F. Scott Fitzgerald wrote that "there are no second acts in American lives" but he didn't say anything about sequels. Individuals and organizations have had a marvelous ability over the years to "reinvent themselves" and emerge in a new, more viable form. This article will address the phenomenon of mortgage REITs transforming themselves into equity REITs and analyze the implications for investors.
First of all, it is important to define terms here. Equity REITs are real estate investment trusts which own actual properties of one kind or another. Mortgage REITs are real estate investment trusts which own mortgages. Of late, many writers have used the term "mortgage REIT" to apply to "agency mortgage REITs"(REITs which own mortgages or mortgage backed securities guaranteed by a federal agency). We are using the term "mortgage REIT" more broadly in this article to include REITs which own non-agency mortgages as well. In the case of this analysis, all of the REITs which appear to be engaged in the transformation to equity REITs are non-agency mortgage REITS (REITs owning mortgages not guaranteed by federal agencies).
To understand why and how this transformation is occurring and likely will continue to unfold, it is helpful to construct a pro forma or hypothetical model. Let us assume that a mortgage REIT has, as its assets, $400 million face value of mortgages and that these mortgages are carried at a fair market value of $400 million because of minimal default risk. Let us assume (as is often the case) that the mortgage REIT trades at a modest discount to book value so that its market cap is $350 million.
Now, let us assume that, as the mortgages are paid off, the REIT redeploys the cash ($400 million) into real estate equity positions. We will assume that properties are acquired at a 6.5 cap rate (each property produces net operating income of 6.5% of the acquisition cost). We will also assume that the properties are financed with mortgages at 75% of the acquisition cost which bear a weighted average interest rate of 4.5%. The Table below provides some financial data for the transformed REIT after all mortgage assets have been converted into equity.
|total property acquisition cost||$1.6 billion|
|mortgage debt||$1.2 billion|
|net operating income of properties||$104 million|
|interest expense||$54 million|
|management expense||$5 million|
|market cap (14xFFO)||$630 million|
|dividends at 5%||$31.5 million|
|cash flow after dividends||$13.5 million|
The transformation has changed a company with a $350 million market cap into a company with a $630 million market cap with a consequent substantial increase in share price.
I am sure that my pro forma will provoke criticism. The 6.5 cap rate may be optimistic. Recent changes in interest rates may make the 4.5% interest rate on borrowings a bit low. In my hypothetical example, the transformation may take several years in which the metrics may change. However, the prospect of almost doubling market cap and creating an entity which will likely raise rents each year as well as have the opportunity to deploy excess cash flow to pay back debt or acquire more properties is an attractive one. In analyzing mortgage REITs in the past few months, it appears that I am not the only one who has come to this conclusion. The opportunity for investors is to purchase one of these companies in the process of transformation before "the light bulb goes on" and the market realizes that it should be priced as an equity REIT. Here are a few interesting examples.
BRT Realty Trust - BRT Realty Trust (BRT) has traditionally been a mortgage REIT but in the last two years, BRT has aggressively acquired apartment buildings in different parts of the country and, in terms of asset mix and income, may already be better described as an equity REIT. I have written about it before and the price has been moving up although its current valuation does not really track equity REIT metrics. It is interesting that recent SEC filings indicate that there has been a fairly substantial amount of insider buying lately.
iStar Financial (SFI) - I have written about SFI before and pointed out that its substantial net lease assets are undervalued and that, if they were properly valued, SFI would trade at a much higher price. It is a bit unclear whether SFI is committed to a transformation or is simply an opportunistic investor in various asset classes. In any event, it is attractive at its current price
Gramercy Property Trust (GPT) - GPT changed its name and symbol - it used to be Gramercy Capital with a symbol of GKK. It has become an equity REIT and, as the "market memory" of its old share price fades, should trade up to equity REIT multiples. Another author has written a very insightful article making the long case and I agree with his position. I think that GPT will trade up as it has more quarters of equity REIT performance under its belt and investors are more comfortable with applying equity REIT metrics to its valuation.
I am long all three of these companies that are at one stage or another of the process of transformation. RAIT Financial (RAS) is another mortgage REIT with substantial equity holdings but it is not clear exactly what direction it is moving in. While I am long RAS, I think that the jury is still out on whether it will ultimately be valued based on equity REIT metrics.
At any rate, change and transformation are definitely in the air and the next few quarters may provide more examples of this trend. I would hate to see F. Scott Fitzgerald proven wrong but, remember, Nick Carraway was a bond trader and he left Wall Street on the eve of some of the most profitable years in its history.