The real return on government debt dips ever deeper into negative territory. High yield bonds could be sued for false advertising based on their very name. Quality, dividend paying equities are fully priced. MLPs, among the best values following the Lehman collapse, have fully recovered. Where can a bargain seeker turn for yield? Oh, and why should we care about cash yield anyway?
Looking at conventional investor behavior, it is hard to find any type of yieldy security on sale at the moment. I'd be thrilled to have someone list counterexamples in a response. However, it appears as if there are any number of foundations, endowments, advisors, and even families who are currently demanding yield at any price who are, in the process driving those yieldy securities to any price. In some cases, these prices are now decoupled from value and decoupled from risk. It is a frustrating fact for someone who primarily seeks safety that when one overpays for ostensibly safe securities, they become risky securities. Unlike a few years ago, when the marketplace was littered with securities that were both high yield and low risk, such opportunities appear to be gone for the moment.
But why should the market offer us opportunities where we want those opportunities to be located? In most instances, the market does not even know who we are, let alone care about what we want. To say that we want to make an advantageous bet and to say where that bet is to be found is mighty demanding and probably foolhardy. So, there are not currently safe, yieldy opportunities; too bad for us. Let's not try to see something that is not there.
Well and good to avoid a pitfall, but can we go beyond that to somehow exploit this mania? I suspect so. Securities with low or no yield could be cheap and securities with high yields could be expensive, but this state could last longer than I'm able to predict or tolerate. So, my solution is to find securities that are on the verge of changing teams so that I can collect the difference between the out-of-favor security that will shortly become the beneficiary of our current era's latest fad. I want to find something that has no yield but is soon to have a high yield and will almost certainly be loved by conventional investors.
My favorite example of how to put this idea into practice is Gramercy Capital Corp., a commercial REIT with both common and preferred stock (GKK and GKK.A respectively) that is safe, cheap, and ignored. The common currently trades beneath $3 per share and the preferreds trade at about $31 per share. In 2008, after significant turmoil in the company's financing business, GKK decided to stop paying dividends on the prefs and common. Five years later, they have yet to reinstate their dividend, despite having enough cash to do so. As a result, the stock has lost its logical shareholder constituency and suffers from the negative bias towards non-dividend paying investments. The good news: we believe the company is positioned to reinstate their dividend in 2013 and the GKK stock will be the beneficiary of a large re-engaging shareholder base and the market's dividend euphoria.
This year, 2012, was a year of transition for Gramercy. Since 2008, the company and management have been in survival mode. They almost didn't make it out of 2008 due to the highly levered business model and the timing of the crisis. So although they had cash at the management company level, it's understandable that management was hesitant to pay that out. Now, the board has hired a new management team to take the business forward. After a strategic review, the decision was made not to liquidate or sell the business outright. Instead, they are selling off the legacy businesses and taking the proceeds with which to focus on the net-net lease space. We believe there is a lot of merit to that business strategy; however, what's more interesting to us is that Gramercy is re-engaging with the markets in order to be successful in this new endeavor. That will be impossible for a REIT that is unwilling to pay their dividend.
Despite the issues they have had in the past and the large CDO liability on their balance sheet today, we believe there is a big margin of safety in this situation. First, the consolidated financials tell half the story. The CDO liability, although significant, is non-recourse to the parent. So, when you look at the company's financials and net out the CDOs, the picture looks very different (see chart below). Secondly, this company has a lot of cash. They are using the CDO losses and tax loss carry forwards to delay dividend payment and retain their REIT status. However, this masks the true financial health of a healing, growing business.
Condensed Financial Information
Over the course of 2013, we believe GKK will choose to pay off the accrued dividends to their preferred holders. While no one seems to have much interest in buying this non-paying preferred now, the shareholder base and demand will shift once Gramercy becomes a dividend payer. Between receiving the accrued dividends and a market re-pricing, there is probably another $10 or so of value to be collected from this safe and cheap preferred stock.
We anticipate the common stock will likely begin paying regular dividends within a year as well. The stock will probably be worth about $6 per share by the time that they finish the process of resuming dividends.
This REIT survived the financial crisis, has restructured itself to thrive in the future, and will be well regarded as a sensible investment… after they turn on their dividends. The corporation's future is still vulnerable because it is not yet sized appropriately as a standalone entity. The major risk factor to our thesis would be if a larger competitor lobs in an acquisition offer closer to $4 per share before the company completes their transition. Such an offer would be easily justified based on the potential cost savings.
What can we watch for? Gramercy's management team is in the process of trying to sell their legacy CDO business. If they are able to announce a sale at a good price, that will be an auspicious sign that they are on track to complete this transformation. They will have evolved from the financial crisis' orphaned detritus to a staple holding of yield hungry REIT investors. Thus, Gramercy Capital Corp's common and preferred stock top my list of best investment ideas for 2013.
Disclosure: I am long GKK.
Additional disclosure: I have filed a 13G with the SEC, indicating that I own between 5% and 20% of the company's preferred stock.