Non-Agency Mortgage REITs: Part 3 - An Evolving Industry

Includes: DS, RSO, STAR
by: Philip Mause

This article will discuss some of the measures that NMREITs have taken as the market has changed and will feature three stocks in the group which have evolved in interesting ways - iStar Financial (SFI), Newcastle Investment (NCT) and Resource Capital (NYSE:RSO). Each of these companies has responded to a changing market opportunistically and has figured out how to make money by taking advantage of important market trends. An understanding of the group requires an understanding of some of these important trends.

First of all, and easiest to understand, is the gradual migration of NMREITs from a debt oriented asset portfolio to increasing amounts of owned real estate (REO). This frequently occurred due to foreclosures on debt instruments or transfers of title in lieu of foreclosure. The accounting surrounding these transactions can be complex and, as an NMREIT has more and more REO on its balance sheet, the book value becomes a less reliable measure of the true fair value of the assets. I have actually included some companies in this group which originally had asset bases made up primarily of debt instruments but now have a majority of their assets in REO.

A second phenomenon has been the cessation of dividends by some stocks in the group. REITs are required to pay 90% of their income as dividends but income is defined by the IRS and there is some ability to use losses from an earlier time period to offset current income. I am not a tax lawyer but a number of these companies have ceased paying dividends even though there is apparently positive cash flow. In comparing these companies with one another and with agency mortgage REITs, it is important to give the dividend payers credit for the dividendss. A failure to do so will distort analysis to the advantage of the stocks which have stopped dividends.

Many stocks in the group have also had extensive secondary offerings. By this, I mean public offerings of stock with the proceeds generating cash for the company. For the companies which are paying dividends, secondary offerings are an important source of new capital.

Another thing to bear in mind about this group of stocks is that "earnings," especially GAAP earnings, may not be a very reliable indicator of value or even of trended performance. Earnings can be adversely affected by huge bumps in unrealized depreciation due to write offs of bad loans or in realized depreciation due to the sale of assets below book value. These events do not necessarily indicate that the operation as a whole is not viable. Thus, an NMREIT can be losing money on a GAAP basis but still moving forward and an NMREIT can be distributing more money in dividends than GAAP accounting calculates as its earnings and still have sustainable dividends. You must look beyond earnings to trended book value, asset quality, and the nature of debt (recourse or non-recourse) to really get under the hood with these stocks.

Some NMREITs have improved their situation by buying back their own debt at a discount. This often involves an SPE. The NMREIT which has sponsored an SPE and continues to hold a subordinate tranche may identify a senior tranche which is available at substantial discount. The purchase of this tranche reduces debt on the consolidated balance sheet and can enhance cash flow as the NMREIT succeeds to the rights of the tranche holder to receive proceeds from the SPE. If an NMREIT buys all the tranches senior to its own, it can simply take possession of the assets in the SPE as the sole owner.

NMREITs are also earning income as managers or "servicers" of mortgages and mortgage assets. In some cases, they have formed separate subsidiaries for this function and the value of the subsidiary and its flow of servicing income can enhance the value of the SPE. Capital Trust (CT) sold its management arm at an attractive price which enabled it to recently pay a $2 a share special dividend.

NMREITs have also spotted opportunities to buy CDO, RMBS and other securities at large discounts to par and have taken advantage of these discounts to reap some huge profits and generate substantial yield while holding the securities.

The table below gives, for each stock, Wednesday's closing price, the Pre-Crash high, the Post-Crash low, the current yield and an estimated net asset value.

Price High Low Yield Value
SFI $8.39 $107.80 $1.35 ------ $16.13-21.48
NCT $9.88 $32.31 $.33 9.2% $5.73
RSO $5.98 $18.35 $1.65 13.5% $5.50

Once again, let us have a moment of silence please for all of the bereaved Pre-Crash investors in these stocks. Bearing in mind that these stocks probably attracted yield oriented conservative investors who thought that they were picking up a little more yield by taking a little more risk, the shock factor must have been huge. It should be a lesson to us all. On the other hand, kudos to those who jumped in early 2009 when everyone else was hiding in a fallout shelter.

SFI has become primarily an equity REIT with debt instruments now constituting less than one third of its gross assets. The Value estimate is taken from an analysis done in 2012 by a different author. I found the analysis persuasive but have not updated it. SFI has considerable debt although it has been paying debt down. Based on SEC filings it appears that SFI does not use SPE's and I have not been able to find any indication that the debt is non-recourse. With $6.9 billion in assets and $5.4 billion in debt, this means that the leverage is a real concern although as stated above it is on the decline. Indeed, for the first nine months of 2012, interest expense was nearly as much as total revenue. This means that SFI must continue to try to reduce debt and obtain better terms as leverage is reduced if it is to survive without dilution of equity holders. I think it is winning this fight but we are not in the ninth inning yet. A great deal will depend on the value of its REO assets and book value is not necessarily a good indicator of market value for REO assets. SFI has some very high quality assets and could do very well if the economy continues to improve. However, it is still vulnerable to a severe downturn. SFI is not paying a dividend and seems to be using cash flow for balance sheet repair and asset enhancement.

NCT just had of a secondary offering at $9.35. It plans to spin off New Residential Investment Corporation which will take its residential assets early in 2013. The spin off will operate as described as Excess MSRs - which seem to be arrangements under which the company retains proceeds over a certain minimum generated by the servicing of existing mortgages pursuant to contractual terms. As I understand it, NCT shareholders will simply become shareholders of a new entity as well. NCT has also recently "collapsed" a CDO which sounds like a bad thing but is actually a good thing. As I understand it, the CDO is liquidated to the one or two remaining tranche owners and, depending upon the terms, this can result in a large gain. In this case, NCT reaped a big gain as well as a big influx in case. This transaction illustrates why NCT's book value is not a reliable indicator of its actual value. According to the recent earnings call transcript, NCT's interest in the CDO was being carried at a negative book value of $80 million but when the CDO was collapsed, NCT reaped proceeds of $130 million for a book gain of $210 million. The $80 million negative book value really did not make any sense because the CDO debt was non-recourse and so the actual value of NCT's position could not have been less than zero. NCT has been opportunistic in the post crash market buying MBS securities at very large discounts to par and doing very well on some of these deals. It has acquired senior living facilities on an equity basis. NCT seems to have a savvy management and to be steadily moving forward.

RSO's book value involves the same SPE-related issues discussed above and is probably understated. RSO has aggressively reduced leverage since early 2008 and is in a solid financial position. It has opportunistically bought discounted CMBS bonds and has bought debt on its own CDO's at big discounts to par. It has emphasized bridge loans which generally produce large fees and relatively high interest rates. It also owns some real estate equity - primarily in apartment buildings but also including a hotel and office building. All of its CDO's are performing in the sense of making payments as required and have value that is probably understated on its books. Like NCT, RSO appears to be aggressive and opportunistic and appears to have "turned the corner" in terms of financial survival and active reentry into the lending market. When I saw an opportunity to buy it a few weeks ago below the $5.90 price of a recent secondary offering, I jumped in.

I like RSO and NCT as aggressive but reasonably safe investments as part of a diversified yield oriented portfolio. I think SFI may be a bit riskier but could pay off well also. Unlike the agency mortgage REITs, these are all sensitive to the performance of the overall economy. In a reasonably steady recovery, they will tend to outperform. If we have a nasty recession, there could be some bumps in the road.

Disclosure: I am long RSO. 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.