statutory Trust I. The trust simultaneously issued 930 of its common securities to the operating partnership for a purchase price of $930, which constitutes all of the issued and outstanding common securities of the trust. The trust used the proceeds from the sale of the trust preferred securities together with the proceeds from the sale of the common securities to purchase $30,930 in aggregate principal amount of unsecured fixed/floating rate junior subordinated notes due January 30, 2036, issued by the operating partnership. The junior subordinated notes, the common and the trust preferred securities have substantially identical terms, requiring quarterly interest payments calculated at a fixed interest rate equal to 7.68% per annum through January 30, 2016, and subsequently at a variable interest rate equal to LIBOR plus 2.60% per annum. The notes mature on January 30, 2036, and may be redeemed, in whole or in part, at par, at the Company’s option, beginning on January 30, 2011. The trust preferred and common securities do not have a stated maturity date; however, they are subject to mandatory redemption upon the redemption or maturity of the notes.
 
The principal amount of the junior subordinated notes of $30,930 is reported as other long-term debt on the Company’s Consolidated Balance Sheet. However, because the Company is not deemed to be the primary beneficiary of the trust under FASB Interpretation Number 46, Consolidation of Variable Interest Entities, the Company’s investment in the trust is not eliminated from the Company’s financial statements in consolidation. Instead, the Company records its investment in the trust’s common shares of $930 as part of other assets on the Company’s Consolidated Balance Sheet.
 
The Company incurred issuance costs associated with the offering of $972. These costs are included as a component of other assets on the Company’s Consolidated Balance Sheet, and are being amortized into interest expense using the effective yield method through the date the fixed interest period expires (the expected maturity date of the trust preferred securities). The Company’s effective borrowing rate on the trust preferred securities, inclusive of deferred issuance costs, is approximately 8.30% per annum.
 
19

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
Scheduled principal amortization and balloon payments for long-term debt as of March 31, 2007 for the next five years and thereafter are as follows:

   
Scheduled
Amortization
 
Balloon
Payments
 
Total
 
9 Months Ending December 31, 2007
  
$
4,035
  
$
–
  
$
4,035
  
2008
    
7,527
   
-
   
7,527
 
2009
    
9,255
   
-
   
9,255
 
2010
    
34,081
   
-
   
34,081
 
2011
    
24,713
   
-
   
24,713
 
Thereafter
    
133,236
   
915,863
   
1,049,099
 
   
$
212,847
  
$
915,863
  
$
1,128,710
  
 
12.  
Commitments and Contingencies
 
The Company is involved from time to time in litigation arising in the ordinary course of business. The Company is not currently involved in any matter which management believes will have a material adverse effect on its business, results of operations or financial condition.
 
As an owner of commercial real estate, the Company is subject to potential environmental costs. At March 31, 2007, the Company was not aware of any environmental concerns that would have a material adverse effect on the Company’s financial position or results of operations.
 
The Company is obligated under a letter of credit with respect to one of its 1999 securitization transactions (BSCMS 1999-CLF1). The maximum potential amount of future required payments under the letter of credit is $2,850. The letter of credit expires on February 18, 2009. The trustee may draw the letter of credit if there are realized losses on the mortgage loans that would create a shortfall in the interest or principal on any investment grade certificate. The letter of credit may be withdrawn when the ratings of the investment grade certificates are no longer dependent upon the credit support provided by the letter of credit. During February 2005, one of the mortgage loans in the securitization on a property leased to Winn-Dixie defaulted, in connection with the bankruptcy of Winn-Dixie. However, management does not expect any draw on the letter of credit as a result of this mortgage default, or otherwise. Letter of credit fees included in interest expense were $25 and $26 for the quarters ended March 31, 2007 and March 31, 2006, respectively.
 
The Company had outstanding commitments to fund loans of $12,000 related to its credit agreement to support YUM! Brands, Inc. franchise loans as of March 31, 2007. As of March 31, 2007, advances of $5,879 had been made against these commitments.
 
During October 2006, the Company acquired a real property in Fresno, California leased to Aetna Life Insurance Company, and agreed to fund expected improvements to the real property of approximately $812. During November 2006, the Company arranged long-term financing on this property and it funded a reserve account with its lender for the full amount of this obligation. The Company expects these funds will be disbursed in full as improvements are completed. As of March 31, 2007, none of these funds have been disbursed.
 
As discussed under Note 8 above, the Company has agreed to contribute up to $5,000 of capital to a newly formed management company organized to form and manage real estate investment funds offered and sold to European investors, subject to the satisfaction of certain terms and conditions by the principals of the management company. As of March 31, 2007, the Company had deposited $385 toward its aggregate $5,000 commitment.
 
20

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
13.  
Minority Interests
 
As of March 31, 2007, Caplease, LP had issued and outstanding 263,157 common units of limited partnership to a minority interest holder. All of these units were issued in connection with the acquisition of a property acquired in June 2006. Beginning on June 13, 2008, the units of limited partnership are redeemable by the holder, at its option, on the basis of one unit for either one share of CLF, Inc. common stock or cash equal to the fair market value of a share of common stock at the time of the redemption. The units of limited partnership do not have a liquidation preference.
 
Cash distributions by Caplease, LP will be paid in the following priority: first, to the minority interest holder until such holder receives the amount it would have received if the holder’s units of limited partnership interest were converted to an equal number of shares of CLF, Inc. common stock, and then, to CLF, Inc. Since July 2006, the minority interest holder has been paid a cash dividend of $0.20 per limited partnership unit simultaneous with the payment of CLF, Inc.’s cash dividend of $0.20 per share of common stock.
 
Net income has been allocated to the minority interest holder on an “as converted” basis. In other words, the limited partnership units are treated as converted to shares of CLF, Inc. common stock, and the minority interest holder is allocated a percentage of the Company’s net income based on its percentage of as converted common shares outstanding. In addition, a weighted average is used for units outstanding for less than a full period.
 
14.  
Stockholders’ Equity
 
Stock Issuances
 
CLF, Inc.’s authorized capital stock consists of 500,000,000 shares of common stock, $0.01 per share, and 100,000,000 shares of preferred stock, $0.01 per share. As of March 31, 2007, CLF, Inc. had issued and outstanding 34,413,061 shares of common stock, and 1,400,000 shares of 8.125% Series A cumulative redeemable preferred stock.
 
During March 2007, CLF, Inc. issued 314,750 shares of common stock to its executive officers, other employees and directors pursuant to the Company’s stock incentive plan. As of March 31, 2007, the Company had awarded 1,396,745 shares of common stock under the stock plan, all in the form of stock awards to executive officers, other employees and directors of the Company (see Note 15 below).
 
During March 2007, CLF, Inc. issued 482 shares of common stock through its dividend reinvestment and stock purchase plan at a price of $10.60 per share.
 
Dividends
 
CLF, Inc. has paid cash dividends to its common stockholders each quarter since the third quarter of 2004, and to its Series A preferred stockholders each quarter since the fourth quarter of 2005.
 
The following table summarizes the dividend history on shares of CLF, Inc. common stock for the periods indicated.

Quarter
Ended
 
Record
Date
 
Payment
Date
 
Dividend
Per Share
 
Total
Amount
 
12/31/2005
    
12/30/2005
    
1/17/2006
  
$
0.20
  
$
5,574
  
3/31/2006
    
3/31/2006
    
4/17/2006
    
0.20
   
5,636
 
6/30/2006
    
6/30/2006
    
7/17/2006
    
0.20
   
6,783
 
9/30/2006
    
9/29/2006
    
10/16/2006
    
0.20
   
6,785
 
12/31/2006
    
12/29/2006
    
1/16/2007
    
0.20
   
6,818
 
3/31/2007
    
3/30/2007
    
4/16/2007
    
0.20
   
6,883
 
21

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
The following table summarizes the dividend history on shares of CLF, Inc. Series A preferred stock for the periods indicated.

Quarter
Ended
  
Record
Date
 
Payment
Date
 
Dividend
Per Share
 
Total
Amount
 
12/31/2005
    
12/30/2005
    
1/17/2006
  
$
0.4852400
  
$
679
  
3/31/2006
 
  
3/31/2006
    
4/17/2006
    
0.5078125
   
711
 
6/30/2006
    
6/30/2006
    
7/17/2006
    
0.5078125
   
711
 
9/30/2006
    
9/29/2006
    
10/16/2006
    
0.5078125
   
711
 
12/31/2006
    
12/29/2006
    
1/16/2007
    
0.5078125
   
711
 
3/31/2007
    
3/30/2007
    
4/16/2007
    
0.5078125
   
711
 
 
15.  
Stock Based Compensation
 
The Company adopted a stock incentive plan for its employees and directors during March 2004 in connection with its initial public offering. 2,323,000 shares of common stock are authorized for issuance under the stock plan, inclusive of 1,250,000 shares approved by the Company’s stockholders at the Company’s annual stockholder meeting held on June 14, 2006. As of March 31, 2007, the Company had awarded 1,396,745 shares of common stock under the stock plan, all in the form of stock awards to executive officers, other employees and directors of the Company. The Company has not awarded any options, stock appreciation rights or other stock based compensation under the stock plan.
 
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (Revised 2004) − Share-Based Payment (“SFAS No. 123R”), using the modified prospective transition method. SFAS No. 123R replaces SFAS No. 123, which the Company adopted on January 1, 2003. Under that transition method, compensation cost recognized on and after January 1, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all share-based payments granted on or after January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R.
 
Because the Company has historically valued compensation cost for stock awards at fair value under SFAS No. 123, the adoption of SFAS No. 123R had no impact on the Company’s income from continuing operations, net income, earnings per share (basic and diluted), cash flows from operations or cash flows from financing activities.
 
The Company uses the closing stock price on the grant date as its estimate of the fair value of the award.
 
A summary of the Company’s activity under the stock plan from January 1, 2006 through the quarter ended March 31, 2007, is presented below:

   
Number of Shares
  
Stock Awards at January 1, 2006
    
760,546
 
Granted During the Year Ended December 31, 2006
    
332,450
(1)
Forfeited During the Year Ended December 31, 2006
    
(11,001
)
Stock Awards at January 1, 2007
    
1,081,995
 
Granted During the Period Ended March 31, 2007
    
314,750
(2)
Stock Awards at March 31, 2007
    
1,396,745
 
 
(1)
Shares are scheduled to vest between March 2007 and March 2011, but will generally be forfeited if the recipient either terminates his employment with the Company or ceases to be a member of CLF, Inc.’s Board of Directors at any time prior to the vesting date. Vesting of an aggregate of 133,500 shares is also subject to satisfaction of objective and subjective performance criteria, to be determined by CLF, Inc.’s Compensation Committee.
(2)
Shares are scheduled to vest between March 2008 and March 2012, but will generally be forfeited if the recipient either terminates his employment with the Company or ceases to be a member of CLF, Inc.’s Board of Directors at any time prior to the vesting date. Vesting of an aggregate of 156,750 shares is also subject to satisfaction of objective and subjective performance criteria, to be determined by CLF, Inc.’s Compensation Committee.
 
22

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 

A summary of the status of unvested shares from January 1, 2006 through the quarter ended March 31, 2007, is presented below:

   
Shares Awarded Under Plan
 
Shares Priced Under SFAS 123 and 123R
 
Weighted Average Fair Value
  
Nonvested at January 1, 2006
    
495,647
   
371,203
 
$
10.83
  
Current period awards
    
332,450
   
243,450
   
11.07
 
Prior period awards
    
N/A
    
62,222
   
10.66
 
Vested
    
(228,983
)
  
(228,983
)
  
10.72
 
Forfeited
    
(11,001
)
  
(11,001
)
  
11.02
 
Nonvested at January 1, 2007
    
588,113
   
436,891
   
10.99
 
Current period awards
    
314,750
   
189,350
   
10.91
 
Prior period awards
    
N/A
    
30,771
   
10.91
 
Vested
    
(202,905
)
  
(202,905
)
  
10.96
 
Nonvested at March 31, 2007
    
699,958
   
454,107
   
11.00
 
 
As the immediately preceding table indicates, not all Company share awards have been valued for purposes of SFAS 123R, as the Company’s stock awards include shares awarded with vesting dependant upon satisfaction of performance criteria and with the performance criteria on a portion of the shares to be determined in the future. “Prior period awards” represent share awards made in a prior period which have been valued for purposes of SFAS 123R in the current period when the CLF, Inc. Compensation Committee determined the performance criteria.
 
As of March 31, 2007, $4,911 of unvested shares (fair value at the grant dates) is expected to be charged to the Company’s Consolidated Income Statement ratably over the remaining vesting period (through March 2012). As of March 31, 2007, the grant date fair value for awards of 49,776 shares made in 2005, 70,675 shares made in 2006 and 125,400 shares made in 2007, has not yet been determined because the grant date (as defined under SFAS 123R) has not yet occurred.
 
The following summarizes the expense the Company recorded in its Consolidated Income Statement during the quarters ended March 31, 2007 and March 31, 2006, for stock based compensation:

   
For the three months
 
 
 
ended March 31,
 
 
 
2007
 
2006
  
General and administrative expenses-stock based compensation
  
$
323
  
$
671
  
 
16.  
Other Comprehensive Income
 
Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances, excluding those resulting from investments by and distributions to owners. For the Company’s purposes, comprehensive income represents net income, as presented in the Company’s Consolidated Income Statements, adjusted for unrealized gains or losses on securities available for sale, unrealized gains or losses on derivatives designated as cash flow hedges, and realized gains and losses on derivatives designated as cash flow hedges (net of amortization of those realized gains and losses into interest expense). The Company’s comprehensive income for the quarters ended March 31, 2007 and March 31, 2006 is summarized below:
 
23

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 


   
 For the three months
  
   
ended March 31,
  
   
2007
 
 2006
  
Net income
  
$
618
  
$
2,352
  
Unrealized change in value on securities available for sale
    
(253
)
  
(3,218
)
Unrealized gain (loss) on derivatives
    
(110
)
  
3,559
  
Realized gain (loss) on derivatives, net of amortization
    
509
    
264
  
Comprehensive income (loss)
  
$
764
  
$
2,957
  
 
SFAS No. 130, Reporting Comprehensive Income, divides comprehensive income into “net income” and “other comprehensive income.” Other comprehensive income is defined as revenues, expenses, gains and losses that under generally accepted accounting principles are included in comprehensive income but excluded from net income. Other comprehensive income is also summarized on the Company’s Consolidated Statement of Changes in Stockholders’ Equity (fourth column). The following table summarizes the Company’s accumulated other comprehensive income (loss) as reported on the Consolidated Statement of Changes in Stockholders’ Equity.

   
Mar 31, 2007
 
 Dec 31, 2006
 
 
 
(unaudited)
 
     
 Net unrealized gains on securities
  
$
6,439
  
$
6,692
  
 Net unrealized gains (losses) on derivatives
    
(61
)
  
48
  
 Net realized losses on derivatives
    
(10,492
)
  
(11,000
)
 Accumulated other comprehensive loss
  
$
(4,114
)
$
(4,260
)
 
17.  
Rental Income
 
The Company is the lessor to tenants under operating leases with expiration dates ranging from 2007 to 2026 (not including incidental leases). The minimum rental amounts due under the leases are generally subject to scheduled fixed increases. The leases generally also require that the tenants pay for or reimburse the Company for the occupancy and operating costs of the properties, or in certain cases reimburse the Company for increases in certain operating costs and real estate taxes above their base year costs. Approximate future minimum rents to be received over the next five years and thereafter for non-cancelable operating leases in effect at March 31, 2007, are as follows:
 
 9 Months Ending December 31, 2007
 
$
66,319
  
 2008
    
89,356
  
 2009
    
87,912
  
 2010
    
86,172
  
 2011
    
87,172
  
 Thereafter
    
656,091
  
   
$
1,073,022
  
 
18.  
Pro Forma Condensed Consolidated Income Statements 
 
The accompanying unaudited Pro Forma Condensed Consolidated Income Statements are presented as if, at January 1, 2006, the Company acquired all real properties purchased during the quarter ended March 31, 2007 and the year ended December 31, 2006. Earnings per share are presented using the weighted average shares outstanding during the relevant periods. In management's opinion, all adjustments necessary to reflect the effects of the above transactions have been made.
 
The unaudited Pro Forma Condensed Consolidated Income Statements are not necessarily indicative of what the actual results of operations would have been assuming the acquisition transactions had occurred at the date indicated above, nor do they purport to represent our future results of operations.
 
24

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)

 
  
For the three months
ended March 31,
  
 
  
2007
  
2006
  
Total revenues
  
$
35,520
  
$
31,015
  
Income from continuing operations
  
$
639
  
$
3,040
  
Net income (loss) allocable to common stockholders
  
$
(28
)
$
2,440
  
Income per basic and diluted common share from continuing operations
  
$
0.02
  
$
0.11
  
Net income per basic and diluted common share
  
$
0.00
  
$
0.09
  
 
19.  
Segment Reporting
 
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes the manner in which public businesses report information about operating segments in annual and interim financial reports issued to stockholders. SFAS No. 131 defines a segment as a component of an enterprise about which separate financial information is available and that is evaluated regularly to allocate resources and assess performance. The Company conducts its business through two segments: operating real estate (including its investments in owned properties) and lending investments (including its loan investments as well as its investments in securities). For segment reporting purposes, the Company does not allocate interest income on short-term investments or general and administrative expenses.
 
Selected results of operations for the quarters ended March 31, 2007 and March 31, 2006, are as follows:

   
Corporate /
Unallocated
 
Operating
Real Estate
 
Lending
Investments
 
 
 
Mar 31, 2007
 
Mar 31, 2006
 
Mar 31, 2007
 
Mar 31, 2006
 
Mar 31, 2007
 
Mar 31, 2006
  
Total revenues
  
$
136
  
$
228
  
$
26,809
  
$
18,995
  
$
8,219
  
$
9,125
  
Total expenses and minority interest
    
3,556
   
3,637
   
25,532
   
17,583
   
5,545
   
4,824
 
Income (loss) from continuing operations
    
(3,420
)
  
(3,409
)
  
1,277
   
1,412
   
2,674
   
4,301
 
Total assets
    
38,328
   
49,118
   
1,206,598
   
957,212
   
456,880
   
409,979
 
 
20.  
Variable Interest Entities
 
In January 2003, the FASB issued Interpretation Number 46, Consolidation of Variable Interest Entities. FIN 46 was revised by FIN 46(R) in December 2003 (as revised, “FIN 46”). FIN 46 defines a variable interest entity (“VIE”) as an entity with one or more of the following characteristics:
 
·  
the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties;
 
·  
equity holders either (a) lack direct or indirect ability to make decisions about the entity, (b) are not obligated to absorb expected losses of the entity or (c) do not have the right to receive expected residual returns of the entity if they occur; or
 
·  
equity holders have voting rights that are not proportionate to their economic interests, and the activities of the entity involve or are conducted on behalf of an investor with a disproportionately small voting interest.
 
If an entity is deemed to be a VIE, an enterprise that absorbs a majority of the expected losses of the entity is considered the primary beneficiary and must consolidate the VIE.
 
As part of the Company’s developer loan program, the Company funds loans to an entity that owns an undeveloped property. These loans are used to finance pre-construction costs related to the property, such as due diligence costs and land acquisition contract deposits, rather than costs to build on the property. The Company has funded two such loans as of March 31, 2007, with an aggregate unpaid principal amount of approximately $1,148 as of that date. The Company has determined that its borrowers are VIEs under FIN 46. Each loan is secured, in part, by a personal guarantee by the borrowing entity’s owner. The Company has concluded it is not the primary beneficiary of the VIE (and, therefore, the Company has not consolidated the VIE under FIN 46). The Company’s maximum exposure to loss as a result of its involvement with these VIEs is the amount funded on the loans.
 
25

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
During June 2006, the Company entered into a revolving credit agreement with a third party borrower pursuant to which the Company agreed to provide up to $12,000 to support the borrower’s capital contributions to a joint venture that provides franchise loans to franchisees of YUM! Brands, Inc. restaurant concepts such as Taco Bell, Kentucky Fried Chicken and Pizza Hut. The Company is generally required to make advances simultaneous with the borrower’s capital contributions to the joint venture to fund the underlying franchise loans. As of March 31, 2007, the Company had advanced $5,879 under the agreement. The Company has determined that the borrower is a VIE under FIN 46. The Company’s advances are secured by a pledge of the borrower’s 50% membership interest in the joint venture and a limited guaranty by one of the principals of the borrower. The Company has determined it is not the primary beneficiary of the VIE (and, therefore, the Company has not consolidated the VIE under FIN 46). The Company’s maximum exposure to loss as a result of this investment is the amount advanced under the credit agreement.
 
21.  
Subsequent Events
 
Acquisition of Net Lease Portfolio
 
On April 18, 2007, the Company completed the acquisition of a portfolio of 18 real estate assets net leased to five different tenants. The purchase price for the assets was $364,400, including $159,317 of assumed mortgage debt. The portfolio includes the following assets:
 
Tenant or Guarantor
  
Number of Properties
  
Location
  
Property Type
  
Approximate Rentable Square Feet
  
Lease Maturity
                     
Nestlé Holdings, Inc.(1)
  
3
  
Breinigsville, Pennsylvania; Fort Wayne, Indiana; and Lathrop, California
  
Warehouse/ Distribution Facilities
  
2,560,000
  
12/2012
The Kroger Co.(2)
  
11
  
Various locations in Kentucky (5), Georgia (4) and Tennessee (2)
  
Grocery Stores
  
685,000
  
1/2022
Factory Mutual Insurance Company(3)
  
1
  
Johnston, Rhode Island
  
Office Building
  
346,000
  
7/2009
Qwest Business Resources, Inc.(4)
  
2
  
Omaha, Nebraska
  
Office Buildings
  
420,000
  
6/2010
The Travelers Corporation(5)
  
1
  
Hartford, Connecticut
  
Office Building
  
130,000
  
10/2011
 
________________ 
(1) The Company acquired the improvements on the land and controls the land through an estate for years that expires in December 2012. Upon expiration of the estate for years, the Company has the option to lease the land for five years plus 11 five-year renewal options (or, a total of 60 years) at a fixed annual rent of $1,120 for the first 40 years and market rent thereafter. The Company also has the option to purchase the land upon expiration of the estate for years in December 2012 and on the last day of the primary term and each renewal term of the ground lease at fair market value.
(2) The Company acquired the improvements on the land and controls the land through an estate for years that expires in January 2022. Upon expiration of the estate for years, the Company has the option to lease the land for five years plus 11 five-year renewal options (or, a total of 60 years) at a fixed annual rent of $770 for the first 35 years and market rent thereafter. The Company also has the option to purchase the land upon expiration of the estate for years in January 2022 and on the last day of the primary term and each renewal term of the ground lease at fair market value.
(3) The Company acquired the improvements on the land and controls the land through a ground lease with an initial term expiring in July 2009. The Company can renew the ground lease for 10 successive five year periods (or, through July 2059). The annual ground rent is approximately $115 during the initial term and the first eight renewal terms. The annual ground rent during the final two renewal terms is the greater of (i) $115 and (ii) the fair market rent.
(4) The Company acquired the improvements on the land and controls the land through an estate for years that expires in June 2010. The Company owns two buildings, 1200 Landmark and 94 West Dodge. Upon expiration of the estate for years, the Company has the option to lease the relevant land for five years plus 12 five-year renewal options (or, a total of 65 years), at a fixed annual rent of approximately $263 for the first 40 years and market rent thereafter with respect to the 1200 Landmark building, and at a fixed annual rent of $117 for the first 40 years and market rent thereafter with respect to the 94 West Dodge building. The Company also has the option to purchase the relevant land upon expiration of the estate for years in June 2010 and on the last day of the primary term and each renewal term of the ground lease at fair market value.
(5) The Company owns the improvements and controls the air space through an easement in perpetuity.
 
26

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
Assumed Debt
 
The following summarizes certain terms of the debt the Company assumed:
 
Property
  
Indebtedness
  
Principal Amount as of April 18, 2007
  
Coupon Rate
  
Maturity Date
  
                   
Nestlé Holdings, Inc.
   Series A Mortgage Notes  
$
14,539
    
8.484
%
  
January 2009
  
Nestlé Holdings, Inc.
   Series B Mortgage Notes    
46,459
    
8.654
%
  
July 2012
  
The Kroger Co.
   Mortgage Notes    
41,562
    
8.03
%
  
January 2019
  
Factory Mutual Insurance Company
   Second Mortgage Notes(1)
 
  
12,168
    
10.00
%
  
August 2019
  
Qwest Business Resources, Inc.
   Mortgage Notes    
10,961
    
8.05
%
  
January 2010
  
The Travelers Corporation
   Series M Mortgage Notes    
22,082
    
9.7978
%
  
September 2011
  
The Travelers Corporation
   Series Z Mortgage Notes    
11,546
    
10.7561
%
  
October 2011
  
         
$
159,317
              
 
_______________ 
(1) The Company also defeased first mortgage notes with an outstanding principal balance of $12,963 at closing of the acquisition, at a total cost of $13,919.

The debt the Company assumed is customary third-party mortgage debt that is non-recourse but is secured by the Company’s interest in the respective properties and its lease with the respective tenant.
 
The Company expects to refinance substantially all of the debt it assumed within a few months.
 
Bridge Debt
 
In order to fund a portion of the purchase price of the above acquisition, the Company borrowed $210,273 under a new short-term credit agreement with Wachovia Bank, N.A. (the “Bridge Facility”). Caplease, LP is the borrower under the Bridge Facility and CLF, Inc. and various of its other subsidiaries are guarantors.
 
The Bridge Facility has an initial term of 90 days that the Company may extend for an additional 45 days upon payment of an extension fee of 0.50% of the amount outstanding. The Company can repay its borrowings in whole or in part at any time (subject to a $2,000 minimum) without any penalty or premium. The Company is required to repay the Bridge Facility with net proceeds from any debt or equity issuance by CLF, Inc. or any of its subsidiaries, other than special purpose subsidiaries that may be formed from time to time in connection with the acquisition of additional real estate properties other than the portfolio. The Company intends to repay its borrowings under the Bridge Facility with the proceeds from refinancing the debt it assumed on the properties, through potential property sales, and/or through issuances of equity, long-term debt or other permanent capital alternatives, all of which the Company is evaluating.
 
During the initial term, the Company’s borrowings under the Bridge Facility will bear interest at prevailing short-term interest rates (30-day LIBOR plus 250 basis points). During any extended term, the interest rate on the Company’s borrowings will increase to 30-day LIBOR plus 350 basis points. The Company funded the estimated amount of its interest cost on the Bridge Facility into a reserve account at Wachovia Bank. The Company paid Wachovia Bank fees in connection with the Bridge Facility of $2,632.
 
27

Capital Lease Funding, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share amounts)

March 31, 2007 (unaudited)
 
The Company’s borrowings under the Bridge Facility are secured by a pledge of substantially all of its unencumbered assets, including the equity interest in the subsidiary that indirectly owns the portfolio of properties. The Bridge Facility is a fully recourse lending arrangement.
 
The Company has agreed to maintain a fixed charge coverage ratio of not less than 1.25 to 1.00 during the term of the Bridge Facility. The Company also made customary representations and warranties and affirmative and negative covenants, and agreed to customary events of defaults. The Bridge Facility is cross-defaulted with the Company’s repurchase agreement and its real property acquisition facility with Wachovia Bank or its affiliates.
 
28

Item 2.  
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion should be read in conjunction with the consolidated financial statements and the notes to those financial statements, included elsewhere in this filing. Where appropriate, the following discussion includes analysis of our predecessor entity.
 
General
 
We are a diversified REIT that invests primarily in single tenant commercial real estate assets subject to long-term leases to high credit quality tenants. We focus on properties that are subject to a net lease, or a lease that requires the tenant to pay all or substantially all expenses normally associated with the ownership of the property (such as utilities, taxes, insurance and routine maintenance) during the lease term. We also continue to be opportunistic and have made and expect to continue to make investments in single tenant properties where the owner has exposure to property expenses when we determine we can sufficiently underwrite that exposure and isolate a predictable cash flow.
 
Our primary business objective is to generate stable, long-term and attractive returns based on the spread between the yields generated by our assets and the cost of financing our portfolio. We invest at all levels of the capital structure of net lease or other single tenant properties, including equity investments in real estate (owned real properties), debt investments (mortgage loans and net lease mortgage backed securities) and mezzanine investments secured by net leased or other single tenant real estate collateral.
 
The principal sources of our revenues are rental income on our owned real properties and interest income from our debt investments (loans and securities). The principal sources of our expenses are interest expense on our assets financed, depreciation expense on our real properties, general and administrative expenses and property expenses (net of expense recoveries).
 
We rely on leverage to allow us to invest in a greater number of assets and enhance our asset returns. We seek to finance our assets on a long-term basis with fixed-rate debt of a like maturity. Through March 31, 2007, our long-term financings have been in the form of traditional third party mortgage financings (on most of our owned real properties) and our first CDO (completed in March 2005). We have short-term floating rate borrowing arrangements in place to facilitate our investment activity while we arrange long-term financing. We employ a hedging strategy to mitigate our exposure to changes in interest rates while our assets are financed under our short-term borrowing arrangements. We expect our leverage to average 70% to 85% of our assets in portfolio. Including the trust preferred debt we issued in December 2005, our overall portfolio leverage as of March 31, 2007 was approximately 83.7%.
 
We rely primarily on equity and debt capital to fund our portfolio growth. Through March 31, 2007, our primary capital issuances have been our initial public offering of common stock in March 2004 (net proceeds of $221.8 million), a Series A preferred stock issuance in October 2005 (net proceeds of $33.7 million), trust preferred debt issued in December 2005 (net proceeds of $29.9 million), and a follow-on common stock offering in May 2006 (net proceeds of $57.3 million).
 
Summary of Investment and Financing Activity in First Quarter of 2007
 
The following highlights our investment and financing activity during the quarter ended March 31, 2007:
 
·  
We added assets of $58.3 million to our portfolio, including two new real property acquisitions for an aggregate purchase price of $58.2 million. We also entered into a definitive agreement to acquire a portfolio of 18 real estate assets net leased to five different tenants, for a purchase price of $364.4 million. See “Recent Developments” below.
 
·  
We added total third party mortgage debt of $36 million on the two property acquisitions we closed during the quarter. The 10-year mortgage notes have a weighted average coupon rate of 5.77%.
 
Recent Developments
 
On April 18, 2007, we completed the acquisition of a portfolio of 18 real estate assets net leased to five different tenants. The purchase price for the assets was $364.4 million, including $159.3 million of assumed mortgage debt. In order to fund the balance of the purchase price, we borrowed $210.3 million under a new short-term credit agreement with Wachovia Bank, N.A. See the “Subsequent Events” footnote in the financial statements included elsewhere in this Form 10-Q for additional details about the portfolio of properties we acquired, the debt we assumed and our new short-term borrowing facility.
 
29
 
Business Environment
 
Our ability to grow our portfolio is subject to a variety of factors beyond our control, including competitive conditions in the commercial real estate markets and interest rate levels. Bidding for new properties continues to be very competitive, and if competitive conditions intensify or market interest rates increase (without a corresponding increase in asset returns), our ability to continue to add new assets may be adversely affected. Spread compression and competition from conduit lenders also continue to make it challenging for us to add new loans with yield and risk characteristics that fit within our targets.
 
Application of Critical Accounting Policies
 
A summary of our critical accounting policies is included in our Annual Report on Form 10-K for the year ended December 31, 2006 in Management’s Discussion and Analysis of Financial Condition and Results of Operations.  There have been no significant changes to those policies during the first quarter of 2007.
 
Property Acquisitions
 
During the three months ended March 31, 2007, we completed the following property acquisitions (dollar amounts in thousands):

Month Acquired
 
Tenant or Guarantor
 
Location
 
Purchase Price
 
Lease Expires
 
Net Rentable Square Feet
  
January
    
County of Yolo, California
    
25 North Cottonwood Street, Woodland, CA
  
$
16,400
    
June 2023
    
63,000
 
January
    
Farmers Group, Inc.
    
3039-3041 Cochran Street, Simi Valley, CA
    
41,812
   
January 2017
    
271,000
 
               
$
58,212
              
 
Business Segments
 
We conduct our business through two operating segments:
 
·  
operating real estate (including our investments in owned real properties); and
 
·  
lending investments (including our loan business as well as our investments in securities).
 
Selected results of operations for the three months ended March 31, 2007 and March 31, 2006, are as follows (dollar amounts in thousands):

   
Corporate /
  
 Operating
  
Lending
  
   
Unallocated
  
 Real Estate
  
Investments
  
   
Mar 31, 2007
  
Mar 31, 2006
  
 Mar 31, 2007
  
Mar 31, 2006
  
Mar 31, 2007
  
Mar 31, 2006
  
Total revenues
  
$
136
  
$
228
  
$
26,809
  
$
18,995
  
$
8,219
  
$
9,125
  
Total expenses and minority interest
    
3,556
    
3,637
    
25,532
    
17,583
    
5,545
    
4,824
  
Income (loss) from continuing operations
    
(3,420
)
  
(3,409
)
  
1,277
    
1,412
    
2,674
    
4,301
  
Total assets
    
38,328
    
49,118
    
1,206,598
    
957,212
    
456,880
    
409,979
  
 
Results of Operations
 
During the first quarter of 2007, we continued to execute on our business plan as a long-term holder of equity, debt and mezzanine investments in net lease or other single tenant assets.
 
Comparison of the Quarter Ended March 31, 2007 to the Quarter Ended March 31, 2006
 
The following discussion compares our operating results for the quarter ended March 31, 2007 to the comparable period in 2006.
 
30
 
Revenue.
 
Total revenue increased $6.8 million, or 24%, to $35.2 million. The increase was primarily attributable to increases in rental revenue, property expense recoveries and interest income, offset in part by a decrease in gain on sale income and other revenue.
 
Rental revenue and property expense recoveries, in the aggregate, increased $7.7 million, or 41%, to $26.6 million. The increase was due to a substantial increase in the underlying property investments from the prior year period. Between March 31, 2006 and March 31, 2007, we added 11 properties for an aggregate purchase price of approximately $258 million.
 
Interest income increased $0.2 million, or 2%, to $8.4 million. Our loan portfolio decreased slightly ($1.3 million) from the prior year.
 
We had no gains on sale of mortgage loans or securities, compared to $0.6 million gain on the sale of a loan in the 2006 period.
 
Other revenue decreased $0.4 million to $0.1 million, primarily reflecting income we received from loans that were paid off in the 2006 period.
 
Expenses.
 
Total expenses increased $8.5 million, or 33%, to $34.6 million. The increase in expenses was primarily attributable to higher levels of interest expense, depreciation and amortization expense on real property, property expenses and general and administrative expenses, offset in part by lower general and administrative expenses-stock based compensation.
 
Interest expense increased $5.0 million, or 36%, from $14.0 million to $19.1 million. The increase in 2007 consisted of $3.6 million of additional interest expense on property mortgages originated or assumed in 2006 and 2007, and $1.4 million (from $2.0 million to $3.4 million) of additional interest expense on our borrowings under our repurchase agreement, primarily as a result of higher borrowing levels and interest rates in 2007.
 
Depreciation and amortization expense on real property increased $2.8 million, or 53%, from $5.4 million to $8.2 million, due to the significant increase in property investments compared with the prior year period.
 
Property expenses increased $0.8 million, or 21%, to $4.3 million. The net amount of property expenses we incurred (net of expense recoveries) during the 2007 period was $1.8 million. The growth in property expenses reflects the growth of our portfolio as well as our purchase of properties with greater overall exposure to property expenses under the lease provisions, primarily with respect to leases with the United States Government. While our investment focus continues to be on net lease properties, we expect to continue to make owned property investments where we have exposure to property expenses when we determine we can sufficiently underwrite that exposure and isolate a predictable cash flow.
 
General and administrative expense increased $0.3 million, or 11%, to $2.6 million, due primarily to higher employee compensation and depreciation on corporate fixed assets.
 
General and administrative expense-stock based compensation decreased $0.3 million, or 52%, to $0.3 million. The decrease was a result of our transition to a five year vesting period on stock awards during the 2007 period. As of March 31, 2007, $4.9 million of unvested shares (fair value at the grant dates) is expected to be charged to our Consolidated Income Statement ratably over the remaining vesting period (through March 2012). As of March 31, 2007, the grant date fair value for awards of 49,776 shares made in 2005, 70,675 shares made in 2006, and 125,400 shares made in 2007 had not yet been determined because the grant date (as defined under relevant accounting guidance) had not yet occurred.
 
Net income.
 
Net income decreased from $2.4 million to $0.6 million, as a result of the factors discussed above. Net income allocable to common stockholders was $(0.1) million in the first quarter of 2007, reflecting dividends to preferred stockholders of $0.7 million.
 
31
 
Funds from Operations
 
Funds from operations, or FFO, is a non-GAAP financial measure. We believe FFO is a useful additional measure of our performance because it facilitates an understanding of our operating performance after adjustment for real estate depreciation, a non-cash expense which assumes that the value of real estate assets diminishes predictably over time. In addition, we believe that FFO provides useful information to the investment community about our financial performance as compared to other REITs, since FFO is generally recognized as an industry standard for measuring the operating performance of an equity REIT. FFO does not represent cash generated from operating activities in accordance with GAAP and is not indicative of cash available to fund cash needs. FFO should not be considered as an alternative to net income or earnings per share determined in accordance with GAAP as an indicator of our operating performance or as an alternative to cash flow as a measure of liquidity. Since all companies and analysts do not calculate FFO in a similar fashion, our calculation of FFO may not be comparable to similarly titled measures reported by other companies.
 
We calculate FFO in accordance with standards established by the National Association of Real Estate Investment Trusts (“NAREIT”) which defines FFO as net income (computed in accordance with GAAP) excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures.
 
The following table reconciles our net income to FFO for the three months ended March 31, 2007 and March 31, 2006.

   
 For the Three Months
  
   
 Ended March 31
  
(in thousands, except per share amounts)
  
2007
  
 2006
  
Net income (loss) allocable to common stockholders
  
$
(93
)
$
1,641
  
Adjustments:
              
 Add: Minority interest-OP units
    
(1
)
  
-
  
 Add: Depreciation and amortization expense on real property
    
8,203
    
5,378
  
 Add: Depreciation and amortization expense on discontinued operations
    
43
    
-
  
Funds from operations
  
$
8,152
  
$
7,019
  
Weighted average number of common shares outstanding, basic and diluted
    
34,122
    
27,893
  
Weighted average number of OP units outstanding
    
263
    
-
  
Weighted average number of common shares and OP units outstanding, basic and diluted
    
34,385
    
27,893
  
Net income (loss) per common share, basic and diluted
  
$
(0.00
)
$
0.06
  
Funds from operations per share
  
$
0.24
  
$
0.25
  
Gains on sale of mortgage loans and securities
  
$
-
  
$
645
  
 
Liquidity and Capital Resources
 
As of March 31, 2007, we had $10.0 million in available cash and cash equivalents. As a REIT, we are required to distribute at least 90% of our taxable income to our stockholders on an annual basis, and we intend to distribute all or substantially all of our REIT taxable income in order to comply with the distribution requirements of the Internal Revenue Code and to avoid federal income tax and the nondeductible excise tax. We declared a dividend of $0.20 per share of common stock in the quarter ended March 31, 2007. We also declared a dividend of $0.5078125 per share of 8.125% Series A cumulative redeemable preferred stock in the quarter ended March 31, 2007.
 
We believe that our working capital and cash provided by operations will be sufficient to fund our operations and pay our distributions necessary to enable us to continue to qualify as a REIT. However, our strategy contemplates additional investments and, therefore, as we approach or reach our target leverage level from time to time, we will need to raise additional capital. As of March 31, 2007, we had an effective shelf registration statement under which we can offer an aggregate of $202.5 million of common stock, preferred stock and/or senior or subordinated debt securities from time to time.
 
We implemented a dividend reinvestment and direct stock purchase plan in March 2007. The plan provides us with an additional source of equity capital. The plan allows interested stockholders to reinvest all or a portion of their cash dividends in shares of our common stock and to make monthly purchases of our common stock generally up to a maximum of $10,000 (unless a higher amount is approved by us in our sole discretion). Shares purchased through the plan may be either (i) newly issued by us or (ii) purchased by the plan administrator in the open market, at our discretion. During March 2007, we issued 482 shares of common stock through the plan at an average price of $10.60 per share.
 
32
 
We recognize rental income on our owned properties on a straight line basis in accordance with SFAS 13. As of March 31, 2007, this has resulted in the company accruing $17.0 million of rental income in excess of our actual rent cash flows under the various leases, with $2.1 million accruing during the quarter ended March 31, 2007. We expect the impact of straight-lining of rents to fluctuate over time as contractual rents step up and our actual rent cash flows increase under the various leases and we purchase additional properties.
 
Short-Term Liquidity and Financing.
 
We expect to meet our short-term liquidity requirements generally through our available cash and cash equivalents, cash provided by operations, as well as through our short-term borrowing arrangements. As of March 31, 2007, our short-term borrowing arrangements were comprised of a repurchase agreement with Wachovia Bank (aggregate borrowing capacity of $250 million) and a real property acquisition facility with Wachovia Bank and one of its affiliates (two loan agreements with aggregate borrowing capacity of $100 million). These arrangements are uncommitted, meaning the lenders may decline to advance on any asset we seek to finance.
 
In anticipation of our next CDO issuance, Wachovia Bank has agreed to temporarily expand our borrowing capacity under our repurchase agreement to $350 million.
 
We had $224.4 million outstanding as of March 31, 2007 under our Wachovia repurchase agreement, which borrowings were secured by loan investments with an aggregate carry value of $184.1 million, and securities with a carry value of $96.0 million. We had no borrowings outstanding as of March 31, 2007 under our real property acquisition facility. Our short-term borrowing arrangements are co-terminus, and they are scheduled to expire in August 2007.
 
Our short-term borrowing arrangements allow us to finance our assets on a short-term basis while we arrange long-term financing. We pay interest at prevailing short-term interest rates plus a spread. These borrowing arrangements are secured by the assets financed and are fully recourse to our other assets. Our lender also has the right to initiate a margin call if our assets financed decline in value (including as a result of a tenant downgrade). We are required to comply with various covenants under these arrangements, including financial covenants of minimum liquidity, minimum consolidated net worth and maximum leverage.
 
As of March 31, 2007, we were in compliance with the terms of our short-term borrowing arrangements. We do not currently anticipate any difficulty in maintaining compliance with these terms in future periods. We believe our relationship with Wachovia Bank is excellent. However, because our short-term borrowing arrangements are uncommitted, we cannot make any assurance that these facilities will continue to be available to us.
 
During April 2007, we borrowed $210.3 million from Wachovia Bank, N.A. under a new short-term credit agreement to fund a portion of the purchase price of the net lease portfolio we acquired on April 18. See “Recent Developments” above. The facility has a 90 day initial term that we may extend for an additional 45 days upon payment of an extension fee of 0.50% of the amount outstanding. We intend to repay our borrowings under the facility with the proceeds from refinancing the debt we assumed on the portfolio properties, through potential property sales, and/or through issuances of equity, long-term debt or other capital alternatives, all of which we are evaluating. Our ability to raise capital is influenced by market conditions, and we cannot assure you that conditions for raising capital will be favorable for us at any time.
 
Long-Term Liquidity and Financing.
 
We expect to meet our long-term liquidity requirements generally through cash provided by operations, long-term fixed-rate financings on our asset investments and issuances of debt and equity capital.
 
We finance our investments through short-term financing arrangements and, as soon as practicable thereafter, we obtain long-term financing for these investments, generally on a secured, non-recourse basis. Through March 31, 2007, our long-term financings have been in the form of traditional third party mortgage financings (on most of our owned real properties) and our first CDO (completed in March 2005). As of March 31, 2007, we have financed on a long-term basis an aggregate of approximately $1.41 billion of assets in portfolio with third party mortgage debt of $829.6 million and collateralized debt obligations of $268.2 million. We also issued $30.0 million of trust preferred debt in December 2005. We expect our leverage to average 70% to 85% of our assets in portfolio. Including the December 2005 trust preferred debt, our overall portfolio leverage as of March 31, 2007 was approximately 83.7%.
 
33
 
Long-Term Mortgage Financings.
 
During the quarter ended March 31, 2007, we obtained $36 million of long-term third party mortgage financing on two new real property acquisitions. The principal economic terms of the notes are summarized in the following table:

   
Original Face Amount
 
 
 
 
 
 
 
 
 
of Mortgage Note
 
 
 
 
 
Balloon at Maturity
 
 Description
 
(in thousands)
 
Coupon
 
Maturity Date
 
(in thousands)
  
County of Yolo, California, Woodland, CA
  
$
10,332
    
5.68
%
  
February 2017
  
$
10,332
  
Farmers Group, Inc., Simi Valley, CA
    
25,620
    
5.81
%
  
January 2017
    
25,620
  
 
Our mortgage financings are fixed rate financings. The notes typically mature over a long-term period of approximately ten years, and debt service is payable monthly. The notes are generally non-recourse to us but are secured by a mortgage on the property and an assignment of the underlying lease and rents on the property. The notes include customary non-recourse exceptions. The notes are often interest only for all or a portion of the note term, and thus require a balloon payment at maturity. We believe the value of the assets financed is, and will continue to be, sufficient to repay or refinance our debt at maturity.
 
CDO Financing.
 
In March 2005, we completed our first CDO. Our CDO was an entirely fixed rate financing. We aggregated approximately $300 million of assets into the pool, and we created $285 million face amount of multi-class notes and $15 million of preferred equity through the CDO trust. The net amount of the debt we issued was $268.1 million, inclusive of a $0.4 million discount to face, as we retained the three most junior note classes aggregating a face amount of $16.5 million and the full $15 million of preferred equity. Each of the five note classes of the CDO was rated investment grade. During the first five years of the CDO term, we expect to reinvest principal repayments on the underlying assets into qualifying replacement collateral. The CDO notes are expected to mature in January 2015. Our effective blended financing rate (inclusive of original issue discount and debt issuance and hedge costs) on our CDO is approximately 5.67%. Our CDO debt is non-recourse to us but is secured by the assets in the pool.
 
We expect our next CDO issuance to occur in the second quarter of 2007.
 
Statement of Cash Flows
 
Operating activities provided $4.5 million of cash during the quarter ended March 31, 2007, primarily driven by net income as adjusted by various non-cash gains, income and charges of $7.3 million, partially offset by increases in other assets of $3.1 million. We used $5.1 million of cash in operating activities in the quarter ended March 31, 2006, primarily driven by an increase in other assets of $7.6 million, including a $6.4 million increase in funds held by our CDO trustee pending distribution or reinvestments, and decreases of $1.7 million in deposits and escrows and $0.9 million in accounts payable, accrued expenses and other liabilities. Our net income as adjusted for straight-lining of rents, various non-cash gains and losses and depreciation and amortization was $4.9 million in the first quarter of 2006.
 
Investing activities used $55.1 million during the quarter ended March 31, 2007, which primarily resulted from net investments in real estate of $58.5 million and deposits on real estate investments of $4.0 million, partially offset by proceeds from sales of real estate investments of $2.9 million and principal received on loans of $4.1 million and securities of $0.6 million. Investing activities used $137.3 million during the quarter ended March 31, 2006, which primarily resulted from net investments in real estate of $165.4 million and net investments in loans of $51.1 million, partially offset by proceeds from sale of loans of $78.6 million.
 
Cash provided by financing activities during the quarter ended March 31, 2007 was $56.2 million, which primarily resulted from net borrowings from mortgages on real estate investments of $34.9 million and net borrowings under repurchase agreements and other short-term financing obligations of $28.9 million, partially offset by dividends and distributions paid of $7.5 million. Cash provided by financing activities during the period ended March 31, 2006 was $133.6 million, which primarily resulted from net borrowings under repurchase agreements and other short-term financing obligations of $62.5 million, net borrowings from mortgages on real estate investments of $71.4 million, reductions in escrows held with mortgage lender of $6.1 million, and dividends paid of $6.3 million.
 
34
 
See our consolidated statements of cash flows included in the historical consolidated financial statements included elsewhere in this filing for a reconciliation of our cash position for the periods described above.
 
Derivative and Other Risk Management Transactions
 
Since our initial public offering, we have entered into derivative and other risk management transactions in order to hedge the value of our future debt obligations from changes in underlying interest rates during the period between closing and obtaining long-term financing of our assets. Our derivative and other risk management activities during this period have consisted primarily of interest rate swaps, and we expect they will continue to consist primarily of interest rate swaps in the future. In accordance with SFAS 133, the interest rate swaps, to the extent that they have been designated and qualify as part of a hedging relationship, are treated as cash flow hedges for accounting purposes.
 
Net realized gains and losses on our qualifying cash flow hedges are included in other comprehensive income and will be reclassified and amortized as part of interest expense on our Consolidated Income Statement over the expected term of the related debt issuances. For the three months ended March 31, 2007 and March 31, 2006, we had net realized gains and (losses) of $0.2 and $(0.0) million, respectively, related to cash flow hedges. For the three months ended March 31, 2007 and March 31, 2006, we reclassified $0.3 million and $0.3 million, respectively, from accumulated other comprehensive loss into interest expense related to the underlying debt issuances.
 
Within the next twelve months, we estimate that $1.3 million of net losses currently held within Accumulated Other Comprehensive Income will be reclassified to earnings as additional interest expense.
 
Consistent with SFAS No. 133, open cash flow hedges are marked to fair value at each reporting date, with a corresponding offset to other comprehensive income (a component of Stockholders’ Equity). The change in net unrealized gains and (losses) of $(0.1) million and $3.6 million in the quarter ended March 31, 2007 and March 31, 2006, respectively, for derivatives designated as cash flow hedges is separately disclosed in the Company’s statement of changes in stockholders’ equity.
 
We do not use derivative and other risk management transactions for trading or speculative purposes and we only enter into contracts or hedging arrangements with major financial institutions.
 
We settle our derivative and other risk management transactions in cash. Therefore, upon settlement, we will pay or receive cash for the net amount due. These amounts could be material and could have a material impact (positive or negative) on our liquidity. We seek to settle these transactions simultaneous with the closing of our financing transaction for the related hedged asset to mitigate the possible adverse impact on our liquidity.
 
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

We may from time to time make written or oral forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements contained in our filings with the Securities and Exchange Commission and in our press releases and webcasts. Forward-looking statements relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. In some cases, you can identify forward-looking statements by terms such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “should,” “strategy,” “will” and other words of similar meaning. The forward-looking statements are based on our beliefs, assumptions and expectations of future performance, taking into account all information currently available to us. These beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us or are within our control. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we are hereby identifying important factors that could cause actual results and outcomes to differ materially from those contained in any forward-looking statement made by or on our behalf. Such factors include, but are not limited to:
 
·  
our ability to make additional investments in a timely manner or on acceptable terms;
 
·  
our ability to obtain long-term financing for our asset investments at the spread levels we project when we invest in the asset;
 
35
 
·  
adverse changes in the financial condition of the tenants underlying our investments;
 
·  
increases in our financing costs, our general and administrative costs and/or our property expenses;
 
·  
changes in our industry, the industries of our tenants, interest rates or the general economy;
 
·  
the success of our hedging strategy;
 
·  
our ability to raise additional capital;
 
·  
impairments in the value of the collateral underlying our investments; and
 
·  
the degree and nature of our competition.
 
In addition, we may be required to defer revenue recognition on real properties we acquire if the property is under construction or is not yet ready for occupancy.
 
These risks and uncertainties should be considered in evaluating any forward-looking statement we may make from time to time. Any forward-looking statement speaks only as of its date. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are qualified by the cautionary statements in this section. We undertake no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date made.
 
Item 3.  
Quantitative and Qualitative Disclosures About Market Risk
 
Market risk refers to the risk of loss from adverse changes in the level of one or more market prices, rate indices or other market factors. We are exposed to market risk primarily from changes in interest rates, credit spreads, tenant credit ratings and equity prices. We attempt to mitigate certain of these risks by entering into hedge and other risk management transactions during the short-term and fixed-rate financings for the long-term. We seek to obtain long-term fixed rate financing as soon as practicable after we make an asset investment. There can be no assurance, however, that such mitigation strategies will be completely or even partially successful. The level of our exposure to market risk is subject to factors beyond our control, including political risk (including terrorism), monetary and tax policy, general economic conditions and a variety of other associated risks.
 
Interest Rate Exposure
 
We are exposed to interest rate risk in various aspects of our business. The most significant ways we can be impacted by interest rates are as follows. Increases in the level of interest rates may impact our ability to add new assets, as spreads on assets we are targeting may compress (unless there is a corresponding increase in asset returns) and demand for our products may be adversely affected.
 
Also, to the extent we finance assets in our portfolio on our short-term borrowing facilities, our net income from these fixed rate assets will decrease as interest rates rise and our borrowing cost increases. In addition, as interest rates rise, our anticipated cost to finance these assets on a long-term basis may rise, causing our expected spread on these assets to be reduced. We attempt to mitigate these risks by entering into risk management transactions that react in a manner that offsets our increased interest costs and by locking our long-term financing cost as soon as practicable after we commit to an asset. As noted above, there can be no assurance that our mitigation strategies will be successful.
 
Furthermore, shifts in the U.S. Treasury yield curve, which represents the market’s expectations of future interest rates, would also affect the yield required on our fixed-rate assets. This would have similar effects on the fair value of our loans and real estate securities, our financial position and results of operations, as would a change in general credit spreads (described below).
 
Credit Spread Curve Exposure
 
Our loans and real estate securities are subject to spread risk. The majority of these assets are fixed-rate assets, which are valued based on a market credit spread over the rate payable on fixed-rate U.S. Treasuries of like maturity. In other words, their value is dependent on the yield demanded on such assets by the market based on their credit relative to U.S. Treasuries. Changes in the general credit markets can lead to changes in the required yield on these assets, which would result in a higher or lower value for our loans and real estate securities. If the required market yields increase as a result of these general credit-market changes, the value of our fixed-rate assets would decline relative to U.S. Treasuries. Conversely, if the required market yields decrease as a result of these general credit-market changes, the value of our fixed-rate assets would increase relative to U.S. Treasuries. These changes in the market value of our fixed-rate asset portfolio may affect the equity on our balance sheet or our results of operations directly through provisions for losses on loans or on available-for-sale securities. These value changes may also affect our ability to borrow and access capital.
 
36
 
Tenant Credit Rating Exposure
 
Substantially all of our portfolio assets are subject to risks due to credit rating changes of the underlying tenant or tenants. Deterioration in the underlying tenant’s credit rating can result in a lower value for the related asset, which could result in a reduction in the equity on our balance sheet or a charge to our income statement. In addition, precipitous declines in the credit rating of a particular tenant prior to our obtaining long-term financing may significantly impede or eliminate our ability to finance the asset. We manage these risks by maintaining diversity among our credits and assessing our aggregate exposure to ratings classes, in particular lower rated classes. We also seek to lock or procure long-term financing on our assets as promptly as practicable after we commit to invest.
 
Equity Price Risk Exposure
 
We may seek to raise capital by sale of our common stock. Our ability to do so is dependent upon the market price of our common stock and general market conditions.
 
Fair Value
 
For certain of our financial instruments, fair values are not readily available since there are no active trading markets as characterized by current exchanges between willing parties. Accordingly, we derive or estimate fair values using various valuation techniques, such as computing the present value of estimated future cash flows using discount rates commensurate with the risks involved. However, the determination of estimated cash flows may be subjective and imprecise. Changes in assumptions or estimation methodologies can have a material affect on these estimated fair values. The fair values indicated below are indicative of the interest rate and credit spread environment as of March 31, 2007, and may not take into consideration the effects of subsequent interest rate or credit spread fluctuations, or changes in the ratings of the underlying tenants.
 
The following summarizes certain data regarding our interest rate sensitive instruments as of March 31, 2007:

           
Weighted
          
           
Average
          
   
Carrying
  
Notional
  
Effective
          
   
Amount
  
Amount
  
Interest Rate
  
Maturity Date
  
Fair Value
  
       
 (dollars in thousands)
      
Assets:
                      
 Loans held for investment (1)
  
$
270,152
  
$
268,358
    
6.78
%
  
Various
  
$
275,516
  
 Securities available for sale - CMBS (2)
    
182,334
    
192,086
    
7.60
%
  
2009-2028
    
182,334
  
 Structuring fees receivable
    
3,093
    
N/A
    
8.00
%
  
2010-2020
    
3,093
  
 Derivative assets (3)
    
2,394
    
242,743
    
N/A
    
N/A
    
2,394
  
Liabilities
                                
 Repurchase agreement and other short-term
                                
 financing obligations (4)
    
224,427
    
224,427
    
6.27
%
  
Short-term
    
224,427
  
 Mortgage notes payable (5)
    
829,580
    
824,864
    
5.59
%
  
2013-2024
    
822,523
  
 Collateralized debt obligations (5)
    
268,199
    
268,500
    
5.67
%
  
2015
    
255,939
  
 Other long-term debt (6)
    
30,930
    
30,930
    
8.30
%
  
2016
    
30,718
  
 Derivative liabilities (3)
    
2,542
    
107,586
    
N/A
    
N/A
    
2,542
  
 
37
 
_____________
    (1) This portfolio of loans bears interest at fixed rates. We have estimated the fair value of this portfolio of loans based on sales of loans with similar credit and structural characteristics where available, and management’s estimate of fair values where comparable sales information is not available. The maturity dates for the loans range from 2007 through 2033.
    (2) Securities available for sale represent subordinate interests in securitizations (CMBS), as well as pass-through certificates representing our pro rata investments in a pool of mortgage loans. Structuring fees receivable represent cash flows receivable by us from the sale of loans to third-party purchasers. The notional values for the CMBS are shown at their respective face amounts. Fair value for the CMBS is based on third-party quotations, where obtainable, or our estimate of fair value, based on yields of comparably rated securities in the CMBS market. Fair value for the structuring fees receivable is shown at our amortized cost for these items. For the securities available for sale, we expect to receive monthly interest coupon payments, and contractual principal payments as scheduled.
    (3) These instruments represent hedging and risk management transactions involving interest rate swaps. They have been valued by reference to market quotations.
    (4) Our repurchase agreement and other short-term financing obligations bear interest at floating rates, and we believe that for similar financial instruments with comparable credit risks, the effective rates approximate market value. Accordingly, the carrying amounts outstanding are believed to approximate fair value.
    (5) We estimate the fair value of mortgage notes on real estate investments and collateralized debt obligations using a discounted cash flow analysis, based on our estimates of market interest rates. For mortgages where we have an early payment right, we also consider the prepayment amount to evaluate the fair value. The maturity date of the collateralized debt obligations reflects our expected maturity date in January 2015 and is used to compute the related fair value and weighted average effective interest rate.
    (6)  We estimate the fair value of our other long-term debt using a discounted cash flow analysis, based upon management’s estimates of market interest rates. The maturity date of our other long-term debt reflects our expected maturity date in January 2016 and is used to compute the related fair value and weighted average effective interest rate.
 
Scheduled maturities of interest rate sensitive instruments as of March 31, 2007 are as follows:

   
Expected Maturity Dates
 
 
 
2007
 
 2008
 
 2009
 
 2010
 
2011
 
Thereafter
  
       
  (in thousands, notional amounts where appropriate,
  
       
 otherwise carrying amounts)
  
Loans held for investment
  
$
9,511
  
$
5,972
  
$
15,010
  
$
11,393
  
$
12,493
  
$
213,979
  
Securities available for sale - CMBS
    
1,327
    
2,177
    
25,103
    
2,338
    
2,893
    
158,248
  
Structuring fees receivable
    
499
    
713
    
772
    
768
    
73
    
268
  
Derivative assets
    
2,394
    
-
    
-
    
-
    
-
    
-
  
Mortgages on real estate investments
    
4,062
    
7,565
    
9,296
    
11,289
    
13,852
    
783,516
  
Repurchase agreement and other short-term
                                      
financing obligations
    
224,427
    
-
    
-
    
-
    
-
    
-
  
Collateralized debt obligations
    
(27
)
  
(38
)
  
(41
)
  
22,792
    
10,861
    
234,652
  
Other long-term debt
    
-
    
-
    
-
    
-
    
-
    
30,930
  
Derivative liabilities
    
2,542
    
-
    
-
    
-
    
-
    
-
  
 
Negative amounts shown with respect to our collateralized debt obligations represent amortization of original issue discount.
 
The expected maturity dates shown for loan investments, securities available for sale and structuring fees receivable are based on the contractual terms of the underlying assets. These assets, based on our current operating strategy, are held for investment. Our liabilities with respect to our repurchase agreement are short-term in nature and, accordingly, are listed in the current period. The material assumptions used to determine fair value are included in footnotes 1 through 6 in the immediately preceding table.
 
Item 4.  
Controls and Procedures
 
Evaluation of Disclosure Controls and Procedures
 
We maintain disclosure controls and procedures (as defined under Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
 
38
 
Pursuant to Rule 13a-15(b) under the Exchange Act, we carried out an evaluation, with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective.
 
Changes in Internal Controls
 
There has been no change in our internal control over financial reporting during the quarter ended March 31, 2007, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
PART II.  
OTHER INFORMATION
 
Item 1.  
Legal Proceedings
 
From time to time, we are involved in legal proceedings in the ordinary course of business. We do not believe any matter we are currently involved in will have a material adverse effect on our business, results of operations or financial condition.
 
Item 1A.  
Risk Factors
 
The following risk factors amend and restate those risk factors with the same caption headings included in our Form 10-K for the year ended December 31, 2006.
 
We are subject to tenant credit concentrations that make us more susceptible to adverse events with respect to certain tenants.
 
We are subject to the following tenant credit concentrations as of March 31, 2007:
 
·  
approximately $205.8 million, or 12.7%, of our assets in portfolio involve properties leased to the United States Government;
 
·  
approximately $90.4 million, or 5.6%, of our assets in portfolio involve properties leased to, or leases guaranteed by, TJX Companies, Inc.;
 
·  
approximately $87.2 million, or 5.4%, of our assets in portfolio involve properties leased to, or leases guaranteed by, Lowe’s Companies Inc.; and
 
·  
approximately $80.8 million, or 5.0%, of our assets in portfolio involve properties leased to, or leases guaranteed by, Aon Corporation.
 
Any bankruptcy, insolvency or failure to make rental payments by, or any adverse change in the financial condition of, one or more of these tenants or any other tenant to whom we may have a significant credit concentration in the future, could result in a material reduction of our cash flows or material losses to our company.
 
We are subject to tenant industry concentrations that make us more susceptible to adverse events with respect to certain industries.
 
We are subject to the following industry concentrations as of March 31, 2007:
 
·  
approximately $239.5 million, or 14.8%, of our assets in portfolio involve properties leased to, or leases guaranteed by, companies in the insurance industry (e.g., Aon Corporation, Allstate Insurance Company, Farmers New World Life Insurance Company, Aetna Life Insurance Company);
 
·  
approximately $137.8 million, or 8.5%, of our assets in portfolio involve properties leased to, or leases guaranteed by, companies in the retail department stores industry (e.g., TJX Companies, Inc., Kohl’s Corporation);
 
39
 
·  
approximately $104.0 million, or 6.4%, of our assets in portfolio involve properties leased to, or leases guaranteed by, companies in the retail home improvements industry (e.g., Lowe’s Companies, Inc., Home Depot USA, Inc.);
 
·  
approximately $88.8 million, or 5.5%, of our assets in portfolio involve properties leased to, or leases guaranteed by, companies in the retail drug industry (e.g., CVS Corporation, Walgreen Co.); and
 
·  
approximately $83.2 million, or 5.1%, of our assets in portfolio involve properties leased to, or leases guaranteed by, companies in the banking industry (e.g., AmeriCredit Corp., Capital One Financial Corporation, Harris Bankcorp, Inc., Bank of America, N.A., National City Bank)
 
Any downturn in one or more of these industries, or in any other industry in which we may have a significant credit concentration in the future, could result in a material reduction of our cash flows or material losses to our company.
 
We are subject to geographic concentrations that make us more susceptible to adverse events in these areas.
 
We are subject to the following geographic concentrations as of March 31, 2007:
 
·  
approximately $180.0 million, or 11.1%, of our assets in portfolio are investments in properties located in the Chicago, Illinois metropolitan area;
 
·  
approximately $177.3 million, or 11.0%, of our assets in portfolio are investments in properties located in the Washington, D.C. metropolitan area;
 
·  
approximately $145.4 million, or 9.0%, of our assets in portfolio are investments in properties located in the New York City and Northern New Jersey area;
 
·  
approximately $128.9 million, or 8.0%, of our assets in portfolio are investments in properties located in the Philadelphia, Pennsylvania metropolitan area; and
 
·  
approximately $103.8 million, or 6.4%, of our assets in portfolio are investments in properties located in the Southern California area; and
 
·  
approximately $92.5 million, or 5.7%, of our assets in portfolio are investments in properties located in the Dallas, Texas metropolitan area.
 
An economic downturn or other adverse events or conditions such as terrorist attacks or natural disasters in one or more of these areas, or any other area where we may have a significant credit concentration in the future, could result in a material reduction of our cash flows or material losses to our company.
 
Our investments in assets backed by below investment grade credits have a greater risk of default.
 
We invest in assets where the underlying tenant’s credit rating is below investment grade (approximately $212.0 million, or 13.1%, of our assets in portfolio as of March 31, 2007). These investments will have a greater risk of default and bankruptcy than investments on properties leased exclusively to investment grade tenants.
 
Our investments in commercial mortgage-backed securities may be subordinated.
 
As of March 31, 2007, our CMBS investments included $51.1 million of below investment grade bond classes (approximately 3.2% of our assets in portfolio as of March 31, 2007). Generally, these classes represent subordinate classes of the securitization pool, meaning that we hold the “first loss” position or a near “first loss” position in the event of losses on the assets within the pool. We may not be able to recover our investment in these subordinated CMBS classes. In addition, the value of these subordinated investments may be adversely affected by defaults or decreases in the value of the underlying collateral, increases in market rates for similar collateral pools or economic downturns, and we may be required under GAAP to record an impairment loss on our investment if any of these developments occur.
 
Item 2.  
Unregistered Sales of Equity Securities and Use of Proceeds
 
None.
 
40
 
Item 3.  
Defaults Upon Senior Securities
 
None.
 
Item 4.  
Submission of Matters to a Vote of Security Holders
 
None. 
 
Item 5.  
Other Information
 
None.
 
Item 6.  
Exhibits
 
a.  
Exhibits
 
10.1
Membership Interests Purchase Agreement dated as of March 14, 2007 between EntreCap Financial LLC and Caplease, LP
12.1
Computation of ratio of earnings to fixed charges and preferred stock dividends
31.1
Certification of the Registrant’s Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of the Registrant’s Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of the Registrant’s Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
Certification of the Registrant’s Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
41

SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
   
CAPITAL LEASE FUNDING, INC.
   
Registrant
     
Date: May 10, 2007
  
/s/ Paul H. McDowell
   
Paul H. McDowell
Chief Executive Officer
     
Date: May 10, 2007
  
/s/ Shawn P. Seale
   
Shawn P. Seale
Senior Vice President, Chief Financial Officer
and Treasurer
     

 
42