The Real Opportunity In The Two Harbors/Silver Bay IPO

| About: Two Harbors (TWO)

Back in the first quarter, we were analyzing Two Harbor Investment Corporation (NYSE:TWO). At the time, we were intrigued at the idea that this mortgage REIT had started a project of retaining and renting out some of the delinquent properties that were part of its mortgage portfolio.

In September, the company announced that this rental business will ultimately be spun off as an independent company, Silver Bay Realty Trust (NYSE:SBY), and an IPO will be initiated to provide some of the financing. The IPO will be 15.2 million shares, with a target price of $18-20 per share, for proceeds of a bit more than $300 Million.

Silver Bay has issued an S-11 which contains some pro-forma financials for this new entity, giving us a chance to see some of the numbers. This is particularly interesting to us, because we have gone through the economics of buying one of these foreclosed properties, and renting it out, and so we do have some understanding of the economics in this business at the individual property level.

The 9-month income statement for Silver Bay was given on page 55. According to the prospectus, the company has a total portfolio of 2548 houses, of which they have held and rented 895 for more than six months. The average nominal "value" of these places is $121K, according to the company. If you divide the 9-month data by 9, and then by the number of units, you can get the economics at the individual property level as follows:

Current 9-Month ($M) 1-month ($M) Per House ($)
Rental Income $ 8,178 $ 909 $ 1,050
Maintenance $ 2,216 $ 246 $ 285
Real Estate Taxes $ 1,800 $ 200 $ 231
HOA $ 1,083 $ 120 $ 139
Property Management Fee $ 5,771 $ 641 $ 741
Depreciation and Amortization $ 3,038 $ 338 $ 390
Advisory Fee $ 7,725 $ 858 $ 992
General and Administrative $ 3,242 $ 360 $ 416
Total Expenses $ 24,875 $ 2,764 $ 3,195
Net Loss $ (16,697) $ (1,855) $ (2,145)

The company's average rental fee is around $1100 per month (for the purposes of this calculation I am not troubled by the fact that the company has claimed an average $1126 rent and the calculated amount, above, is about $1050). From this is subtracted the maintenance expense, homeowner fees, local taxes, management fees, and corporate expenses. We had researched this at the single property level some time ago, so we can be fairly comfortable with the numbers. In fact, according to the prospectus, some of these places are actually in my area.

There are a couple of areas of interest: The maintenance expense, of nearly $300 per month, is higher than we would normally expect for a rental property that rents for $1100 and so we can probably assume that this represents the rehab costs of the portfolio of 2500 properties spread out over the 900 or so that are currently productive. Also, the homeowner's fees of $120 per month, nearly $1400 per year, are probably also a bit pricey for a $121,000 property, unless the property is relatively upscale (the homeowner's fee in my neighborhood is $500 per year). The local tax rate of $200/month or $2400 per year might actually be low, depending on what part of the country the property is in.

The really interesting numbers are the last three: The "Property Management Fee" of $641 per month per property is probably greatly higher than what we would expect, and may represent the management fees on the entire portfolio. The "Advisory Fee" and "Administrative" charges probably represent corporate expenses, and may be fixed rather than variable. Depreciation: The company's portfolio right now is valued at $310 million. The annualized depreciation expense on the Pro Forma was about $4M, which is 1.3% of the original investment, so this is probably also low. The management is using a 27.5 year straight line depreciation method which would have been about 3.6%, so evidently the company is not taking a depreciation charge until the property is placed in service.

It is clear on the basis of the pro-forma that the company is profit and cash-flow negative at the current scale, with a portfolio of 2500-plus properties, and only about 900 being productive. It is of course a developed skill to acquire, do rehab, and rent out a rental unit, and presumably, part of the high property management fee is for hiring the expertise to do this work.

The company is well aware of this, and acknowledged in the prospectus the need for the company to increase in size to become what it needs to be:

Our principal objective is to generate attractive risk-adjusted returns for our stockholders over the long term, primarily through dividends and secondarily through capital appreciation. We seek to establish a reputation as a good landlord to our tenants and a good neighbor in the communities where we operate. We believe that we can achieve economies of scale and develop a valuable consumer brand and that we are well positioned to be a market-leading firm in the single-family rental industry.

We can do the calculation the other way, to see how big the company would have to get to become profitable. I did this calculation using the current portfolio of 2549 properties rented out at $1125 per month:

At Full Scale Per House/Month Adjustment Full Scale Per Yr Double Scale
Number of Properties 2,548 5,096
Plausible Rental Income $1,126 $34,428,576 $68,857,152
Maintenance $246 $123 $3,764,245 $7,528,491
Taxes $200 $200 $6,115,200 $12,230,400
HOA $120 $60 $1,834,560 $3,669,120
Property Management Fee $641 $113 $3,442,858 $6,885,715
Depreciation and Amortization $11,272,727 $22,545,455
Advisory Fee $10,299,974 $10,299,974
General and Administrative $4,322,559 $4,322,559
Total Expenses $41,052,123 $67,481,713
Net Income ($6,623,547) $1,375,439
Positive Cash Flow $4,649,180 $23,920,893

Even at a 100% rental rate, using the 2549 properties now in the portfolio, and using the average rents currently obtained, and adjusting the homeowners fees and property management fees downward based on what is currently typical in my area, the company is still unprofitable. However, the cash flow is positive, based on the 27.5 year straight line depreciation for the entire $310M portfolio.

The "double scale" simplified version is that the company would be pretty reasonably profitable at about twice its current "fully utilized" size, and there is some expectation that this could and needs to happen. The word "scale" is heavily emphasized in the S-11.

Here is a per-share summary:

Full Scale Double Scale
Shares Outstanding 15,237,000 15,237,000
Cash Flow Per Share $ 0.31 $ 1.57
Current Price $19.00 $19.00
Cash ROR 1.61% 8.26%
Depreciation/Share $ 0.74 $ 1.48

So what to make of all of this?

First of all, it is clear that the company will have to continue to grow in order to be a more attractive investment on its face.

Secondly, it is clear that the real opportunity in this is an investment in TWO. One of the big problems in TWO's business plan of servicing the high-risk borrowers is what to do with the foreclosed homes, and this is a really interesting way to free the books of TWO of this issue. In fact, this is such a good idea that SBY can expand it to some of the other REITs that have exactly the same problem.

Thirdly, I have to make a comment about the possibility of price appreciation. For many decades, the mentality among real estate people has been that price appreciation is a built-in part of the investment calculation. This has been so deeply ingrained in the industry that even during the height of the ongoing real estate crisis, with prices as much as 50% lower than before the bust, and still declining, this was still cited as a good reason to buy real estate. The management of SBY has included the possibility of a price recovery and an improvement in property values as a long-term business strategy. Individual investors will have to take into consideration whether they still believe in the fundamental principle of making an investment based on the expectation of future pricing. I personally am skeptical.

I will say, though, that because of the high level of homeowners association fees, there is a good chance that some of these properties are upscale, and the entry price on these investments may have been low enough that the probability of a value increase is realistic. Let the investor make his or her own determination.

Fourthly, as I am always careful to mention, every time I use the words "if", "estimated", "should", "plausible", "probably" or "could", this is an estimate and subject to being wrong.

The headwinds: These are excellently outlined in the S-11, and include the ongoing worries about government policy as it applies to the real estate markets, government policy as it applies to finance and interest rates, and the overall health of the economy. Add to that, the peril that there has been some active real estate construction recently, in the face of an extended period of record foreclosures, which threatens the rental market. Furthermore, this is not an original idea, there are already competitors in the marketplace. There is also the ongoing problem of learning how to be in this business. The company needs to control the cost of rehab of these properties, maintain the neighborhood to keep the nominal market price for both the property and rental market from deterioration, and cope with a lot of other problems associated with being a landlord, except on a much more massive scale.

I would further point out as a side issue that if we are still in a situation where the holders of cash, namely the mortgage lenders, are more profitable than the holders of the actual property, that is the very definition of a deflationary market, and that is probably still the biggest headwind of all.

I think there is some potential in this idea, and at some point this company could be a good investment. I will look for four things: If the IPO price is a lot less than $19 it could be interesting. If the expansion plans are announced, and capital can be raised in a cheap fashion, either through additional offerings or through some debt, that would be a plus. It would mean the management has taken the path of growth. If a couple of sets of quarterly results come in, and there is a significant improvement in per-unit repair and management fees, that would show the company is learning how to be a good landlord. Overall utilization is a factor. The percentage of the portfolio that is rented needs to stabilize in the low 90's percent wise, and the company needs to be quick at turning around newly acquired assets.

Do with this information what you will, keeping in mind that the world is full of chaos, and there are no guarantees on anything, especially price appreciation in the residential real estate market.

Disclosure: I am long TWO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I also own a portfolio of one residential property in one of the areas to be served by SBY, so I am intimately aware of the local conditions.