GKK Gramercy Property Trust, Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

1. Business and Organization

Gramercy Capital Corp. (the “Company” or “Gramercy”) is a self-managed, integrated commercial real estate investment and asset management company. The Company was formed in April 2004 and commenced operations upon the completion of its initial public offering in August 2004. In June 2012, following a strategic review process completed by a special committee of the Company’s Board of Directors, the Company announced it will remain independent and will now focus on deploying the Company's capital into income-producing net leased real estate. The Company’s new investment criteria will primarily focus on single tenant net lease investments with durable credits across a variety of industries in markets across the United States. New investments initially will be funded from existing financial resources. Subsequently, subject to market conditions, the Company expects to seek to raise additional debt and/or equity capital to support further growth. The Company’s commercial real estate finance business, which operates under the name Gramercy Finance, currently manages approximately $1,800,000 of whole loans, bridge loans, subordinate interests in whole loans, mezzanine loans, preferred equity, commercial mortgage-backed securities, or CMBS, and other real estate related securities which are financed through three non-recourse collateralized debt obligations, or CDOs. The Company’s property management and investment business, which operates under the name Gramercy Realty, currently manages, for third parties, approximately $1,900,000 of commercial properties leased primarily to regulated financial institutions, and affiliated users throughout the United States. Neither Gramercy Finance nor Gramercy Realty is a separate legal entity but are divisions of the Company through which the Company’s commercial real estate finance and property management and investment businesses are conducted.

The Company has elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code, and generally will not be subject to U.S. federal income taxes to the extent it distributes its taxable income, if any, to its stockholders. The Company has in the past established, and may in the future establish taxable REIT subsidiaries, or TRSs, to effect various taxable transactions. Those TRSs would incur U.S. federal, state and local taxes on the taxable income from their activities.

The Company conducts substantially all of its operations through its operating partnership, GKK Capital LP, or the Operating Partnership. The Company is the sole general partner of the Operating Partnership. The Operating Partnership conducts its finance business primarily through two private REITs, Gramercy Investment Trust and Gramercy Investment Trust II; its commercial real estate investment business through various wholly-owned entities; and its realty management business through a wholly-owned TRS.

 As of September 30, 2012 , Gramercy Finance held loans and other lending investments and CMBS of $1,810,615 net of unamortized fees, discounts, asset sales, reserves for loan losses and other adjustments, with an average spread to 30-day LIBOR of 350 basis points for its floating rate investments, and an average yield of approximately 8.65% for its fixed rate investments. As of September 30, 2012, Gramercy Finance also held interests in one credit tenant net lease investment, or CTL investment, and seven interests in real estate acquired through foreclosures.

 As of September 30, 2012, Gramercy Realty’s portfolio consisted of 31 bank branches and 13 office buildings and Gramercy Realty’s consolidated properties aggregated approximately 572 thousand rentable square feet. As of September 30, 2012 and December 31, 2011, the occupancy of Gramercy Realty’s consolidated properties was 40.9% and 39.2%, respectively. In addition to its owned portfolio, Gramercy Realty also manages approximately $1,900,000 of real estate assets that were transferred to affiliates of KBS Real Estate Investment, Inc., or KBS, pursuant to a collateral transfer and settlement agreement, or the Settlement Agreement, executed in September 2011 for an orderly transition of substantially all of Gramercy Realty’s prior assets to affiliates of KBS, Gramercy Realty’s senior mezzanine lender, in full satisfaction of Gramercy Realty’s obligations with respect to Gramercy Realty’s $549,713 senior and junior mezzanine loans with KBS, Goldman Sachs Mortgage Company, or GSMC, Citicorp North America, Inc., or Citicorp, and SL Green, or the Goldman Mezzanine Loans. The portfolio of transferred properties, or the KBS Portfolio, is comprised of 514 bank branches, 273 office buildings and one land parcel, totaling approximately 20.1 million rentable square feet.

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

Basis of Quarterly Presentation

The accompanying Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP, for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, it does not include all of the information and footnotes required by GAAP for complete financial statements. In management’s opinion, all adjustments (consisting of normal recurring accruals) considered necessary for fair presentation have been included. The 2012 operating results for the period presented are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. These financial statements should be read in conjunction with the consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. The Condensed Consolidated Balance Sheet at December 31, 2011 has been derived from the audited financial statements at that date, but does not include all the information and footnotes required by GAAP for complete financial statements.

2. Significant Accounting Policies

Reclassifications and Prior Year Adjustments

For purposes of comparability, certain prior-year amounts have been reclassified to conform to the current-year presentation for assets classified as discontinued operations.

The prior year amounts presented for the three and nine months ended September 30, 2011 have been adjusted to correct for an overstatement of the charge related to other-than-temporary impairment on CMBS investments. The Company identified and corrected an error in the discount rate used in the calculation of other-than-temporary impairment on CMBS investments and recorded an adjustment to correct the other-than-temporary impairment in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. This error resulted in a $15,048 overstatement of the other-than-temporary impairment charge within continuing operations reflected in the Company’s Condensed Consolidated Statements of Comprehensive Income (Loss) and a corresponding understatement of the unrealized holding gains (losses) reflected in Other Comprehensive Income and an overstatement of accumulated deficit and a corresponding understatement in accumulated other comprehensive loss in the Company’s Condensed Consolidated Statements of Stockholders’ Equity (Deficit) and Non-Controlling Interests. In addition this error resulted in an understatement of income from continuing operations and net income for the three and nine months ended September 30, 2011, but did not affect comprehensive income attributable to the Company during such periods.

Principles of Consolidation

The Condensed Consolidated Financial Statements include the Company’s accounts and those of the Company’s subsidiaries which are wholly-owned or controlled by the Company, or entities which are variable interest entities, or VIEs, in which the Company is the primary beneficiary. The primary beneficiary is the party that absorbs a majority of the VIE’s anticipated losses and/or a majority of the expected returns. The Company has evaluated its investments for potential classification as variable interests by evaluating the sufficiency of each entity’s equity investment at risk to absorb losses, and determined that the Company is the primary beneficiary for three VIEs and has included the accounts of these entities in the Condensed Consolidated Financial Statements.

All significant intercompany balances and transactions have been eliminated. Entities which the Company does not control or entities which are VIEs and where the Company is not the primary beneficiary are accounted for as investments in joint ventures or as investments in CMBS.

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

Variable Interest Entities

The following is a summary of the Company’s involvement with VIEs as of September 30, 2012:

The following is a summary of the Company’s involvement with VIEs as of December 31, 2011:

Unconsolidated VIEs

Investment in CMBS

The Company has investments in certain CMBS which are considered to be VIEs. These securities were acquired through investment, and are primarily comprised of securities that were originally investment grade securities, and do not represent a securitization or other transfer of the Company’s assets. The Company is not named as the special servicer or collateral manager of these investments, except as discussed further below.

The Company is not obligated to provide, nor has it provided, any financial support to these entities. Substantially all of the Company’s securities portfolio, with an original aggregate face amount of $1,192,466, is financed by the Company’s CDOs, and the Company’s exposure to loss is therefore limited to its interests in these consolidated entities described above. The Company has not consolidated the aforementioned CMBS investments due to the determination that based on the structural provisions and nature of each investment, the Company does not directly control the activities that most significantly impact the VIE’s economic performance.

As of December 31, 2011, the Company had an investment in a controlling class CMBS with a carrying value of $0. The Company analyzed its investment in the controlling class CMBS to determine if it was the primary beneficiary and determined that it was not required to consolidate the CMBS Trust. At September 30, 2012, the Company’s investment in the securities of the controlling non-investment grade CMBS investment, GS Mortgage Securities Trust 2007-GKK1, or the Trust, were fully charged off.

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

 The Trust is a resecuritization of $633,654 of CMBS originally rated AA through BB. The Company purchased a portion of the below investment grade securities, originally totaling approximately $27,287. The Company is the collateral administrator on the transaction and receives a total fee of 5.5 basis points on the par value of the underlying collateral. The Company has determined that it is the non-transferor sponsor of the Trust. As collateral administrator, the Company has the right to purchase defaulted securities from the Trust at fair value if very specific triggers have been reached. The Company has no other rights or obligations that could impact the economics of the Trust and therefore has concluded that it is not the primary beneficiary. The Company can be removed as collateral administrator, for cause only, with the vote of 66 2/3% of the certificate holders. There are no liquidity facilities or financing agreements associated with the Trust. The Company has no on-going financial obligations, including advancing, funding or purchasing collateral in the Trust.

Investments in Joint Ventures

The Company accounts for its investments in joint ventures under the equity method of accounting since it exercises significant influence, but does not unilaterally control the entities, and is not considered to be the primary beneficiary. In the joint ventures, the rights of the other investors are both protective and participating. Unless the Company is determined to be the primary beneficiary, these rights preclude it from consolidating the investments. The investments are recorded initially at cost as an investment in joint ventures, and subsequently are adjusted for equity in net income or loss and cash contributions and distributions. Any difference between the carrying amount of the investments on the Company’s Condensed Consolidated Balance Sheet and the underlying equity in net assets is evaluated for impairment at each reporting period. None of the joint venture debt is recourse to the Company. As of September 30, 2012 and December 31, 2011, the Company had investments of $10,733 and $496 in two and one joint ventures, respectively.

Cash and Cash Equivalents

The Company considers all highly liquid investments with maturities of three months or less when purchased to be cash equivalents.

Restricted Cash

Restricted cash at September 30, 2012 consists of $69,813 on deposit with the trustee of the Company’s CDOs. The remaining balance consists of $90 which represents amounts escrowed pursuant to mortgage agreements securing the Company’s real estate investments and CTL investments for insurance, taxes, repairs and maintenance, tenant improvements, interest, and debt service and amounts held as collateral under security and pledge agreements relating to leasehold interests.

Assets Held-for-Sale

Real Estate and CTL Investments Held-for-Sale

Real estate investments or CTL investments to be disposed of are reported at the lower of carrying amount or estimated fair value, less cost to sell. Once an asset is classified as held-for-sale, depreciation expense is no longer recorded and current and prior periods are reclassified as “discontinued operations.” As of September 30, 2012 and December 31, 2011, the Company had real estate investments held-for-sale of $18,514 and $42,965, respectively. The Company recorded impairment charges of $1,981 and $4,620 for the three and nine months ended September 30, 2012, respectively, and $0 and $886 for the three and nine months ended September 30, 2011, respectively, related to real estate investments classified as held-for-sale, which are included in net income (loss) from discontinued operations.

Loans and Other Lending Investments Held-for-Sale

Loans held-for-investment are intended to be held-to-maturity and, accordingly, are carried at cost, net of unamortized loan origination fees, discounts, and repayments unless such loan or investment is deemed to be impaired. Loans held-for-sale are carried at the lower of cost or market value using available market information obtained through consultation with dealers or other originators of such investments. As of September 30, 2012 and December 31, 2011, the Company had no loans and other lending investment designated as held-for-sale. The Company recorded impairment charges of $0 and $1,000 for the three and nine months ended September 30, 2012 and no impairment charges for the three and nine months ended September 30, 2011 related to loans and other lending investments held-for-sale. 

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

Settlement and Extinguishment of Debt

A gain on settlement of debt is recorded when the carrying amount of the liability settled exceeds the fair value of the assets transferred to the lender. Pursuant to the execution of the Settlement Agreement, the initial transfer of 317 Gramercy Realty properties, with an aggregate carrying value of $414,413, associated mortgage and other liabilities of $378,276, and associated mezzanine debt of $90,814 occurred on September 1, 2011 and the Company recognized a gain on settlement of debt of $54,677 as part of discontinued operations on the Condensed Consolidated Statement of Operations. The gain on settlement of debt includes $24,125 of gain on disposal of assets.

In July 2011, the Company’s Dana portfolio, which consists of 15 properties totaling approximately 3.8 million rentable square feet, was transferred to its mortgage lender through a deed in lieu of foreclosure. In connection with the transfer of properties, with an aggregate carrying value of $185,466 and associated mortgage and other liabilities of $259,740, the Company recognized a gain on settlement of debt of $74,274 as part of discontinued operations on the Condensed Consolidated Statement of Operations. The gain on settlement of debt includes $15,892 of gain on the disposal of the assets.

During the three and nine months ended September 30, 2012, the Company did not repurchase notes previously issued by the Company’s CDOs. During the three and nine months ended September 30, 2011, the Company repurchased, at a discount, $0 and $48,259, respectively, of notes previously issued by one of the Company’s three CDOs. The Company recorded a net gain on the early extinguishment of debt of $0 and $14,526 for the three and nine months ended September 30, 2011, respectively, in connection with the repurchase of the notes.

Commercial Mortgage-Backed Securities

The Company designates its CMBS investments on the date of acquisition of the investment, including the determination of the appropriate accounting model for impairment and revenue recognition based on the Company’s assessment of the risk of loss. CMBS securities that the Company does not hold for the purpose of selling in the near-term but may dispose of prior to maturity, are designated as available-for-sale and are carried at estimated fair value with the net unrealized gains or losses recorded as a component of accumulated other comprehensive income (loss) in stockholders’ equity (deficit). Upon the disposition of a CMBS investment designated as available-for-sale, the unrealized gain or loss recognized in accumulated other comprehensive income is reversed. A realized gain or loss is computed by comparing the amortized cost of the CMBS investment sold to the cash proceeds received, and the resultant gain or loss is recorded in other income on the Condensed Consolidated Statement of Comprehensive Income (Loss). Unrealized losses that are, in the judgment of management, an other-than-temporary impairment are bifurcated into (i) the amount related to credit losses and (ii) the amount related to all other factors. The evaluation includes a review of the credit status and the performance of the collateral supporting those securities, including key terms of the securities and the effect of local, industry and broader economic trends. The portion of the other-than-temporary impairment related to credit losses is computed by comparing the amortized cost of the investment to the present value of cash flows expected to be collected and is charged against earnings on the Condensed Consolidated Statement of Comprehensive Income (Loss). The portion of the other-than-temporary impairment related to all other factors is recognized as a component of other comprehensive loss on the Condensed Consolidated Balance Sheet. The determination of an other-than-temporary impairment is a subjective process, and different judgments and assumptions could affect the timing of loss realization.

On a quarterly basis, when significant changes in estimated cash flows from the cash flows previously estimated occur due to actual prepayment and credit loss experience, and the present value of the revised cash flow is less than the present value previously estimated, an other-than-temporary impairment is deemed to have occurred. The security is written down to the net present value of expected cash flows with the resulting charge against earnings and a new cost basis is established, with the difference between the revised present value of cash flows and the security's fair value recognized as a component of other comprehensive loss on the Condensed Consolidated Balance Sheet.

During the three and nine months ended September 30, 2012, the Company recorded an other-than-temporary impairment charge of $15,372 and $51,446, respectively, due to adverse changes in expected cash flows related to nine and 22 CMBS investments. During the three and nine months ended September 30, 2011, the Company recognized an other-than-temporary impairment charge of $5,653 and $11,690, respectively, due to an adverse change in expected cash flows related to credit losses for two and three CMBS investments, respectively, which are recorded in the Company’s Condensed Consolidated Statement of Comprehensive Income (Loss).

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

At the date of the other-than-temporary impairment, the Company calculates a revised yield based on the current amortized cost of the investment (including any other-than-temporary impairments recognized to date) and the revised yield is then applied prospectively to recognize interest income. Assumptions about future cash flows consider reasonable management judgment about the probability that the holder of an asset will be unable to collect all amounts due.

The Company determines the fair value of CMBS based on the types of securities in which the Company has invested. The Company consults with dealers of securities to periodically obtain updated market pricing for the same or similar instruments. For securities for which there is no active market, the Company may utilize a pricing model to reflect changes in projected cash flows. The value of the securities is derived by applying discount rates to such cash flows based on current market yields. The yields employed are obtained from the Company’s own experience in the market, advice from dealers when available, and/or information obtained in consultation with other investors in similar instruments. Because fair value estimates, when available, may vary to some degree, the Company must make certain judgments and assumptions based on unobservable inputs about the appropriate price to use to calculate the fair values for financial reporting purposes. Different judgments and assumptions could result in materially different presentations of value.

During the three and nine months ended September 30, 2012, the Company sold no CMBS investments. The Company did not sell any CMBS investments during the three months ended September 30, 2011. During the nine months ended September 30, 2011, the Company sold eight CMBS investments for a realized gain of $15,126. 

Tenant and Other Receivables

Tenant and other receivables are primarily derived from the rental income that each tenant pays in accordance with the terms of its lease, which is recorded on a straight-line basis over the initial term of the lease. Since many leases provide for rental increases at specified intervals, straight-line basis accounting requires the Company to record a receivable, and include in revenues, unbilled rent receivables that will only be received if the tenant makes all rent payments required through the expiration of the initial term of the lease. Tenant and other receivables also include receivables related to tenant reimbursements for common area maintenance expenses and certain other recoverable expenses that are recognized as revenue in the period in which the related expenses are incurred.

Tenant and other receivables are recorded net of the allowances for doubtful accounts, which as of September 30, 2012 and December 31, 2011 were $286 and $280, respectively. The Company continually reviews receivables related to rent, tenant reimbursements and unbilled rent receivables and determines collectability by taking into consideration the tenant’s payment history, the financial condition of the tenant, business conditions in the industry in which the tenant operates and economic conditions in the area in which the property is located. In the event that the collectability of a receivable is in doubt, the Company increases the allowance for doubtful accounts or records a direct write-off of the receivable in the Condensed Consolidated Statements of Comprehensive Income (Loss).

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

Valuation of Financial Instruments

ASC 820-10, “Fair Value Measurements and Disclosures,” among other things, establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. Considerable judgment is necessary to interpret market data and develop estimated fair values. Accordingly, fair values are not necessarily indicative of the amounts the Company could realize on disposition of the financial instruments. Financial instruments with readily available actively quoted prices or for which fair value is based upon significant observable inputs with actively quoted prices will have a higher degree of pricing observability and will require a lesser degree of judgment to be utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have less, or no, pricing observability and will require a higher degree of judgment to be utilized in measuring fair value. Pricing observability is generally affected by such items as the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions. The use of different market assumptions and/or estimation methodologies may have a material effect on estimated fair value amounts.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, or an exit price. The level of pricing observability generally correlates to the degree of judgment utilized in measuring the fair value of financial instruments. The less judgment utilized in measuring fair value of financial instruments, such as with readily available active quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability. Conversely, financial instruments rarely traded or not quoted have less observability and are measured at fair value using valuation models that require more judgment. Impacted by a number of factors, pricing observability is generally affected by such items as the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions.

The three broad levels defined are as follows:

Level I — This level is comprised of financial instruments that have quoted prices that are available in active markets for identical assets or liabilities. The type of financial instruments included in this category are highly liquid instruments with quoted prices.

Level II — This level is comprised of financial instruments that have pricing inputs other than quoted prices in active markets that are either directly or indirectly observable. The nature of these financial instruments includes instruments for which quoted prices are available but traded less frequently and instruments that are fair valued using other financial instruments, the parameters of which can be directly observed.

Level III — This level is comprised of financial instruments that have little to no pricing observability as of the reported date. These financial instruments do not have active markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment and assumptions. Instruments that are generally included in this category are derivatives, whole loans, subordinate interests in whole loans, mezzanine loans and CMBS securities.

For a further discussion regarding the measurement of financial instruments see Note 8, “Fair Value of Financial Instruments.”

Revenue Recognition

Real Estate and CTL Investments

Rental income from leases is recognized on a straight-line basis regardless of when payments are contractually due. Certain lease agreements also contain provisions that require tenants to reimburse the Company for real estate taxes, common area maintenance costs, use of parking facilities and the amortized cost of capital expenditures with interest. Such amounts are included in both revenues and operating expenses when the Company is the primary obligor for these expenses and assumes the risks and rewards of a principal under these arrangements. Under leases where the tenant pays these expenses directly, such amounts are not included in revenues or expenses.

Deferred revenue represents rental revenue and management fees received prior to the date earned. Deferred revenue also includes rental payments received in excess of rental revenues recognized as a result of straight-line basis accounting.

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

Management fees are recognized as earned, regardless of when payments are due.

Other income includes revenues from our foreclosed properties and is recognized as earned.

The Company recognizes sales of real estate properties only upon closing. Payments received from purchasers prior to closing are recorded as deposits. Profit on real estate sold is recognized using the full accrual method upon closing when the collectability of the sale price is reasonably assured and the Company is not obligated to perform significant activities after the sale. Profit may be deferred in whole or part until the sale meets the requirements of profit recognition on sale of real estate.

Finance Investments

Interest income on debt investments, which includes loan and CMBS investments, are recognized over the life of the investments using the effective interest method and recognized on an accrual basis. Depending on the nature of the CMBS investment, changes to expected cash flows may result in a prospective change in yield or a retrospective change which would include a catch up adjustment. Fees received in connection with loan commitments are deferred until the loan is funded and are then recognized over the term of the loan using the effective interest method.

Anticipated exit fees, whose collection is expected, are also recognized over the term of the loan as an adjustment to yield. Fees on commitments that expire unused are recognized at expiration.

Income recognition is generally suspended for debt investments at the earlier of the date at which payments become 90 days past due or when, in the opinion of management, a full recovery of income and principal becomes doubtful. Income recognition is resumed when the loan becomes contractually current and performance is demonstrated to be resumed.

The Company designates loans as non-performing at such time as: (1) the loan becomes 90 days delinquent or (2) the loan has a maturity default. All non-performing loans are placed on non-accrual status and subsequent cash receipts are applied to principal or recognized as income when received. At September 30, 2012, the Company had one whole loan with a carrying value of $51,417 which was classified as a non-performing loan. At December 31, 2011, the Company had one whole loan with a carrying value of $51,417 and two mezzanine loans with an aggregate carrying value of $0 which were classified as non-performing loans.

The Company classifies loans as sub-performing if they are not performing in material accordance with their terms, but they do not qualify as non-performing loans and the specific facts and circumstances of these loans may cause them to develop into non-performing loans should certain events occur in the normal passage of time, which the Company considers to be 90 days from the measurement date. At September 30, 2012, two whole loans with a carrying value of $23,313 and one subordinate interest in a whole loan with a carrying value of $3,000 were classified as sub-performing. At December 31, 2011, two whole loans with an aggregate carrying value of $44,555 and one preferred equity investment with a carrying value of $1,295 were classified as sub-performing.

Reserve for Loan Losses

Specific valuation allowances are established for loan losses on loans in instances where it is deemed probable that the Company may be unable to collect all amounts of principal and interest due according to the contractual terms of the loan. The reserve is increased through the provision for loan losses on the Condensed Consolidated Statement of Comprehensive Income (Loss) and is decreased by charge-offs when losses are realized through sale, foreclosure, or when significant collection efforts have ceased.

The Company considers the present value of payments expected to be received, observable market prices or the estimated fair value of the collateral (for loans that are dependent on the collateral for repayment), and compares it to the carrying value of the loan. The determination of the estimated fair value is based on the key characteristics of the collateral type, collateral location, quality and prospects of the sponsor, the amount and status of any senior debt, and other factors. The Company also includes the evaluation of operating cash flow from the property during the projected holding period, and the estimated sales value of the collateral computed by applying an expected capitalization rate to the stabilized net operating income of the specific property, less selling costs, all of which are discounted at market discount rates. The Company also considers if the loan’s terms have been modified in a troubled debt restructuring. Because the determination of estimated value is based upon projections of future economic events, which are inherently subjective, amounts ultimately realized from loans and investments may differ materially from the carrying value at the balance sheet date.

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

If, upon completion of the valuation, the estimated fair value of the underlying collateral securing the loan is less than the net carrying value of the loan, an allowance is created with a corresponding charge to the provision for loan losses. The allowance for each loan is maintained at a level the Company believes is adequate to absorb losses. During the nine months ended September 30, 2012, the Company incurred charge-offs totaling $157,774 relating to realized losses on six loan investments. During the year ended December 31, 2011, the Company incurred charge-offs totaling $66,856 relating to realized losses on five loans. The Company maintained a reserve for loan losses of $79,228 against eight separate investments with an aggregate carrying value of $238,447 as of September 30, 2012, and a reserve for loan losses of $244,840 against 15 separate investments with an aggregate carrying value of $294,083 as of December 31, 2011.

Stock-Based Compensation Plans

The Company has stock-based compensation plans, as more fully described in Note 9. The Company accounts for these plans using the fair value recognition provisions. The Company uses the Black-Scholes option-pricing model to estimate the fair value of a stock option award. This model requires inputs such as expected term, expected volatility, and risk-free interest rate. Further, the forfeiture rate also impacts the amount of aggregate compensation cost. These inputs are highly subjective and generally require significant analysis and judgment to develop.

Compensation cost for stock options, if any, is recognized ratably over the vesting period of the award. The Company’s policy is to grant options with an exercise price equal to the quoted closing market price of its stock on the business day preceding the grant date. Awards of stock or restricted stock are expensed as compensation over the benefit period.

The fair value of each stock option granted is estimated on the date of grant for options issued to employees, and quarterly awards to non-employees, using the Black-Scholes option-pricing model with the following weighted average assumptions for grants in 2012 and 2011:

Derivative Instruments

In the normal course of business, the Company uses a variety of derivative instruments to manage, or hedge, interest rate risk. The Company requires that hedging derivative instruments be effective in reducing the interest rate risk exposure that they are designated to hedge. This effectiveness is essential for qualifying for hedge accounting. Instruments that meet these hedging criteria are formally designated as hedges at the inception of the derivative contract. The Company uses a variety of commonly used derivative products that are considered “plain vanilla” derivatives. These derivatives typically include interest rate swaps, caps, collars and floors. The Company expressly prohibits the use of unconventional derivative instruments and using derivative instruments for trading or speculative purposes. Further, the Company has a policy of only entering into contracts with major financial institutions based upon their credit ratings and other factors.

To determine the fair value of derivative instruments, the Company uses a variety of methods and assumptions that are based on market conditions and risks existing at each balance sheet date. For the majority of financial instruments including most derivatives, long-term investments and long-term debt, standard market conventions and techniques such as discounted cash flow analysis, option-pricing models, replacement cost and termination cost are used to determine fair value. All methods of assessing fair value result in a general approximation of value, and such value may never actually be realized. 

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

In the normal course of business, the Company is exposed to the effect of interest rate changes and limits these risks by following established risk management policies and procedures including the use of derivatives. To address exposure to interest rates, the Company uses derivatives primarily to hedge the cash flow variability caused by interest rate fluctuations of its CDO liabilities. Each of the Company’s CDOs maintains a maximum amount of allowable unhedged interest rate risk. The 2005 CDO permits 20% of the net outstanding principal balance and the 2006 CDO and the 2007 CDO permit 5% of the net outstanding principal balance to be unhedged.

The Company recognizes all derivatives on the Condensed Consolidated Balance Sheets at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will either be offset against the change in fair value of the hedged asset, liability or firm commitment through earnings, or recognized in other comprehensive loss until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. Derivative accounting may increase or decrease reported net income and stockholders’ equity (deficit) prospectively, depending on future levels of LIBOR, swap spreads and other variables affecting the fair values of derivative instruments and hedged items, but will have no effect on cash flows, provided the contract is carried through to full term.

All hedges held by the Company are deemed effective based upon the hedging objectives established by the Company’s corporate policy governing interest rate risk management. The effect of the Company’s derivative instruments on its financial statements is discussed more fully in Note 11.

Income Taxes

The Company elected to be taxed as a REIT, under Sections 856 through 860 of the Internal Revenue Code, beginning with its taxable year ended December 31, 2004. To qualify as a REIT, the Company must meet certain organizational and operational requirements, including a requirement to distribute at least 90% of its ordinary taxable income to stockholders. As a REIT, the Company generally will not be subject to U.S. federal income tax on taxable income that the Company distributes to its stockholders. If the Company fails to qualify as a REIT in any taxable year, it will then be subject to U.S. federal income taxes on taxable income at regular corporate rates and will not be permitted to qualify for treatment as a REIT for U.S. federal income tax purposes for four years following the year during which qualification is lost unless the Internal Revenue Service grants the Company relief under certain statutory provisions. Such an event could materially adversely affect the Company’s net income and net cash available for distributions to stockholders. However, the Company believes that it will be organized and operate in such a manner as to qualify for treatment as a REIT and the Company intends to operate in the foreseeable future in such a manner so that it will qualify as a REIT for U.S. federal income tax purposes. The Company is subject to certain state and local taxes.

For the three and nine months ended September 30, 2012, the Company reversed $39 and recorded $3,379 of income tax expense, respectively. For the three and nine months ended September 30, 2011, the Company recorded $0 and $73 of income tax expense, respectively. Tax expense is comprised of U.S. federal, state and local taxes primarily attributable to the TRS in which the Company’s real estate management business is conducted.

The Company’s policy for interest and penalties, if any, on material uncertain tax positions recognized in the financial statements is to classify these as interest expense and operating expense, respectively. For the three and nine months ended September 30, 2012 and September 30, 2011, the Company did not incur any material interest or penalties.

Earnings per Share

The Company presents both basic and diluted earnings per share, or EPS. Basic EPS excludes dilution and is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock, as long as their inclusion would not be anti-dilutive.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

Concentrations of Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash investments, debt investments and accounts receivable. The Company places its cash investments in excess of insured amounts with high quality financial institutions. The Company performs ongoing analysis of credit risk concentrations in its loan and other lending investment portfolio by evaluating exposure to various markets, underlying property types, investment structure, term, sponsors, tenants and other credit metrics. 

Three investments accounted for approximately 24.8% of the total carrying value of the Company’s loan and other lending investments as of September 30, 2012, compared to three investments which accounted for approximately 21.1% of the total carrying value of the Company’s loan and other lending investments as of December 31, 2011. Four investments accounted for approximately 16.1% and 15.4% of the revenue earned on the Company’s loan and other lending investments for the three and nine months ended September 30, 2012, respectively, compared to five and seven investments accounted for approximately 16.5% and 15.6% of the revenue earned on the Company's loan and other lending investments for the three and nine months ended September 30, 2011. The largest sponsor accounted for approximately 17.0% and 14.1% of the total carrying value of the Company’s loan and other lending investments as of September 30, 2012 and December 31, 2011, respectively. The largest sponsor accounted for approximately 12.2% and 11.4% of the revenue earned on the Company's loan and other lending investments for the three and nine months ended September 30, 2012, respectively, compared to 10.4% and 4.0% of the revenue earned on the Company's loan and other lending investments for the three and nine months ended September 30, 2011, respectively.

Recently Issued Accounting Pronouncements

In May 2011, the FASB issued updated guidance on fair value measurement which amends GAAP to conform to International Financial Reporting Standards, or IFRS, measurement and disclosure requirements. The amendment changes the wording used to describe the requirements in GAAP for measuring fair value, changes certain fair value measurement principles and enhances disclosure requirements. This guidance was effective as of January 1, 2012, applied prospectively, and its adoption did not have a material effect on the Company’s Condensed Consolidated Financial Statements. 

In June 2011, the FASB issued updated guidance on comprehensive income which amends GAAP to conform to the disclosure requirements of IFRS. The amendment eliminates the option to present components of other comprehensive income as part of the Statement of Stockholders’ Equity (Deficit) and Non-Controlling Interests and requires a separate Statement of Comprehensive Income or two consecutive statements in the Statement of Operations and in a separate Statement of Comprehensive Income. This guidance also requires the presentation of reclassification adjustments for each component of other comprehensive income on the face of the financial statements rather than in the notes to the financial statements.The Company adopted this in the first quarter of 2012, opting to present the Statement of Comprehensive Income as a single continuous statement. This guidance was effective as of January 1, 2012, except for the disclosure of reclassification adjustments which was postponed for re-deliberation by the FASB, and its adoption did not have a material effect on the Company’s Condensed Consolidated Financial Statements.

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

3. Loans, Other Lending Investments and Commercial Mortgage-Backed Securities

The aggregate carrying values, allocated by product type and weighted-average coupons, of the Company’s loans, other lending investments and CMBS investments as of September 30, 2012 and December 31, 2011, were as follows:

Whole loans are permanent first mortgage loans with initial terms of up to 15 years. Whole loans are first mortgage liens and senior in interest to subordinate mortgage interests in whole loans, mezzanine loan and preferred equity interests.

Subordinate mortgage interests in whole loans are participation interests in mortgage notes or loans secured by a lien subordinated to a senior interest in the same loan. Subordinate interests in whole loans are subject to greater credit risk with respect to the underlying mortgage collateral than the corresponding senior interest.

Mezzanine loans are senior to the borrower’s equity in, and subordinate to a whole loan and subordinate mortgage interest, on a property. These loans are secured by pledges of ownership interests in entities that directly or indirectly own the real property.

Preferred equity are investments in entities that directly or indirectly own commercial real estate. Preferred equity is not secured, but holders have priority relative to common equity holders. 

Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

Quarterly, the Company evaluates its loans for instances where specific valuation allowances are necessary, as described in Note 2. As a component of the Company's quarterly policies and procedures for loan valuation and risk assessment, each loan is assigned a risk rating. Individual ratings range from one to six, with one being the lowest risk and six being the highest risk. Each credit risk rating has benchmark guidelines which pertain to debt-service coverage ratios, loan-to-value, or LTV, ratios, borrower strength, asset quality, and funded cash reserves. Other factors such as guarantees, market strength, remaining loan term, and borrower equity are also reviewed and factored into determining the credit risk rating assigned to each loan. Loans with a risk rating of one to three have characteristics of a lower risk loan and such loans are generally expected to perform through maturity. Loans with a risk rating of four to five generally have characteristics of a higher risk loan and may indicate instances of a higher likelihood of a contractual default or expectation of a principal loss. Loans with a risk rating of six are non-performing and often times have been fully reserved.

A summary of the Company’s loans by risk rating and loan class as of September 30, 2012 and December 31, 2011 are as follows:

  Gramercy Capital Corp.

Notes to Condensed Consolidated Financial Statements

(Unaudited, dollar amounts in thousands, except per share data)

September 30, 2012

As of September 30, 2012, the Company’s loans and other lending investments, excluding CMBS investments, had the following maturity characteristics: