UDF: A Single-Family Residential mREIT

Aug. 5.14 | About: United Development (UDF)

Summary

UDF provides capital for developers and builders of single-family residences.

Think of UDF as a source for short-term "bridge loans" in the strongest US home-building markets.

I found a place for UDF and its 8.8% yield in my retirement income portfolio.

This article is a conclusion to a portfolio update that began with two previous articles: 2 Champions, 2 Contenders and 2 Newbies Added to Portfolio (August 4) and Hannon Armstrong Added to Portfolio (August 5).

On July 16, I made a small initial investment in United Development Funding IV (NASDAQ:UDF), a mortgage REIT that loans money to single-family developers and home builders. This newly-listed trust was brought into my consciousness by Brad Thomas' June 6, 2014 article, A Brand New Mortgage REIT That May Deliver Something Special.

At the $17.83 purchase price, UDF yielded 9.20%. The stock has rebounded somewhat to an August 4 closing price of $18.58. The annual indicated dividend is $1.12, for yield of 8.8% at the August 4 closing price.

A Mortgage REIT with a Slightly Different Flavor

I tend to avoid mortgage REITs because I find it difficult to comprehend the intricacy and complexity of the business models used by REITs such as Annaly Capital Management (NYSE:NLY) and American Capital Agency Corp (NASDAQ:AGNC). However, I have owned shares of Starwood Property Trust (NYSE:STWD), the nation's largest corporate mortgage REIT, since October 2011. Although STWD focuses on commercial property, it accumulated a considerable number of residential properties at distressed prices and subsequently spun those properties off to Starwood Waypoint Residential Trust (SWAY). Shortly after the spin-off, I sold my shares of SWAY, which is actually an equity REIT (not a mortgage REIT) that owns single family housing. So, why would I invest in another residential REIT, particularly one that holds primarily mortgages rather than real estate?

Brad Thomas understands the REIT world as well as anyone. If Brad thinks a REIT is worth a look, most of the time I will take a look. I was particularly intrigued by United Development Funding because I know Brad is reluctant to invest in mREITs. Brad's article draws some excellent graphics from UDF's July 2014 Investor Presentation, Capital Solutions for Homebuilders and Developers. That pdf document will give you a quick introduction to this mREIT.

Corporate Overview

UDF is not widely followed because it has been listed on NASDAQ for just two months. The trust's website provides this corporate overview:

United Development Funding IV ("UDF IV") is a real estate investment trust (REIT) that invests primarily in secured loans for the acquisition and development of land into single-family home lots and the construction of model and new single-family homes. UDF IV also makes strategic equity investments in residential real estate in some of the nation's largest housing markets.

In 2009, UDF IV's experienced management team forecasted shortages of homes and finished lots in desirable markets due to limited development and construction lending. UDF IV took advantage of this dynamic by filling the financing gap left by banks, and continues to help its clients capture market share in select markets with strong demand fundamentals.

UDF began raising capital in 2009 as a public, non-traded REIT, completed its primary offering in May 2013 and listed on the NASDAQ under the symbol "UDF" on June 4, 2014.

Why the Roman Numeral?

Some investors may be confused by the Roman numeral "IV" in the trust's name. UDF's origins were in a residential finance company formed in 2003. The organization has sponsored three private placements and two public programs (UDF III and UDF IV). UDF offerings have raised more than $1.12 billion from over 26,800 investors.

In the organization's start-up phase as a non-traded REIT, several funds were marketed to individual investors. Fund IV was the instrument chosen for listing on NASDAQ. Investors in WP Carey (NYSE:WPC) may be familiar with their practice of creating or buying various investment pools (often as joint ventures) and eventually integrating those entities into the WP Carey REIT. This model enables a REIT to expand its footprint by putting its capital alongside other investors' capital to create an entity that may not be on the company's balance sheet, but the company may receive management fee income from the affiliation. It may be helpful to think of United Development Fund IV as a "sister" to its affiliates, UMTH Land Development and UMT Holdings.

One way to more fully understand the relationship between UDF IV, UMTH Land Development and UMT Holdings is to read the biographical and professional information about their Officers & Directors. Brad Thomas' article about UDF mentions "the RCS Capital (Nick Schorsch platform) model," which provided an incubator for the growth of the fund. If UDF grows along the lines of WP Carey or American Realty Capital Properties (ARCP), the affiliated enterprises will be consolidated and integrated into the UDF structure. (At some point in the future the Roman numeral "IV" may disappear from the trust's name.)

Opportunity & Strategy

The trust's website identifies the opportunity it sees in today's market and the strategy it seeks to employ to respond to that opportunity:

United Development Funding IV ("UDF IV") provides investors with an opportunity to diversify their portfolios with unique and fundamentally sound investments in affordable residential real estate.

UDF IV provides debt and equity capital solutions to leading developers and homebuilders, including financing for acquisition and development of land, loans for finished lot development, homebuilder lines of credit for construction of single-family homes and notes secured by municipal reimbursements. UDF IV also makes strategic investments in residential real estate in select geographic areas. UDF IV geographically concentrates its lending and investments in markets that demonstrate strong housing fundamentals, such as a balanced supply of homes relative to demand, high housing affordability and strong economies with job creation. Our four-step project underwriting process and hands-on asset management are key elements to our ability to generate superior risk-adjusted returns. Loans are generally secured by one or more of the following: senior and subordinate liens on real property and municipal reimbursements, pledges of ownership interest, personal guarantees and earnest money relating to sales contracts.

Key Data Points

Here are some data points gleaned from the trust's July 2014 Investor Presentation:

•UDF was first to market in 2009 with a program designed to take the place of the banks in the single-family residential development space.

•UDF concentrates on healthy markets with affordable and stable home prices, balanced supply, resilient economies and strong demand fundamentals. UDF's management team identified the housing bubble and avoided lending in frothy markets. Key markets identified by the trust are Texas, Florida and North Carolina. Likely markets include Georgia and South Carolina. Markets the trust continues to evaluate are California and Arizona.

•Management forecasted shortages of homes and finished lots in desirable markets due to sustained demand and a shortage of development financing, and identified an opportunity for their clients to capture market share.

•UDF currently provides a base annual distribution of $1.64 per share (paid monthly), and the Board of Trustees has historically declared special distributions in addition to the base distribution rate.

Initial Public Offering

There are some similarities between the listing of UDF and the 2013 listing of Chambers Street Properties (NYSE:CSG). Chambers Street operated as a non-listed REIT since 2004 and CSG's purchase of shares at its listing provided support for existing shareholders to sell shares. On May 22, 2014, UDF announced that concurrent with its June 4 listing on NASDAQ that it would commence a tender offer for up to $35 million of its shares at $20.50 per share. The tender offer expired on July 2, 2014. This helped to establish support for the identified market value of the shares and it provided some initial market liquidity.

A UDF July 9 press release announced the results of the tender offer:

UDF IV has accepted for purchase 1,707,317 Common Shares at a purchase price of $20.50 per share, for an aggregate cost of approximately $35,000,000, excluding fees and expenses relating to the tender offer. The 1,707,317 shares accepted for purchase in the tender offer represent approximately 5.28% of UDF IV's currently issued and outstanding Common Shares.

Due to the oversubscription of the tender offer, shareholders who properly tendered and did not properly withdraw their Common Shares in the tender offer will have approximately 25.50% of their shares purchased on a pro rata basis by UDF IV (other than "odd lot" holders, whose shares will be purchased on a priority basis).

With the $35 million infusion provided by the trust, the stock opened trading on June 4 at $21.04. That was the high price for the day. The low for the opening day was $18.72. The subsequent high for the stock was $19.89 on June 10. Thus far, the low was $17.77 on July 15. The closing price on August 4, 2014 was $18.58.

Business Model

The business model outlined on the trust's website states that UDF invests in secured loans and makes strategic investments throughout stages 2 through 4 of the single-family residential development lifecycle:

1 Raw Land Acquisition

2 Entitled Land and Lot Development

3 Finished Lot Sales

4 Home Construction and Sale

Portfolio

As of March 31, 2014, UDF's portfolio consisted of 120 loans valued at $544.8 million. The average loan amount was $4.5 million. The average term of the loan was 33 months. The combined loan to value was 85%. Of the loans, $381 million were senior liens and $163 million were subordinate liens or other collateral.

Dividend

UDF initiated a monthly dividend of $.1367 in July, 2014. The ex-dividend date was one week after the IPO. That warms the hearts of those of us who seek dividend income. The August ex-dividend date is August 13 and the pay date is August 25. The current annual dividend rate is $1.64. At the August 4 closing price of $18.58, the yield was 8.8%. On August 4, UDF announced that enrollment is open for their dividend reinvestment plan (NYSEARCA:DRIP).

A Small Investment in UDF

After reading Brad Thomas' June 6 article, I began to study UDF. Because the trust is "brand new" as a publicly listed REIT, the usual metrics for making a buy-or-decline decision are not available. Because the trust is not yet widely followed by analysts, a potential investor is largely limited to making an assessment of the trust's management from the information available from the trust's website and from presentations. UDF's 2014 Q2 earnings call will be Tuesday, August 12, at 11:00 AM (EDT). I believe it is important to listen to the calls and read the transcripts of calls of the companies in one's portfolio and companies one is considering. It is doubly important in the case of a newly listed trust like UDF because information is scarce.

Based on the limited information available, I decided to make a "low conviction" purchase of UDF shares on July 16 at $17.83. My reasons for buying were:

1) The trust invests in short-term loans, with the average loan being 33 months. My terminology (not the trust's) for this is a "bridge loan" to the developers and builders to get the project moving.

2) I believe the trust is investing in some strong markets for single family housing.

3) While many of the leaders of the trust are younger than one often finds in corporate management, there appears to be a depth of experience that should serve investors well. Some of the management team members have worked together in this venture for over a decade.

4) For a variety of reasons, the banking system is not meeting the demand for new home loans and this is a crucial area of the economy that needs to move forward. UDF may be in a potentially lucrative "sweet spot" to participate in this needed economic growth.

UDF currently represents .6% (six-tenths of one percent) of my retirement income portfolio. This is my smallest investment because there are still many unknowns.

This article is presented as a journal of my decision to purchase one stock. Everyone has different goals, needs, and risk tolerance, so this is not a recommendation to buy or sell any security, but it is offered for educational purposes to give you an idea for a potential stock to study. Please perform your own study and due diligence.

Disclosure: The author is long UDF, AWR, NWN, GPC, PG, EMR, MMM, KO, JNJ, SYY, PEP, WGL, ORI, T, HCP, CVX, NNN, MDP, O, KMI, WPC, SO, AVA, CBRL, WEC, GIS, DE, DLR, TCAP, STWD, BCE, MAT, ETN, TUP, LNCO, EPR, LTC, VTR, RYN, MAIN, MRK, CSG, ARCP, HASI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.