MacKenzie Realty Capital, Inc. 10-Q

Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Statements by MacKenzie Realty Capital, Inc. and its wholly owned subsidiary MRC TRS, Inc. (the "Company," "we," or "us") contained herein, other than historical facts, may constitute "forward-looking statements." These statements may relate to, among other things, future events or our future performance or financial condition. In some cases, you can identify forward-looking statements by terminology such as "may," "might," "believe," "will," "provided," "anticipate," "future," "could," "growth," "plan," "intend," "expect," "should," "would," "if," "seek," "possible," "potential," "likely" or the negative of such terms or comparable terminology. These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any anticipated results, levels of activity, performance or achievements expressed or implied by such forward-looking statements, including an economic downturn could impair our portfolio companies' ability to continue to operate, which could lead to the loss of some or all of our investments in such portfolio companies; a contraction of available credit and/or an inability to access the equity markets could impair our lending and investment activities; and interest rate volatility could adversely affect our results, particularly if we elect to use leverage as a part of our investment strategy. For a discussion of factors that could cause our actual results to differ from forward-looking statements contained herein, please see the discussion under the heading "Risk Factors" in our Annual Report on Form 10-K. We may experience fluctuations in our operating results due to a number of factors, including the effect of the withdraw of our BDC election, the return on our equity investments, the interest rates payable on our debt investments, the default rates on such investments, the level of our expenses, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition in our markets and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods. Overview We are an externally managed non-diversified closed-end management investment company that has elected to be treated as a BDC under the 1940 Act. Our objective is to generate both current income and capital appreciation through real estate-related investments. We have elected to be treated as a REIT under the Code and as a REIT, we are not subject to federal income taxes on amounts that we distribute to the stockholders, provided that, on an annual basis, we distribute at least 90% of our REIT taxable income to the stockholders and meet certain other conditions. To the extent that we satisfy the annual distribution requirement but distribute less than 100% of our taxable income, we will be subject to an excise tax on our undistributed taxable income. Our wholly owned subsidiary, MRC TRS, Inc., is subject to corporate federal and state income tax on its taxable income at regular statutory rates. We are managed by the Adviser, and MacKenzie provides the non-investment management services and administrative services necessary for us to operate. Authorization to Withdraw BDC Election On October 23, 2020, holders of a majority of the outstanding common stock of the Company approved the authorization of the Company’s Board of Directors to withdraw the Company’s election to be regulated as a business development company under the Investment Company Act of 1940, effective when the Company files the appropriate form with the SEC. The Company expects to submit the withdrawal to be effective with the SEC by the end of December 2020. Withdrawal of our election to be regulated as a BDC will not affect our registration under Section 12(g) of the Securities Exchange Act of 1934 (the “Exchange Act”), and we will continue to file periodic reports on Form 10-K, Form 10-Q, and Form 8-K, and file proxy statements and other reports required under the Exchange Act. Following withdrawal of our election to be regulated as a BDC, the application and presentation of our financial statements under accounting principles generally accepted in the United States of America (“GAAP”) could change. The Company has undertaken several steps to meet the requirements for withdrawal of its election to be regulated as a BDC, including (i) preparing a plan of operations in contemplation of such a change to the status of the Company, (ii) evaluating potential investments in real estate assets that will allow the Company to transition to direct real estate asset investments, (iii) reviewing the potential adjusted investment strategy with potential capital providers, and (iv) consulting with outside counsel as to the requirements for withdrawing its election as a BDC. 21 TABLE OF CONTENTS During this transition period, the Company may liquidate some of its securities portfolio. By the end of the first year after withdrawal of its election, the Company anticipates that its securities portfolio will comprise less than 20% of its assets. Investment Plan While we remain a BDC, our investments are generally expected to range in size from $10,000 to $3 million. However, we may make smaller or larger investments from time to time on an opportunistic basis. We focus primarily on real estate-related securities. We purchase most of our securities (i) directly from existing security holders, (ii) through established securities markets, and (iii) in the case of unregistered, privately offered securities, directly from issuers. We invest primarily in debt and equity securities issued by U.S. companies that primarily own commercial real estate that are either illiquid or not listed on any exchange. While we remain a BDC, we generally seek to invest in interests of real estate-related limited partnerships and REITs. Under normal market conditions, we invest at least 80.0% of our total assets in common stocks and other equity or debt securities issued by real estate companies, including REITs and similar REIT-like entities. A real estate company is one that (i) derives at least 50.0% of its revenue from the ownership, construction, financing, management or sale of commercial, industrial or residential real estate and land; or (ii) has at least 50.0% of its assets invested in such real estate. We do not invest in general partnerships, joint ventures, or other entities that do not afford limited liability to their security holders. However, limited liability entities in which we invest may hold interests in general partnerships, joint ventures, or other non-limited liability entities. We generally consider purchasing securities issued by entities that have (i) completed the initial offering of their securities, (ii) operated for a period of at least two years, and typically more than five years, from the completion of their initial offering, and (iii) fully invested their capital in real properties or other real estate-related investments. While we remain a BDC, we may also acquire (i) individual mortgages secured by real property (i.e., we may originate such loans or we may purchase outstanding loans secured by real estate), (ii) securities of issuers that own mortgages secured by income producing real property, and (iii) using no more than 20.0% of our available capital, securities of issuers that own assets other than real estate. Investment income We generate revenues in the form of capital gains and dividends on dividend-paying equity securities or other equity interests that we acquire, in addition to interest on any debt investments that we hold. Further, we may generate revenue in the form of commitment, origination, structuring or diligence fees, monitoring fees, fees for providing managerial assistance and possibly consulting fees and performance-based fees. Any such fees are generated in connection with our investments and recognized as earned. Expenses Our primary operating expenses include the payment of: (i) investment advisory fees to our Adviser; (ii) our allocable portion of overhead and other expenses incurred by MacKenzie in performing its obligations under the Administration Agreement; and (iii) other operating expenses as detailed below. Our investment advisory fees compensate our Investment Adviser for its work in identifying, evaluating, negotiating, closing, monitoring and servicing our investments. Our expenses must be billed to and paid by us, except that MacKenzie may be reimbursed for actual cost of goods and services used by us and certain necessary administrative expenses. We will bear all other expenses of our operations and transactions, including: 22 TABLE OF CONTENTS • the cost of calculating our NAV; • the cost of effecting sales and repurchases of our shares and other securities; • interest payable on debt, if any, to finance our investments; • fees payable to third parties relating to, or associated with, making investments, including fees and expenses associated with performing due diligence reviews of prospective investments and third-party advisory fees; • transfer agent and safekeeping fees; • fees and expenses associated with marketing efforts; • federal and state registration fees, and any stock exchange listing fees in the future; • federal, state, and local taxes, if any; • Independent Directors' fees and expenses; • brokerage commissions; • fidelity bond, directors and officers errors and omissions liability insurance, and other insurance premiums; • direct costs and expenses of administration, including printing, mailing, and staff; • fees and expenses associated with independent audits and outside legal costs; • costs associated with our reporting and compliance obligations under the 1934 Act, the 1940 Act, and applicable federal and state securities laws; and • all other expenses incurred by either MacKenzie or us in connection with administering our business, including payments under the Administration Agreement that will be based upon our allocable portion of overhead and other expenses incurred by MacKenzie in performing its obligations under the Administration Agreement, including rent, the fees and expenses associated with performing compliance functions, and our allocable portion of the costs of compensation and related expenses of our Chief Compliance Officer, our Chief Financial Officer, Director of Accounting and Financial Reporting, General Counsel, and any administrative support staff. In addition, we will bear organization and offering expenses in connection with our third public offering up to $1,650,000 plus the savings realized by the Company to the extent that broker fees incurred are less than 10%. Any additional amounts with respect to shares being sold pursuant to the third public offering will be paid by our Adviser. Portfolio Investment Composition The following table summarizes the composition of our investments at cost and fair value as of September 30, 2020, and June 30, 2020: September 30, 2020 June 30, 2020 Asset Type Cost Fair Value Cost Fair Value Publicly Traded Companies $ 9,202,806 $ 6,028,120 $ 8,454,348 $ 7,244,654 Non Traded Companies 40,487,164 28,988,430 42,474,614 32,808,076 LP Interests 53,893,255 54,419,019 53,713,785 53,618,425 Investment Trust 49,901 33,990 49,901 33,990 Total $ 103,633,126 $ 89,469,559 $ 104,692,648 $ 93,705,145 Net Asset Value September 30, 2020 vs. June 30, 2020: Our NAV as of September 30, 2020, was $7.85 per share compared to $8.04 per share as of June 30, 2020, a $0.19 per share decrease of approximately 2.31%. The net decrease during the three months was due to (i) net unrealized loss on investments of $0.25 per share, and (ii) net investment loss of $0.02 per share. The decreases were partly offset by an increase resulting from net realized gain from sale of investments of $0.08 per share. Results of Operations COVID-19 pandemic Considerable uncertainty still surrounds the COVID-19 pandemic and its potential effects, and the extent of and effectiveness of any responses taken on a national and local level. However, measures taken to limit the impact of the COVID-19 pandemic, including social distancing and other restrictions on travel, congregation, and business operations have already resulted in significant negative economic impacts, including steep declines in certain stock market segments and in the traded prices for certain real-estate related assets. As a result of these impacts, we have experienced a large decrease in fair values of some of our investments as of September 30, 2020. In addition, some of the companies in which we have invested have cancelled their quarterly dividends and distributions for the current and future quarters. The long-term impact of the COVID-19 pandemic on the United States and world economies remains uncertain, but may result in a world-wide economic downturn, the duration and scope of which cannot currently be predicted. 23 TABLE OF CONTENTS MacKenzie and our Adviser have taken numerous steps, and will continue to take further actions, to address the COVID-19 pandemic. They implemented business continuity plans and the management team is in place to respond to changes in the global environment quickly and effectively. To protect the health and safety of their team members, they successfully transitioned almost their entire workforce to remote work environments. They are working closely with our clients to support them as necessary and as seamlessly as possible. The situation surrounding the COVID-19 pandemic remains fluid, and we are actively managing our response and assessing potential impacts to our financial position and operating results. This includes the evaluation and implementation of certain efforts to help us mitigate the impact that reduced revenues from distributions and capital events may have on our 2020 financial results. We are focusing on maintaining a strong balance sheet and liquidity position and searching for opportunistic investments. In anticipation of reduced revenues and uncertain future economic conditions, the board of directors discontinued dividends starting March 2020 and share redemptions starting May 2020. Three Months Ended September 30, 2020, and 2019: Investment Income: Investment income was made up of dividends, distributions from operations, distributions from sales/capital transactions, interest, and other investment income. Total investment income for the three months ended September 30, 2020, and 2019, was $0.86 million and $1.94 million, respectively. The decrease of $1.08 million or 55.7%, was primarily due to suspensions of dividends and distributions from our investments as a result of the COVID-19 pandemic. During the three months ended September 30, 2020, the Company received $0.51 million of distributions from operations, sales and liquidations as compared to $1.20 million during the three months ended September 30, 2019. During the three months ended September 30, 2020, we received dividends and other investment income of $0.35 million as compared to $0.74 million during the three months ended September 30, 2019. Operating Expenses: Base management fee: The base management fee for the three months ended September 30, 2020 was $0.66 million as compared to $0.61 million for the three months ended September 30, 2019. This increase of $0.05 million, or 8.2% was due to an increase in the Gross Invested Capital by $12.77 million from $116.00 million as of September 30, 2019, to $128.77 million as of September 30, 2020. Portfolio structuring fee : The portfolio structuring fee for the three months ended September 30, 2020, was less than 0.01 million as compared to $0.20 million during the three months ended September 30, 2019. This decrease was because the Company raised lower amount of new capital during the three months ended September 30, 2020. During the three months ended September 30, 2020, the Company raised new capital of $0.16 million as compared to $6.47 million during the three months ended September 30, 2019 through issuance of new shares excluding the DRIP. Subordinated incentive fee: The subordinated incentive fee has two components; Capital Gains Fee and Income Fee. Capital Gains Fee is based on realized gains (including the distributions received from sales/capital transactions) and the Income Fee is based on net investment income. There was neither Income Fee nor Capital Gains Fee for the three months ended September 30, 2020 and 2019. This was because the cumulative net investment income and net realized gains were below the threshold of 7% of Contributed Capital. 24 TABLE OF CONTENTS Administrative cost reimbursements and Transfer agent reimbursements: Costs reimbursed to MacKenzie for the three months ended September 30, 2020, was $0.16 million as compared to $0.17 million for the three months ended September 30, 2019. The slight decrease was due to a decrease in the allocable portion of overhead and other expenses incurred by MacKenzie in comparison to September 30, 2019, as a result of the decrease in the Company’s capital raising activities. Transfer agent cost reimbursement paid to MacKenzie for three months ended September 30, 2020 was $0.03 million as compared to $0.02 for the three months ended September 30, 2019. The slight increase was due to additional software maintenance and implementation costs incurred by MacKenzie. Other operating expenses: Other operating expenses include amortization of deferred offering costs, professional fees, directors’ fees printing and mailing, and other general and administrative expenses. Other operating expenses for the three months ended September 30, 2020 and 2019, were $0.30 million and $0.39 million. The decrease of $0.09 million was mainly due a larger amount of amortization of deferred offering costs for the three months ended September 30, 2019 as compared to the same period in 2020. The decrease in amortization of deferred offering costs was due to the deferred offering costs relating to the second public offering fully amortized as of December 31, 2019 as the offering terminated in October 2019. According to our accounting policy, offering costs are capitalized as deferred offering costs as incurred by the Company and subsequently amortized to expense over a twelve-month period. Any deferred offering costs that have not been amortized upon the expiration or earlier termination of an offering will be accelerated and expensed upon such expiration or termination. Net realized gain/loss on investments: During the three months ended September 30, 2020, the Company had a net realized gain of $1.02 million as compared to net realized loss of $0.11 million during the three months ended September 30, 2019. Total realized gains for the three months ended September 30, 2020, were realized from sales of eleven publicly traded securities, one limited partnership interest and three non-traded REIT securities. Total realized gains for the three months ended September 30, 2019, were primarily realized from sales of two non-traded REIT securities. Net unrealized gain/loss on investments: During the three months ended September 30, 2020, we recorded net unrealized losses of $3.18 million, which were net of $0.81 million of unrealized gains reclassification adjustment. The reclassification adjustment was the accumulated unrealized gains as of June 30, 2020, that were realized during the three months ended September 30, 2020. Accordingly, the net unrealized losses excluding the reclassification adjustment for the three months ended September 30, 2020, were $2.37 million, which resulted from fair value depreciations of $1.88 million from non-traded REIT securities and $1.11 million from publicly traded REIT securities partly offset by a fair value appreciation of $0.62 million from limited partnership interests. The significant decline in the fair value during the current quarter was mainly due to the COVID-19 pandemic resulting in declines in domestic stock markets and in the traded prices for other financial assets as discussed above. During the three months ended September 30, 2019, we recorded net unrealized gains of $1.06 million; however, this is net of $0.05 million of unrealized losses reclassification adjustment. The reclassification adjustment was the accumulated unrealized losses as of June 30, 2019, that were realized during the three months ended September 30, 2019. Accordingly, the net unrealized gains excluding the reclassification adjustment for the three months ended September 30, 2019, were $1.01 million, which resulted from fair value appreciation of $1.86 million from limited partnership interests and $0.5 million from publicly traded REIT securities offset by fair value depreciation of $1.35 million from non-traded REIT securities. Income tax provision (benefit): The Parent Company satisfied the annual dividend payment and other REIT requirements for the tax years ended December 31, 2019. Therefore, it did not incur any tax expense or excise tax on its income from operations during the quarterly periods within the tax year 2019. Similarly, for the tax year 2020, we believe the Parent Company will pay the requisite amounts of dividends during the year such that it will not owe any income taxes. Therefore, the Parent Company did not record any income tax provisions during any fiscal period within the tax year 2019. 25 TABLE OF CONTENTS TRS and MacKenzie NY 2 are subject to corporate federal and state income tax on its taxable income at regular statutory rates. However, as of September 30, 2020, they did not have any taxable income for tax year 2019 or 2020. Therefore, TRS and MacKenzie NY 2 did not record any income tax provisions during any fiscal period within the tax year 2019 and 2020. Liquidity and Capital Resources Capital Resources We offered to sell up to $150 million of shares under our second public offering which ended on October 28, 2019. In September 2019, we filed our third registration statement with the SEC for the public offering of 15 million shares with total potential gross proceeds of $153.75 million. The third registration statement was declared effective by the SEC on October 31, 2019 and the public offering commenced shortly thereafter. As of September 30, 2020, the Company has raised total gross proceeds of $119.04 million from the issuance of shares under three public offerings, $42.46 million from the IPO, which concluded in October 2016, $67.99 million from the second public offering, which concluded in October 2019, and $8.59 million from our third public offering. In addition, we have raised $11.16 million from the issuance of shares under the DRIP. Of the total capital raised from the public offerings as of September 30, 2020, we have used $9.46 million to repurchase shares under the Company’s share repurchase program. We are planning to issue preferred equity in the near future, but do not currently have any. We plan to fund future investments with the net proceeds raised from our third offering and any future offerings of securities and cash flows from operations, as well as interest earned from the temporary investment of cash in U.S. government securities and other high-quality debt investments that mature in one year or less. We may also fund a portion of our investments through borrowings from banks and issuances of senior securities. While we remain as a BDC, we do not have any plans to borrow money on a long-term basis or issue debt securities at the Company level; however, after our BDC status is withdrawn, we may borrow money within the underlying companies in which we have majority ownership. In addition, from time to time we may draw on the margin line of credit on a temporary basis to bridge our investment purchases and sales or capital raising. As of September 30, 2020, we were selling our shares on a continuous basis at a price of $10.25 which may be below NAV per share from time to time, as approved by our stockholders. The third public offering ended on October 31, 2020. Our aggregate borrowings (if any), secured and unsecured, are expected to be reasonable in relation to our net assets and will be reviewed by the Board of Directors at least quarterly. The maximum amount of such borrowing is limited by the 1940 Act. Our primary uses of funds are investing in portfolio companies, paying cash dividends to holders of our common stock (from investment income and realized capital gains), making payments to any lenders or senior security holders, paying operating expenses. If all shares registered in our current public offering are sold, we will receive investable cash totaling approximately $133.76 million, of which approximately $7.52 million has been received as of September 30, 2020. The Company finished the quarter ended September 30, 2020 with substantial liquidity, including $10.86 million in cash and cash equivalents, and only $0.74 million of liabilities. However, the Company has historically relied upon distributions and capital gains from its investments to fund dividends. During and following the outbreak of COVID-19, we do not believe we can rely on our traditional sources of cash flow. Therefore, in anticipation of uncertain future economic conditions, our board of directors discontinued dividends starting March 2020 and share redemptions starting May 2020. The Company intends to continue to qualify as a REIT and to meet the associated testing requirements, including paying out at least 90% of its taxable income. Cash Flows: Three months ended September 30, 2020: For the three months ended September 30, 2020, we experienced a net increase in cash of $1.91 million. During this period, we generated cash of $1.83 million from our operating activities and $0.08 million from our financing activities. 26 TABLE OF CONTENTS The net cash inflow of $1.83 million from operating activities resulted from $4.28 million from distributions received from our investments that are considered return of capital and $5.26 million from sales and liquidations of investments offset by $7.41 million of cash used in purchasing investments and $0.30 million used in operating expenses, net of investment income. The net cash inflow of $0.08 million from financing activities resulted from the sale of shares under our third public offering with gross proceeds of $0.09 million (net of $0.08 million of decrease in capital pending acceptance) offset by cash outflows of $0.01 million from payments of selling commissions and fees. Three months ended September 30, 2019: For the three months ended September 30, 2019, we experienced a net increase in cash of $8.37 million. During this period, we generated cash of $3.40 million from our operating activities and $4.97 from our financing activities. The net cash inflow of $3.40 million from operating activities resulted from $8.34 million of distributions received from investments that are considered return of capital, $1.95 million from sales of investments and $0.33 million from investment income, net of operating expenses, offset by cash outflow of $8.34 million from purchases of investments. The net cash inflow of $4.97 million from financing activities resulted from the sale of shares under our second public offering with gross proceeds of $7.35 million (adjusted for $0.88 million of increase in capital pending acceptance) offset by cash outflows of $1.06 million from payments of cash dividends, $0.63 million from share redemptions, and $0.69 million from payments of selling commissions and fees. Contractual Obligations We have entered into two contracts under which we have material future commitments: (i) the Amended and Restated Investment Advisory Agreement, under which the Adviser serves as our investment adviser, and (ii) the Administration Agreement, under which MacKenzie furnishes us with certain non-investment management services and administrative services necessary to conduct our day-to-day operations. Each of these agreements is terminable by either party upon proper notice. Payments under the Amended and Restated Investment Advisory Agreement in future periods (after the up-front payment of the portfolio structuring fee during the public offering) will be (i) a percentage of the value of our Gross Invested Capital; and (ii) incentive fees based on our income and our performance above specified hurdles (except in the year of liquidation). Payments under the Administration Agreement will occur on an ongoing basis as expenses are incurred on our behalf by MacKenzie. However, if MacKenzie withdraws as our administrator, it will be liable for any expenses we incur as a result of such withdrawal. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources. Borrowings We do not have any current plans to borrow money or issue preferred securities. In the event that we do so borrow, we would expect to be subject to various customary covenants and restrictions on our operations, such as covenants which would (i) require us to maintain certain financial ratios, including asset coverage, debt to equity and interest coverage, and a minimum net worth, and/or (ii) restrict our ability to incur liens, additional debt, merge or sell assets, make certain investments and/or distributions or engage in transactions with affiliates. Critical Accounting Policies The financial statements included in this report are based on the selection and application of critical accounting policies, which require management to make significant estimates and assumptions. Critical accounting policies are those that are both important to the presentation of our financial condition and results of operations and require management's most difficult, complex or subjective judgments. There have been no changes in the significant accounting policies from those disclosed in the audited financial statements for the year ended June 30, 2020, included in the Company's annual report on Form 10-K for the fiscal year ended June 30, 2020. 27 TABLE OF CONTENTS Dividends to Stockholders We pay quarterly dividends to stockholders to the extent that we have income from operations available. Our quarterly dividends, if any, will be determined by our Board of Directors after a review and distributed pro-rata to holders of our shares; we declare dividends on a monthly basis, but pay each quarter. Any dividends to our stockholders will be declared out of assets legally available for distribution. In no event are we permitted to borrow money to make dividends if the amount of such dividend would exceed our annual accrued and received revenues, less operating costs. Dividends in kind are not permitted, except as provided in our Charter. We have elected to be treated as a REIT under the Code. As a REIT, we are required to distribute at least 90% of our REIT taxable income to the stockholders and meet certain other conditions. Our current intention is to make any dividends in additional shares under our DRIP out of assets legally available therefore, unless a stockholder elects to receive dividends in cash, or their participation in our DRIP is restricted by a state securities regulator. If one holds shares in the name of a broker or financial intermediary, they should contact the broker or financial intermediary regarding their election to receive dividends in cash. We can offer no assurance that we will achieve results that will permit the payment of any cash dividends and, if we issue senior securities, we are prohibited from paying dividends if doing so causes us to fail to maintain the asset coverage ratios stipulated by the 1940 Act or if dividends are limited by the terms of any of our borrowings. On March 31, 2020, after assessing the impacts of the Covid-19 pandemic, the Company’s board of directors unanimously approved the suspension of regular quarterly dividends to the Company’s stockholders, effective immediately. As a result, the Company did not pay or accrue any dividend for the quarter ended September 30, 2020. However, if there is any REIT taxable income to be distributed for tax year ended December 31, 2020, we intend to meet the REIT distribution requirements by making the requisite distributions by end of December 31, 2020 or through catch-up distributions in tax year 2021 as permitted by the REIT tax rules.