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10-K 1 w16788e10vk.htm FORM 10-K FOR CAPITALSOURCE INC. e10vk

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

Commission File No. 1-31753

CapitalSource Inc.

(Exact name of registrant as specified in its charter)


Delaware		35-2206895
(State of Incorporation)		(I.R.S. Employer Identification No.)

4445 Willard Avenue, 12th Floor

Chevy Chase, MD 20815

(Address of Principal Executive Offices, Including Zip Code)

(800) 370-9431

(Registrant’s Telephone Number, Including Area Code)

Securities Registered Pursuant to Section 12(b) of the Act:


(Title of Each Class)		(Name of Exchange on Which Registered)

Common Stock, par value $0.01 per share		New York Stock Exchange

Securities Registered Pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. þYes oNo

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. o Yes þNo

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. þYes oNo

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


þ Large Accelerated Filer		o Accelerated Filer		o Non-Accelerated Filer

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No

The aggregate market value of the Registrant’s Common Stock, par value $0.01 per share, held by nonaffiliates of the Registrant, as of June 30, 2005 was approximately $1,293,454,000.

As of March 1, 2006, the number of shares of the Registrant’s Common Stock, par value $0.01 per share, outstanding was 154,251,810.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of CapitalSource Inc.’s Proxy Statement for the 2006 annual meeting of shareholders, a definitive copy of which will be filed with the SEC within 120 days after the end of the year covered by this Form 10-K, are incorporated by reference herein as portions of Part III of this Form 10-K.

TABLE OF CONTENTS


		Page

PART I
Item 1.	Business		2
Item 1A.	Risk Factors		15
Item 1B.	Unresolved Staff Comments		41
Item 2.	Properties		41
Item 3.	Legal Proceedings		41
Item 4.	Submission of Matters to a Vote of Security Holders		41

PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters And Issuer Purchases of Equity Securities		41
Item 6.	Selected Financial Data		43
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		46
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		71
	Management Report on Internal Controls Over Financial Reporting		72
	Report of Ernst & Young LLP, Independent Registered Public Accounting Firm, on Internal Controls Over Financial Reporting		73
Item 8.	Consolidated Financial Statements and Supplementary Data		74
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		126
Item 9A.	Controls and Procedures		126
Item 9B.	Other Information		126

PART III
Item 10.	Directors and Executive Officers of the Registrant		127
Item 11.	Executive Compensation		127
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		127
Item 13.	Certain Relationships and Related Transactions		127
Item 14.	Principal Accounting Fees and Services		127

PART IV
Item 15.	Exhibits and Financial Statement Schedules		128
Signatures			129
Index to Exhibits			130
Certifications

PART I

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-K, including the footnotes to our unaudited consolidated financial statements included herein, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by these forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words such as “intend,” “plan,” “may,” “should,” “will,” “project,” “estimate,” “anticipate,” “believe,” “expect,” “continue,” “potential,” “opportunity,” and similar expressions, whether in the negative or affirmative. Our ability to predict results or the mutual effect of future plans or strategies is inherently uncertain. Although we believe that the expectations reflected in such forward-looking statements are based on reasonable assumptions, actual results and performance could differ materially from those set forth in the forward-looking statements. All statements regarding our expected financial position, business and financing plans are forward-looking statements. All forward-looking statements speak only to events as of the date on which the statements are made. 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 on which the statement is made.

The information contained in this section should be read in conjunction with our consolidated financial statements and related notes and the information contained elsewhere in this Form 10-K, including that set forth under Item 1A, Risk Factors.


ITEM 1.	BUSINESS

Overview

We are a specialized finance company providing loans to small and medium-sized businesses. We also selectively make equity investments, engage in asset management and servicing activities and invest in residential mortgage assets. We intend to qualify as a real estate investment trust (“REIT”) in 2006.

Through our commercial lending activities, our primary goal is to be the lender of choice for small and medium-sized businesses with annual revenues generally ranging from $5 million to $500 million that require customized and sophisticated debt financing. We provide a wide range of financial products that we negotiate and structure on a client-specific basis, through direct interaction with the owners and senior managers of our clients. We seek to add value to our clients’ businesses by providing tailored financing that meets their specific business needs and objectives.

As of December 31, 2005, we had 923 loans outstanding under which we had funded an aggregate of $6.0 billion and committed to lend up to an additional $3.2 billion to our clients.

The financing needs of our clients are often specific to their particular businesses or their particular situation. We believe we can most successfully meet these needs and manage risk through industry or sector focus and flexibility in structuring financings. We offer a range of senior and subordinate mortgage loans, secured asset-based loans, senior secured cash flow loans, mezzanine loans and equity investments to our clients. Because we believe specialized industry and/or sector knowledge is important to successfully serve our client base, we originate, underwrite and manage our loans through three focused commercial lending businesses organized around our areas of expertise. Focusing our efforts in these specific sectors, industries and markets allows us to rapidly design and implement lending products that satisfy the special financing needs of our clients. Our commercial lending businesses are:


	•	Structured Finance, which generally engages in commercial and residential real estate lending and also provides asset-based lending to finance companies;


	•	Healthcare and Specialty Finance, which generally provides asset-based revolving lines of credit, first mortgage loans and other senior and mezzanine loans to healthcare businesses and a broad range of other companies; and

	•	Corporate Finance, which generally provides senior and mezzanine loans principally to businesses backed by private equity sponsors.

We price our loans based upon the risk profile of our clients. Although we make loans greater than $50 million, our loans generally range from $1 million to $50 million, with an average loan size of $6.5 million as of December 31, 2005. Our loans generally have a maturity of two to five years with a weighted average maturity of 3.09 years as of December 31, 2005. Our geographically diverse client base consisted of 611 clients with headquarters in 44 states, the District of Columbia, Canada and the United Kingdom as of December 31, 2005.

Developments during Fiscal Year 2005

In September 2005, after a thorough analysis of our competitive landscape and market position, we announced our intention to elect to be taxed as a REIT commencing in 2006. Our decision to operate as a REIT represents an evolution of our strategy, as real estate based lending has comprised a significant percentage of our origination activities since inception. As a REIT, we will continue to offer each of our traditional lending products, including corporate loans through our taxable REIT subsidiaries, or TRSs. We believe that our after-tax returns on our real estate based lending products will be enhanced by our new structure because, as a REIT, the earnings from these products that we distribute to our shareholders generally will not be subject to corporate-level tax. In addition, we intend to expand into complementary real estate based products and services including direct real estate investments that we consider natural extensions of our historical loan product offerings and services. To prepare for our operation as a REIT, in December 2005 we divided our loan portfolio by separating the majority of our real estate based loans, which constitute “qualifying” REIT assets, from our other assets. We now hold our non real estate based loans in TRSs. The earnings we derive from our TRS operations will continue to be subject to corporate-level tax.

As required by REIT tax rules, we declared a special dividend of $2.50 per share, or $350.9 million in the aggregate, representing our estimate at that time of our cumulative undistributed earnings and profits attributable to tax years ended prior to January 1, 2006. In January 2006, this special dividend was paid $70.2 million in cash and $280.7 million in stock, resulting in the issuance of 12.3 million shares of common stock based on an imputed per share stock price of $22.85.

To facilitate compliance with REIT qualification rules and to begin to optimize the value of the REIT structure, we began investing in residential mortgage-backed securities during the fourth quarter 2005. In November and December 2005, we purchased $2.3 billion of mortgage-backed pass-through certificates guaranteed by the Federal Home Loan Mortgage Corporation (commonly known as Freddie Mac) or the Federal National Mortgage Association (commonly known as Fannie Mae) and collateralized by conforming prime mortgage loans that were originated as hybrid adjustable rate mortgages.

During 2005, we also began to explore several asset management strategies to increase and diversify our portfolio. These strategies include increased loan syndication activities, management of off-balance sheet collateralized loan obligations with respect to senior secured cash flow loans, joint ventures with private equity funds and third-party servicing of distressed loans and investments.

Loan Products, Service Offerings and Investments

The types of loan products and services offered by each of our commercial lending businesses share common characteristics, and we generally underwrite the same types of loans across our three commercial lending businesses using similar criteria. When opportunities arise, we may offer a combination of products to a particular client. This single source approach often allows us to close transactions faster than our competitors by eliminating the need for complicated and time-consuming intercreditor negotiations. Our primary types of loan products and services are as follows:


	•	Senior Secured Asset-Based Loans. Asset-based loans are collateralized by specified assets of the client, generally the client’s accounts receivable and/or inventory. A loan is a “senior” loan when we

have a first priority lien in the collateral securing the loan. These loans, which are generally between $1 million and $50 million, usually have a term of two to five years. We generally will advance a client, on a revolving basis, between 80% and 90% of the value of the client’s eligible receivables and between 30% and 70% of a client’s eligible inventory.

• Senior Secured Cash Flow Loans. Cash flow loans are made based on our assessment of a client’s ability to generate cash flows sufficient to repay the loan and to maintain or increase its enterprise value during the term of the loan. Our senior cash flow term loans generally are secured by a security interest in all or substantially all of a client’s assets. In some cases, the equity owners of a client pledge their stock in the client to us. These loans generally range in size from $1 million to $50 million and have a term of three to five years.

• First Mortgage Loans. We make term loans secured by first mortgages. These loans generally range in size from $2 million to $75 million and have a term of two to five years. We make mortgage loans to clients including owners and operators of hospitals, senior housing and skilled nursing facilities; owners and operators of office, industrial, hospitality, multi-family and residential properties; resort and residential developers; and companies backed by private equity firms that frequently take out mortgages in connection with buyout transactions.

• Sale/ Leasebacks. During the first quarter 2006, we completed our first sale/leaseback transaction. In these transactions, we buy a client’s real property and lease it back to the client over a long-term lease. We generally intend to hold our sale/leaseback assets for long-term investment. Our initial investment involved our purchase of 38 healthcare facilities subject to ten year, triple-net leases. Under a typical net lease, the client agrees to pay a base monthly operating lease payment and all facility operating expenses as well as make capital improvements.

• Term B, Second Lien and Mezzanine Lending. We make Term B, second lien and mezzanine loans. A Term B loan is a loan that shares a first priority lien in the client’s collateral with the lenders on the client’s senior loan but that comes after a senior secured loan in order of payment preference upon a borrower’s liquidation, and, accordingly, generally involves greater risk of loss than a senior secured loan. Term B loans are senior loans and, therefore, are included with senior secured loans in our portfolio statistics. A second lien loan is a loan that has a lien on the client’s collateral that is junior in order of priority and also comes after the senior loans in order of payment. We also make mezzanine loans that may be either cash flow or real estate based loans. A mezzanine loan is a loan that does not share in the same collateral package as the client’s senior loans, may have no security interest in any of the client’s assets and comes after a senior secured loan in order of payment preference. A mezzanine loan generally involves greater risk of loss than a senior loan.

• Residential Mortgage Investments. In connection with our plan to qualify as a REIT, we invest directly in residential mortgage assets that we believe qualify as REIT eligible assets. In 2005, our investments were in mortgage-backed securities guaranteed as to principal and interest by Freddie Mac or Fannie Mae. Subsequent to year end, we purchased an additional $1.1 billion in Freddie Mac and Fannie Mae guaranteed residential mortgage-backed securities and approximately $2.5 billion in residential prime whole loans. Mortgage-backed securities provide for a monthly payment that consists of both interest and principal, including borrower prepayments. We financed our purchases of residential mortgage-backed securities with repurchase agreements and our residential prime whole loans primarily through securitizations along with repurchase agreements.

• HUD Mortgage Originations. As a strategic supplement to our real estate lending business, we also act as an agent for the United States Department of Housing and Urban Development, or HUD, for the origination of federally insured mortgage loans through the Federal Housing Authority, or FHA. Because we are a fully approved FHA Title II mortgagee, we have the ability to originate, underwrite, fund and service mortgage loans insured by the FHA. FHA is a branch of HUD which works through approved lending institutions to provide federal mortgage and loan insurance for housing and healthcare facilities.


	•	Equity Investments. We may purchase equity in a borrower at the same time and on substantially the same terms as a private equity sponsor client. These equity purchases generally range from $250,000 to $2.0 million for any given client. We do not agree to any rate or other lending concessions in the loans we make to these borrowers in return for the opportunity to make these investments.

Loan Syndications

We originate loans that we syndicate to other lenders and for which we act as agent. Our syndication strategy allows us to limit our exposure to larger loans and typically results in additional fees we receive for originating the loan and/or serving as agent for the lending syndicate. As of December 31, 2005, we had syndicated out $975.5 million of the loans in our portfolio. Most of our syndication activity relates to our senior secured cash flow loans.

We also participate in loans originated and syndicated by other lenders where we are not the agent. In these situations, we generally lend money to clients as part of a larger lending package arranged by another lender. As of December 31, 2005, approximately 3% of the aggregate outstanding balance of our loan portfolio comprised loans for which we are not the agent.

Loan Origination, Underwriting and Servicing Process

We have created an integrated approach to our loan origination and underwriting approval process that effectively combines the skills of our professionals with our proprietary information systems. This process allows us to move efficiently and quickly from our initial contact with a prospective client to the closing of our loan transaction while maintaining our rigorous underwriting standards. The primary steps in this process are as follows:


	•	Origination. Our loan origination process begins with our development officers, who are charged with identifying, contacting and screening our prospective clients. They work closely with our investment officers to determine a potential client’s financing needs and to make a determination as to whether to proceed with the prospect. Once the financing for a potential client is approved by all required parties, the investment officer and the client negotiate the principal terms of the financing.

	•	Underwriting. Once the principal terms of the financing are determined, the investment officer, along with our dedicated due diligence and field examination employees, perform comprehensive due diligence and underwriting procedures relating to the proposed transaction.

	•	Approval. The unanimous approval of our credit committee is required before we make a loan. The members of our credit committee are our Chief Executive Officer, our Chief Investment Officer, our President and Chief Operating Officer, our Chief Credit Officer, our Chief Legal Officer and, for each loan proposed to be made by his lending business, the President(s) of that lending business.

	•	Servicing. After a loan is approved and closed, the loan is assigned to a loan officer within a specific lending business to provide tailored and highly customized loan servicing appropriate to that business. Regularly scheduled examinations and due diligence procedures continue to be performed on most loans, depending on their overall complexity and credit risk.

To streamline our loan origination, underwriting and servicing processes and to expedite loan turnaround time, we have developed two proprietary information technology systems that we use in our daily operations. Both of these systems enable us to enhance our loan servicing abilities:


	•	DealTracker, which tracks potential transactions from prospect identification through termination or closing; and

	•	CapitalSource Asset Manager, or CAM, which tracks daily portfolio performance for our loan servicing function.

Loan Ratings

We employ a comprehensive rating system and process to provide timely and accurate assessments of the credit risk inherent in each of our commercial loans. While rating criteria vary by product, each loan rating focuses on the same three factors:


	•	credit;

	•	collateral; and

	•	financial performance.

Our loan officers conduct a review at least quarterly in which they rate each of the loans for which they are responsible. Some loans are reviewed more frequently. Following the review process, the recommended ratings are sent to the office of the Chief Credit Officer for consideration. The office of the Chief Credit Officer prepares reports detailing the rating changes made during the quarter. This report is then provided to the Credit Committee for final review and approval. Once the ratings have been finalized, the new ratings are made available to all of our professional staff.

Commercial Lending Portfolio Overview

The composition of our commercial loan portfolio by loan type and by commercial lending business as of December 31, 2005 and 2004 was as follows:


		December 31,

		2005				2004

		($ in thousands)
Composition of portfolio by loan type:
	Senior secured asset-based loans(1)	$	2,022,123	34	%	$	1,327,556	31	%
	First mortgage loans(1)		1,970,709	33			1,120,204	26
	Senior secured cash flow loans(1)		1,740,184	29			1,583,411	37
	Mezzanine loans		254,727	4			243,354	6

Total		$	5,987,743	100	%	$	4,274,525	100	%

Composition of portfolio by lending business:
	Structured Finance(2)	$	1,909,149	32	%	$	1,335,541	31	%
	Healthcare and Specialty Finance(2)		2,281,419	38			1,229,804	29
	Corporate Finance		1,797,175	30			1,709,180	40

Total		$	5,987,743	100	%	$	4,274,525	100	%


(1)	Includes Term B loans.

(2)	Our security alarm industry loans have been included in our Healthcare and Specialty Finance Business since January 1, 2005 and were previously in our Structured Finance Business as of December 31, 2004, and are reflected as such in the portfolio statistics throughout this Annual Report on Form 10-K.

As of December 31, 2005, our commercial loan portfolio was well diversified, with 923 loans to 611 clients operating in multiple industries. We use the term “client” to mean the legal entity that is the borrower party to a loan agreement with us. As of December 31, 2005, our Structured Finance, Healthcare and Specialty Finance and Corporate Finance businesses had commitments to lend up to an additional $0.9 billion, $1.7 billion and $0.6 billion, respectively, to 180, 305 and 126 existing clients, respectively. Throughout this section, unless specifically stated otherwise, all figures relate to our loans outstanding as of December 31, 2005.

Our commercial loan portfolio by industry as of December 31, 2005 was as follows (percentages by loan balance):

Commercial Loan Portfolio By Industry⁽¹⁾


(1)	Industry classification is based on the North American Industry Classification System (NAICS).

As of December 31, 2005, our loans ranged in size from $0.1 million to $96.3 million. Our commercial loan portfolio by loan balance as of December 31, 2005 was as follows:

Commercial Loan Portfolio By Loan Balance

Our commercial loan portfolio by client balance as of December 31, 2005 was as follows:

Commercial Loan Portfolio By Client Balance

We may have more than one loan to a client and its related entities. For purposes of determining the portfolio statistics in this Annual Report on Form 10-K, we count each loan or client separately and do not aggregate loans to related entities.

No client accounted for more than 10% of our total revenues in 2005. The principal executive offices of our clients were located in 44 states and the District of Columbia. As of December 31, 2005, the largest geographical concentration was Florida, which makes up approximately 11% of the outstanding aggregate balance of our loan portfolio. In addition, we have loans in Canada and the United Kingdom, which comprised less than 2% of the outstanding aggregate balance of our loan portfolio as of December 31, 2005.

Our commercial loan portfolio by geographic region as of December 31, 2005 was as follows:

Commercial Loan Portfolio By Geographic Region


(1)	Includes international locations and all states that have a loan balance that is less than 1% of the aggregate outstanding balance of our commercial loan portfolio.

Our loans primarily provide for contractual variable interest rates from approximately 0% to 14.4% above the prime rate. To mitigate the risk of declining yields if interest rates fall, we seek to include an interest rate floor in our loans whenever possible. Whether we are able to include an interest rate floor in the pricing of a particular loan is determined by a combination of factors, including the potential client’s need for capital and the degree of competition we face in the origination of loans of the proposed type.

Our loans generally have stated maturities at origination that range from two to five years. As of December 31, 2005, the weighted average maturity and weighted average life of our entire commercial loan portfolio was approximately 3.09 years and 2.90 years, respectively. Our clients typically pay us an origination fee based on a percentage of the commitment amount and typically are required to pay a prepayment penalty for at least the first two years following origination. They also often pay us a fee based on any undrawn commitments as well as a collateral management fee in the case of our asset-based revolving loans.

The average sizes of our loans by commercial lending business and across our overall portfolio as of December 31, 2005 were as follows:


	•	Structured Finance — $9.2 million
	•	Healthcare and Specialty Finance — $5.4 million
	•	Corporate Finance — $6.1 million
	•	Overall Portfolio — $6.5 million

Residential Mortgage Investment Portfolio Overview

As part of our efforts to qualify as a REIT, we purchased $2.3 billion in residential mortgage-backed securities during the fourth quarter 2005. In addition, subsequent to year end, we purchased an additional $1.1 billion in residential mortgage-backed securities and purchased approximately $2.5 billion in residential prime whole loans. As of December 31, 2005, all of our residential mortgage investments were in hybrid adjustable-rate mortgage (“ARM”) securities with underlying mortgage loans that were originated as 3/1, 5/1 and 7/1 hybrid ARM loans. Hybrid ARM securities are securities that have a fixed coupon for a specified period of time and then adjust annually thereafter. Each of these securities benefits from a full guaranty as to principal and interest from Freddie Mac or Fannie Mae. As of December 31, 2005, the securities we own

represent 100% of the beneficial interest in each of the trusts holding the hybrid ARM loans underlying our portfolio of mortgage-backed securities.

We have financed our investments in mortgage-backed securities to date primarily through repurchase agreements. Under repurchase agreements, assets are sold to a third party with the commitment to repurchase the same assets at a fixed price on an agreed date. The repurchase price reflects the purchase price plus an agreed upon market rate of interest. We have financed our investments in residential prime whole loans to date primarily through securitizations in which the loans are delivered to a trust that sells notes to investors. We acquire the equity and non-offered notes in these securitizations.

See Off-Balance Sheet Risk in Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 2, Summary of Significant Accounting Policies, in our audited consolidated financial statements for the year ended December 31, 2005 for a discussion of the accounting treatment for our mortgage-backed securities and related repurchase agreements as of December 31, 2005.

Financing

We depend on external financing sources to fund our operations. To date, we have employed a variety of financing arrangements including repurchase agreements, credit facilities, on-balance sheet term debt transactions, convertible debt, subordinated debt and equity. We expect that we will continue to seek external financing sources in the future. Our existing financing arrangements are described in more detail in Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition, Liquidity and Capital Resources.

Competition

Our markets are highly competitive and are characterized by competitive factors that vary based upon product and geographic region. We compete with a large number of financial services companies, including:


	•	specialty and commercial finance companies;

	•	commercial banks;

	•	insurance companies;

	•	private investment funds;

	•	investment banks;

	•	other equity and non-equity based investment funds; and

	•	REITS and other real estate investors.

Some of our competitors have substantial market positions. Many of our competitors are large companies that have substantial capital, technological and marketing resources. Some of our competitors also have access to lower cost capital.

Competition from traditional competitors has been impacted by industry consolidation, increased emphasis on liquidity and credit spreads, with greater dispersion of credit spreads for lower rated credits. We believe we compete based on:


	•	in-depth knowledge of our clients’ industries or sectors and their business needs from information, analysis, and effective interaction between the clients’ decision-makers and our experienced professionals;

	•	our breadth of product offerings and flexible approach to structuring debt financings that meet our clients’ business and timing needs; and

	•	our superior client service.

Regulation

Some aspects of our operations are subject to supervision and regulation by state and federal governmental authorities and may be subject to various laws and judicial and administrative decisions imposing various requirements and restrictions, which, among other things:


	•	regulate credit granting activities, including establishing licensing requirements in some jurisdictions;

	•	regulate mortgage lending activities, including establishing state licensing requirements;

	•	establish the maximum interest rates, finance charges and other fees we may charge our clients;

	•	govern secured transactions;

	•	require specified information disclosures to our clients;

	•	set collection, foreclosure, repossession and claims handling procedures and other trade practices;

	•	regulate our clients’ insurance coverages;

	•	regulate our HUD mortgage origination business;

	•	prohibit discrimination in the extension of credit and administration of our loans; and

	•	regulate the use and reporting of information related to a client’s credit experience.

In addition, many of the healthcare clients of Healthcare and Specialty Finance are subject to licensure, certification and other regulation and oversight under the applicable Medicare and Medicaid programs. These regulations and governmental oversight indirectly affect our business in several ways.


	•	With limited exceptions, the law prohibits payment of amounts owed to healthcare providers under the Medicare and Medicaid programs to be directed to any entity other than actual providers approved for participation in the applicable programs. Accordingly, while we lend money that is secured by pledges of Medicare and Medicaid receivables, if we were required to invoke our rights to the pledged receivables, we would be unable to collect receivables payable under these programs directly. We would need a court order to force collection directly against these governmental payers.

	•	Hospitals, nursing facilities and other providers of healthcare services are not always assured of receiving Medicare and Medicaid reimbursement adequate to cover the actual costs of operating the facilities. Many states are presently considering enacting, or have already enacted, reductions in the amount of funds appropriated to healthcare programs resulting in rate freezes or reductions to their Medicaid payment rates and often curtailments of coverage afforded to Medicaid enrollees. Most of our healthcare clients depend on Medicare and Medicaid reimbursements, and reductions in reimbursements caused by either payment cuts or census declines from these programs may have a negative impact on their ability to generate adequate revenues to satisfy their obligations to us. There are no assurances that payments from governmental payors will remain at levels comparable to present levels or will, in the future, be sufficient to cover the costs allocable to patients eligible for coverage under these programs.

	•	For our clients to remain eligible to receive reimbursements under the Medicare and Medicaid programs, the clients must comply with a number of conditions of participation and other regulations imposed by these programs, and are subject to periodic federal and state surveys to ensure compliance with various clinical and operational covenants. A client’s failure to comply with these covenants and regulations may cause the client to incur penalties and fines and other sanctions, or lose its eligibility to continue to receive reimbursements under the programs, which could result in the client’s inability to make scheduled payments to us.

Taxation as a REIT

We plan to elect to be taxed as a REIT under the Internal Revenue Code (the “Code”) for the year commencing January 1, 2006. Our qualification as a REIT depends on our ability to meet the various requirements imposed by the Code, through actual operating results, asset holdings, distribution levels and diversity of stock ownership. To prepare for our operation as a REIT, in December 2005 we divided our loan portfolio by separating the majority of our real estate based loans, which constitute “qualifying” REIT assets, from our other assets. We now hold our non real estate based loans in TRSs.

Provided we qualify for taxation as a REIT, we generally will not be subject to corporate-level income tax on the earnings distributed to our shareholders that we derive from our REIT qualifying assets. We will still be subject to corporate-level tax on any undistributed earnings from our REIT qualifying assets and on the earnings we derive from our TRS. If we fail to qualify as a REIT in any taxable year, all of our taxable income would be subject to federal income tax at regular corporate rates (including any applicable alternative minimum tax).

We will still be subject to foreign, state and local taxation in various foreign, state and local jurisdictions, including those in which we transact business or reside.

Employees

As of December 31, 2005, we employed 520 people. We believe that our relations with our employees are good.

Executive Officers

Our executive officers and their ages and positions as of March 1, 2006 are as follows:


Name	Age		Position

John K. Delaney		42	Chairman of the Board of Directors and Chief Executive Officer
Jason M. Fish		48	Vice Chairman and Chief Investment Officer
Dean C. Graham		40	President and Chief Operating Officer
Bryan M. Corsini		44	Chief Credit Officer
Thomas A. Fink		42	Chief Financial Officer
Steven A. Museles		42	Chief Legal Officer and Secretary
Joseph A. Kenary, Jr.		41	President — Corporate Finance
James J. Pieczynski		43	Co-President — Healthcare and Specialty Finance
Keith D. Reuben		39	Co-President — Healthcare and Specialty Finance
Michael C. Szwajkowski		39	President — Structured Finance
James M. Mozingo		42	Chief Accounting Officer
Donald F. Cole		35	Chief Operations Officer

Biographies for our executive officers are as follows:

John K. Delaney, 42, a co-founder of the company, is our Chief Executive Officer, Chairman of our board and is a member of our Executive Management Committee. He has been the Chief Executive Officer and has served on our board since our inception in 2000. From inception until our reorganization as a corporation, Mr. Delaney served as one of our two Executive Managers. From 1993 until its sale to Heller Financial in 1999, Mr. Delaney was the co-founder, Chairman and Chief Executive Officer of HealthCare Financial Partners, Inc., a provider of commercial financing to small and medium-sized healthcare service companies. Mr. Delaney received his undergraduate degree from Columbia University and his juris doctor degree from Georgetown University Law Center.

Jason M. Fish, 48, a co-founder of the company, has served as our Vice Chairman and Chief Investment Officer since January 2006, is a director and is a member of our Executive Management Committee. He was our President from our inception in 2000 until assuming his current responsibilities and has served on our board since our inception. From inception until our reorganization as a corporation, Mr. Fish also served as one of our two Executive Managers. Prior to founding CapitalSource, Mr. Fish was employed from 1990 to 2000 by Farallon Capital Management, L.L.C., serving as a managing member from 1992 to 2000. Mr. Fish was responsible for the real estate activities of and was involved in both credit and private equity investing for Farallon Capital Management, L.L.C. and Farallon Partners, L.L.C. and their affiliates. Before joining Farallon, Mr. Fish worked at Lehman Brothers Inc., where he was a Senior Vice President responsible for its financial institution investment banking coverage on the West Coast. Mr. Fish currently serves on the board of directors of Town Sports International Inc. He received his undergraduate degree from Princeton University.

Dean C. Graham, 40, has served as the President and Chief Operating officer since January 2006 and is a member of our Executive Management Committee. Mr. Graham served as the President — Healthcare and Specialty Finance from February 2005 until assuming his current responsibilities and as the Managing Director — Group Head of our Healthcare Finance group from September 2001 through January 2005. Prior to joining us, Mr. Graham was employed from 1998 to 2001 at Heller Healthcare Finance and its predecessor company HealthCare Financial Partners, where he was the Senior Vice President of the Portfolio Development Group and a member of the Heller Healthcare Finance credit committee. Mr. Graham holds an undergraduate degree from Harvard College, a juris doctor degree from the University of Virginia School of Law and a masters degree from the University of Cambridge.

Bryan M. Corsini, 44, has served as our Chief Credit Officer since our inception in 2000 and is a member of our Executive Management Committee. Prior to joining CapitalSource, Mr. Corsini worked from 1986 to 2000 at Fleet Capital Corporation, a commercial finance company, as Senior Vice President, Head of Loan Administration and Senior Vice President, Underwriting Manager and, most recently, as Executive Vice-President in charge of underwriting and credit for the Northeast Division. Prior to joining Fleet Capital, he was a senior auditor for Coopers & Lybrand where he was responsible for planning, administration and audits of various public and private companies. Mr. Corsini is a certified public accountant and received his undergraduate degree from Providence College.

Thomas A. Fink, 42, has served as our Chief Financial Officer since May 2003 and is a member of our Executive Management Committee. Prior to joining CapitalSource, Mr. Fink worked as an independent management and finance consultant from December 2001 to May 2003. From 1989 until 2001, Mr. Fink held a variety of finance positions at US Airways Group, Inc. including Treasurer and, most recently, Vice President — Purchasing. Mr. Fink received his undergraduate degree from the University of Notre Dame and his masters of business administration from the University of Chicago Graduate School of Business.

Steven A. Museles, 42, has served as our Chief Legal Officer and Secretary since our inception in 2000 and is a member of our Executive Management Committee. Prior to joining us, Mr. Museles was a partner practicing corporate and securities law at the law firm of Hogan & Hartson L.L.P., which he joined in 1993. Mr. Museles holds his undergraduate degree from the University of Virginia and his juris doctor degree from Georgetown University Law Center.

Joseph A. Kenary, Jr., 41, has served as the President — Corporate Finance since February 2005 and is a member of our Executive Management Committee. Mr. Kenary served as the Managing Director — Group Head of our Corporate Finance group from September 2001 until assuming his current responsibilities. From our inception until September 2001, Mr. Kenary served as an investment officer in our Corporate Finance group. Prior to joining us, Mr. Kenary was employed from 1998 to 2000 at Heller HealthCare Finance and its predecessor company, HealthCare Financial Partners, most recently serving as a Vice President/Investment Officer. Mr. Kenary received his undergraduate degree from Harvard College and his masters of business administration from the Anderson School at University of California, Los Angeles.

James J. Pieczynski, 43, has served as Co-President — Healthcare and Specialty Finance since January 2006. Mr. Pieczynski served as Managing Director — Healthcare Real Estate Group from February 2005 until assuming his current responsibilities and as Director — Long Term Care from November 2001 through

January 2005. Prior to joining us, Mr. Pieczynski was employed from 1993 until 2001 at LTC Properties, Inc., a real estate investment trust which primarily invests in healthcare properties, where he held a variety of positions including President, Chief Financial Officer and most recently, Chief Strategic Planning Officer. Mr. Pieczynski received his undergraduate degree from the University of Illinois, Urbana-Champaign.

Keith D. Reuben, 39, has served as Co-President — Healthcare and Specialty Finance since January 2006. Mr. Reuben served as Managing Director — Healthcare and Specialty Finance from February 2005 until assuming his current responsibilities, as Chief Operating Officer of Healthcare and Specialty Finance from January 2004 through January 2005, as Director from November 2001 through December 2003 and as Investment Officer from May 2001 through October 2001. Prior to joining us, Mr. Reuben was employed from 1999 until 2001 at Heller Healthcare Finance where he served as Senior Counsel and Investment Officer. Mr. Reuben received his undergraduate degree from Yale University and his juris doctor degree from the University of Pennsylvania.

Michael C. Szwajkowski, 39, has served as the President — Structured Finance since February 2005 and is a member of our Executive Management Committee. Mr. Szwajkowski served as the Managing Director — Group Head of our Structured Finance group from September 2001 until assuming his current responsibilities. Prior to joining us, from April 1999 until October 2000, Mr. Szwajkowski served as the founder and President of Clarity Holdings, Inc., a financial services holding company which owned and operated a national bank. Mr. Szwajkowski received his undergraduate degree from Bowdoin College and a masters of business administration from the University of Chicago Graduate School of Business.

James M. Mozingo, 42, has served as the Chief Accounting Officer since October 2003. Mr. Mozingo served as Controller from our inception until assuming his current position. Prior to joining us, Mr. Mozingo served as the controller of Orbital Imaging Corporation, a satellite imaging company which filed a voluntary petition of reorganization under Chapter 11 of the federal bankruptcy code in April 2002, from 1998 to 2000. Prior to that, Mr. Mozingo was a senior manager at Ernst & Young LLP. Mr. Mozingo is a certified public accountant and received his undergraduate degree in accounting from William & Mary.

Donald F. Cole, 35, has served as our Chief Operations Officer since February 2005 and is a member of our Executive Management Committee. Mr. Cole served as our Chief Information Officer from July 2003 until assuming his current responsibilities. Mr. Cole joined us in March 2001 as a loan officer, was promoted first to Control Systems Officer in 2002 and then to Director of Operations in January 2003. Prior to joining us, Mr. Cole practiced law at Covington & Burling, LLP from 2000 until 2001. Mr. Cole is a certified public accountant and earned both his undergraduate degree and his masters of business administration from the State University of New York at Buffalo and his juris doctor degree from the University of Virginia School of Law.

Other Information

Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on our website at www.capitalsource.com as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.

We also provide access on our website to our Principles of Corporate Governance, Code of Business Conduct and Ethics, the charters of our Audit, Compensation, Credit Policy and Nominating and Corporate Governance Committees and other corporate governance documents. Copies of these documents are available to any shareholder upon written request made to our corporate secretary at our Chevy Chase, Maryland address. In addition, we intend to disclose on our website any changes to, or waivers from, our Code of Business Conduct and Ethics.

ITEM 1A. RISK FACTORS

Our business faces many risks. The risks described below may not be the only risks we face. Additional risks that we do not yet know of or that we currently believe are immaterial may also impair our business operations. If any of the events or circumstances described in the following risks actually occur, our business, financial condition or results of operations could suffer, and the trading price of our common stock could decline. You should know, however, that many of the risks described may apply to more than just the subsection in which we grouped them for the purpose of this presentation. As a result, you should consider all of the following risks, together with all of the other information in this Annual Report on Form 10-K, before deciding to invest in our common stock.

Risks Impacting Our Funding and Growth


	*If we fail to effectively manage our growth, our financial results could be adversely affected.*

We believe that the success of a commercial finance business like ours depends on our ability to increase our interest-earning assets while continuing to maintain disciplined origination and credit decision-making. To that end, from our inception to December 31, 2005, our assets have grown to $7.0 billion and as of December 31, 2005, we had 520 employees and 23 offices. We must continue to refine and expand our marketing capabilities, our management procedures, our internal controls and procedures, our access to financing sources and our technology. As we grow, we must continue to hire, train, supervise and manage new employees. In addition our recent election to be taxed as a REIT has imposed added challenges on our senior management and other employees, who together must monitor our REIT compliance obligations, develop new real estate-related product offerings and make appropriate alterations to our loan origination, marketing and monitoring efforts. We may not be able to hire and train sufficient lending and administrative personnel or develop management and operating systems to manage our expansion effectively. If we are unable to manage our growth effectively, our operations, REIT compliance and financial results could be adversely affected.


	*Our ability to grow our business depends on our ability to obtain external financing.*

We require a substantial amount of money to make new loans and to fund obligations to existing clients. As a REIT, we are even more dependent on external sources of capital than we have been in the past. This increased dependence results from the requirement that to qualify as a REIT we generally have to distribute to our shareholders 90% of our taxable income, including taxable income where we do not receive corresponding cash. In the past, we have obtained the cash required for our operations through the issuance of equity, convertible debentures and subordinated debt, and by borrowing money through credit facilities, term debt and repurchase agreements. Our continued access to these and other types of external capital depends upon a number of factors, including general market conditions, the market’s perception of our growth potential, our current and potential future earnings, cash distributions and the market price of our common stock. We cannot assure you that sufficient funding or capital will be available to us in the future on terms that are acceptable to us. If we cannot obtain sufficient funding on acceptable terms, there may be a negative impact on the market price of our common stock and our ability to pay dividends to our shareholders.


	*If our lenders terminate or fail to renew any of our credit facilities or repurchase agreements, we may not be able to continue to fund our business.*

At December 31, 2005, we had eight credit facilities totaling $4.1 billion in commitments. The majority of our loans that we have not securitized are held in these facilities. Under the terms of these facilities, we receive the cash flow generated by our loans held in these facilities after deductions for monthly interest and fee payments payable to our lenders. Several of the credit facilities are renewable annually and the repurchase agreements generally have terms of one year or less. Additionally, these facilities contain customary representations and warranties, covenants, conditions and events of default that if breached, not satisfied or triggered could result in termination of the facilities. Consequently, if one or more of these facilities were to terminate prior to its expected maturity date or if any such facility were not renewed, our liquidity position

would be materially adversely affected, and we may not be able to satisfy our outstanding loan commitments, originate new loans or continue to fund our operations.

In addition, we cannot assure you that we will be able to extend the term of any of our existing financing arrangements or obtain sufficient funds to repay any amounts outstanding under any financing arrangement before it expires, either from one or more replacement financing arrangements or an alternative debt or equity financing. If we were unable to repay or refinance any amounts outstanding under any of our existing financing arrangements, our ability to operate our business in the ordinary course would be severely impaired. Even if we are able to refinance our debt, we may not be able to do so on favorable terms. If we are not able to obtain additional funding on favorable terms or at all, our ability to grow our business will be severely impaired.


	Our use of significant leverage could adversely affect our residential mortgage loan and mortgage-backed securities portfolio and negatively affect cash available for distribution to our shareholders.

We have borrowed significant funds to finance the acquisition of the assets comprising our portfolio of residential mortgage loans and mortgage-backed securities through repurchase agreements and securitizations. Our use of repurchase facilities to finance the purchase of residential mortgage loans and mortgage-backed securities exposes us to the risk that a decrease in the value of such assets may cause our lenders to make margin calls that we may not be able to satisfy. To meet margin calls, we may have to sell residential mortgage loans and/or mortgage-backed securities, which could result in realized losses and negatively affect cash available for distribution to our shareholders. If we fail to meet a margin call or if we are required to sell residential mortgage loans and/or mortgage-backed securities to meet a margin call, our ability to comply with the REIT asset tests could be adversely affected. Furthermore, because the disposition of only part of a whole pool of mortgage-backed securities that we hold could adversely affect our exemption under the Investment Company Act of 1940, the effect of a margin call could be compounded by the fact that we might be required to dispose of the entire pool of securities on which the margin call was made. See Off-Balance Sheet Risk in Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 2, Summary of Significant Accounting Policies, in our audited consolidated financial statements for the year ended December 31, 2005 for a discussion of the accounting treatment for these mortgage-backed securities as of December 31, 2005.

Further, the percentage of leverage we are able to employ with respect to our residential mortgage loans and mortgage-backed securities, and the cost of that leverage, varies depending on market conditions. Our debt service payments reduce cash flow available for distributions to shareholders. To the extent that changes in market conditions cause the cost of our financing to increase relative to the income that can be derived from our mortgage loans and mortgage-backed securities, the return on such assets and the cash available for distribution to our shareholders may be reduced.


		have a first priority lien in the collateral securing the loan. These loans, which are generally between $1 million and $50 million, usually have a term of two to five years. We generally will advance a client, on a revolving basis, between 80% and 90% of the value of the client’s eligible receivables and between 30% and 70% of a client’s eligible inventory.

	•	Senior Secured Cash Flow Loans. Cash flow loans are made based on our assessment of a client’s ability to generate cash flows sufficient to repay the loan and to maintain or increase its enterprise value during the term of the loan. Our senior cash flow term loans generally are secured by a security interest in all or substantially all of a client’s assets. In some cases, the equity owners of a client pledge their stock in the client to us. These loans generally range in size from $1 million to $50 million and have a term of three to five years.

	•	First Mortgage Loans. We make term loans secured by first mortgages. These loans generally range in size from $2 million to $75 million and have a term of two to five years. We make mortgage loans to clients including owners and operators of hospitals, senior housing and skilled nursing facilities; owners and operators of office, industrial, hospitality, multi-family and residential properties; resort and residential developers; and companies backed by private equity firms that frequently take out mortgages in connection with buyout transactions.

	•	Sale/ Leasebacks. During the first quarter 2006, we completed our first sale/leaseback transaction. In these transactions, we buy a client’s real property and lease it back to the client over a long-term lease. We generally intend to hold our sale/leaseback assets for long-term investment. Our initial investment involved our purchase of 38 healthcare facilities subject to ten year, triple-net leases. Under a typical net lease, the client agrees to pay a base monthly operating lease payment and all facility operating expenses as well as make capital improvements.

	•	Term B, Second Lien and Mezzanine Lending. We make Term B, second lien and mezzanine loans. A Term B loan is a loan that shares a first priority lien in the client’s collateral with the lenders on the client’s senior loan but that comes after a senior secured loan in order of payment preference upon a borrower’s liquidation, and, accordingly, generally involves greater risk of loss than a senior secured loan. Term B loans are senior loans and, therefore, are included with senior secured loans in our portfolio statistics. A second lien loan is a loan that has a lien on the client’s collateral that is junior in order of priority and also comes after the senior loans in order of payment. We also make mezzanine loans that may be either cash flow or real estate based loans. A mezzanine loan is a loan that does not share in the same collateral package as the client’s senior loans, may have no security interest in any of the client’s assets and comes after a senior secured loan in order of payment preference. A mezzanine loan generally involves greater risk of loss than a senior loan.

	•	Residential Mortgage Investments. In connection with our plan to qualify as a REIT, we invest directly in residential mortgage assets that we believe qualify as REIT eligible assets. In 2005, our investments were in mortgage-backed securities guaranteed as to principal and interest by Freddie Mac or Fannie Mae. Subsequent to year end, we purchased an additional $1.1 billion in Freddie Mac and Fannie Mae guaranteed residential mortgage-backed securities and approximately $2.5 billion in residential prime whole loans. Mortgage-backed securities provide for a monthly payment that consists of both interest and principal, including borrower prepayments. We financed our purchases of residential mortgage-backed securities with repurchase agreements and our residential prime whole loans primarily through securitizations along with repurchase agreements.

	•	HUD Mortgage Originations. As a strategic supplement to our real estate lending business, we also act as an agent for the United States Department of Housing and Urban Development, or HUD, for the origination of federally insured mortgage loans through the Federal Housing Authority, or FHA. Because we are a fully approved FHA Title II mortgagee, we have the ability to originate, underwrite, fund and service mortgage loans insured by the FHA. FHA is a branch of HUD which works through approved lending institutions to provide federal mortgage and loan insurance for housing and healthcare facilities.