The commercial mortgage REIT space has a reputation for greater volatility than the broader equity REIT group, but that can play to investors' advantage during the right part of the cycle. So far this year, the average 21.5% return for a group of the larger CRE players (discussed below) has strongly outperformed both the S&P 500 (+10.6%) and the MSCI REIT Index (+ 8.1%). This note discusses some of the returns variance within the commercial mortgage REIT group and summarizes what investors should expect from the rest of the cycle.
The following percentages are year-to-date returns to common equity through March 28, 2013, including dividends paid in 1Q'13 (but excluding any special dividends).
- CXS - 8.9%
- ARI - 10.8%
- CLNY - 15.6%
- STWD - 22.8%
- SFI - 33.6%
- NRF - 37.2%.
What can we learn from the above? First, the more aggressive names such as iStar Financial (SFI) and Northstar Realty (NRF) have produced the best returns, as investors have clearly favored the risk-on trade. Keep in mind that SFI is still in recovery mode and doesn't pay a common dividend, but even so it's been a good run. SFI at this point is more a play on recovering land values, condo sales and development potential, but that has been to the company's advantage this year as the housing recovery has gained strength. Important questions still remain about SFI's ability to monetize its land and REO investments given a higher cost of capital, and the lack of a common dividend probably makes it difficult to re-enter the equity markets. Nonetheless, SFI has survived against long odds, which suggests a certain determination by management to play in the next round.
Northstar Realty Finance has produced the best YTD returns of the group (+37.2%), which is primarily the result of a downward shift in the dividend yield. NRF now yields 7.6%, which is significantly lower than the company's 10.1% dividend yield in 4Q'12 and 10.8% yield for 2012 as a whole. A number of factors seem to be resonating with investors, not least of which is NRF's steady sequential increase in the quarterly dividend rate (beginning 4Q'11), which compares favorably to the flatter dividend profiles at ARI and STWD (and lack of a dividend at SFI).
Behind NRF's dividend growth has been a series of savvy (so far) investment plays including buying heavily discounted CDO bonds, equity investments in CMBS deals, and the secondary purchase of equity interests in a series of CRE private equity funds. While most of these investments generate some level of current income, there is also a large total-return component that makes NRF less predictable. Interestingly, NRF has recently announced a series of portfolio investments in manufactured housing properties, which is a steady but dull business and one not typically associated with traditional mortgage REITs.
At the opposite end of the spectrum, CXS returned only 8.9% during the first quarter, probably due to its pending $13.00/share buyout offer from Annaly Capital Management which capped the upside. ARI's total return of 10.8% in 1Q'13 was also modest, reflecting its slower portfolio growth rate and focus on more traditional mortgage lending. We note that ARI is on the smaller side (approximate $490 million equity cap) in an industry that favors larger players. Will ARI change its investment/growth strategy this year in an attempt to keep up with STWD? Or could ARI decide that a strategic transaction with its manager provides better upside? There doesn't seem to be much downside in the stock with a 9.1% dividend yield, so investors are probably getting paid to be patient here.
As the cycle turns…
It is no longer early innings in the commercial mortgage REIT space. Early innings in the cycle are characterized by REITs originating whole loans with coupons fat enough (such as hotel loans) to cover the cost of capital. As markets start to recover and spreads contract, incremental leverage is employed to meet return hurdles. REITs then move to split the whole loan into safer A-notes (sold to insurance companies) while retaining the higher-yielding (and subordinate) B-notes for themselves. The structured finance markets are also useful in providing non-recourse leverage. In 2012 for example, NRF completed a $351 million CMBS deal that consisted of $228 million investment-grade notes sold to institutional investors, and $123 million of retained equity interests with an expected lifetime yield of 20%.
The next step in the process is using corporate leverage to boost earning yields. This was evident in 2012 when ARI, CLNY and NRF each closed on preferred deals with coupons in the mid-8% range. A more recent example would be STWD's $525 million 4.55% senior convertible note offering, which closed in February 2013. Most of the REITs also utilize bank credit facilities to provide warehouse financing for new deals, prior to terming out balances in the capital markets.
The final part of the cycle is when the REITs stretch for IRR by moving away from traditional mortgage product and into riskier investments. This was clearly seen in SFI's purchase of Fremont General's construction loan book at the top of the last cycle (July 2007), which exposed SFI to significant credit risk and layered on approximately $4.4 billion of future funding commitments. So do we see similar out-of-the-box thinking today? Clearly we do, with NRF buying into private equity funds, CLNY moving into the purchase of single-family homes, and STWD's pending purchase of LNR Property LLC, a large special servicer. While each of these investments appears to have solid reasoning behind them, they do illustrate that the core business of investing in commercial mortgage loans, by itself, does not have enough juice to meet equity return expectations.
Summary and Outlook
Commercial real estate markets are still improving, the CMBS new-issue market is starting to grow again, REITs' access to capital is generally good, interest rates are low and investors are seeking yield wherever they can find it. These positive elements should continue to support the commercial mortgage REIT sector at least through 2013 and perhaps next year. But we are now firmly in the middle innings of the cycle, and while we think there's still some room to go before things get too frothy, now is the time to start thinking about portfolio concentration limits, name diversification and outright exit strategies before it's too late. Trouble comes suddenly to commercial mortgage REITs. In the late '90s, the Russian debt crisis was the catalyst for significant problems within the CRE space and an outright bankruptcy filing by Criimie Mae in 1998. The initial constriction in 2007 and then complete seizure of the structured finance markets in 2008 marked the end of the second cycle. The current "up" phase might be called Commercial Mortgage REITs 3.0 - how will it end this time?
Additional disclosure: As of the date of this article, accounts managed by the author held long positions in the preferred stock of ARI, NRF, and SFI, and long positions in the common stock of ARI, NRF and STWD.