Dividend Investor Boot Camp, Part 3: Commercial Mortgage REITs

by: Philip Mause

We have been reviewing mortgage REITs, real estate investment trusts which invest in mortgages rather than equity in properties. You can find part 1 here, and part 2 here. While there are some of these entities which combine commercial and residential mortgage, there is a general division in the industry between residential mortgage REITs and commercial mortgage REITs, with the latter holding mortgages on commercial properties including office buildings, and retail buildings as well as buildings used for industrial purposes and health care.

This sector may present some of the greatest risks and opportunities in the mortgage REIT area and, indeed, in the entire finance area. I like to think about investing in these companies as "buying debt in the equity market" - I approached the Business Development Companies that way, buying stocks well below book value as the debt market improved, and did very well. This sector affords similar opportunities to buy debt at deep discounts. On the other hand, many of these companies have complex structures, are still laden with bad loans, and have confusing financial reports. In addition, commercial mortgages themselves tend to be more complex than residential mortgages and this creates valuation issues and classification issues that can muddy the waters.

Many mortgage REITs are involved one way or the other with special purpose or variable interest entities. While there are a variety of these entities with different characteristics, as a general matter, these entities hold multiple mortgages generating interest and principal payments; securities are sold to investors - the senior securities entitle the investors to the first layer of payments. Frequently, a mortgage REIT will manage one of these entities and will retain a subordinate position entitling it to get paid after the holders of the senior securities are paid. For accounting purposes, the entire entity is often put on the balance sheet of the mortgage REIT making it appear that the REIT has huge assets and liabilities. In fact, the liabilities are usually non-recourse securities that entitle the holders to the assets in the entity but do not entitle them to go after any other assets of the REIT. While the Enron scandal gave special purpose entities a bad reputation, they can be used legitimately to spread risk and raise capital. As used by REITs, they tend to reduce risk by creating non-recourse liabilities that cannot reach other assets of the REIT.

Another layer of complexity here is in the borrowings of the REITs. There are often rather complex terms creating defaults even when the required payments are being made. In addition, some mortgage REITs mark their borrowings to "fair value" on their balance sheets making it less than obvious exactly how much money they owe. Vintaging is another layer of complexity. The financial meltdown was a little bit like the asteroid that killed the dinosaurs; the world after the event bore little resemblance to the world before the event. Thus, loans made in 2006-07 were made with terms and under assumptions about property values that were completely different from the terms and assumptions that prevailed after the meltdown. A great deal depends upon the "vintage" of a mortgage REIT's loan portfolio, or of the loan portfolio in one of the above described entities on its balance sheet.

This sector consistently produces interesting news as some companies teeter on the brink of failure while others are briskly proceeding with large secondary equity offerings. Indeed, it has been striking how much new money has gone into the mortgage REIT sector recently. As was discussed in an earlier article, REITs usually dividend out most of their income so that it is difficult for them to grow unless they can return to the market to sell more equity. Just as many large caps have been buying back their own stock, this sector has been issuing and selling new stock - I think this is another manifestation of the "yield hunger" phenomenon which is characterizing the market as a result of ultra-low interest rates.

The list below includes Friday's closing price, the price book ratio, the leverage level, and the dividend yield. Leverage is based on all-in financial statement balance sheet numbers and generally includes non-recourse debt. In this regard, these leverage levels may suggest misleadingly high levels of risk; as I have indicated before, investors should examine the financials of any individual company before investing. The notation "N" under price book value and leverage means that financial statement book value is negative (again, these numbers generally include non-recourse debt and thus a company with an N may have real value); when "N" appears under dividend, it means that no dividend is currently being paid.

  1. Arbor Realty Trust (NYSE:ABR): ($5.84)(.70)(6.7)(N)
  2. BRT Realty Trust (NYSE:BRT): ($6.33)(.71)(.5)(N)
  3. Capital Trust (CT): ($2.38)(N)(N)(N)
  4. Gramercy Capital (GKK): ($4.39)(.59)(11)(N)
  5. NorthStar Realty Finance (NRF): ($4.39)(.40)(3.2)(7.9)
  6. Newcastle Investment (NCT): ($6.07)(N)(N)(N)
  7. PMC Commerce Trust (PCC): ($8.80)(.62)(.5)(7.3)
  8. Resource Capital (NYSE:RSO): ($6.91)(1.17)(4.6)(14.3)
  9. iStar Financial (SFI): (9.00)(.5)(4.4)(N)
  10. Colony Financial (CLNY): ($19.99)(1.04)(.18)(6.4)
  11. Starwood Property Trust (NYSE:STWD): ($23.06)(1.04)(.56)(7.3)

It is beyond the scope of this article to analyze each of these companies in depth although I hope to provide such analysis of some of the companies in future articles. A few points. Two of the companies, CT and GKK, are in negotiations with lenders which should clarify their future within the next 30 days. Until that clarification, an investment would be speculative - if things go well with the lenders, the stocks could pop up: if things go badly, the opposite could happen.

Two of the companies, BRT and PMC are relatively small with little leverage, reasonably understandable financials and BRT's management appears to have a large equity stake. I do not think either of these will be the next Apple (NASDAQ:AAPL), but they are worth a look for a long term value investor because they are trading well below book value. CLNY and STWD are relatively new and thus did not have the opportunity to make a lot of loans before the meltdown. They both seem to still be in the process of deploying capital and it may be too early to see exactly how their portfolios will perform.

I have a position in NRF and have done well with it. Its management appears to have an excellent reputation and it seems to have resolved any problems it may have had with lenders. ABR is interesting - it has made quite a bit of money buying back its own debt at a discount (a number of these companies have followed that strategy). It appears that most of its remaining debt is non-recourse and so the balance sheet leverage gives an overly pessimistic picture of financial risk. What interests me is that on the most recent conference call (a transcript is on Seeking Alpha, here), management seemed to indicate that "economic" book value is $12-13 per share or more than twice the current share price.

RSO sports a great dividend and recently priced a secondary offering of its shares at $6.90. An investor should review the recent financials and satisfy himself about the company's prospects: for the most recent year, it showed a loss on a GAAP accounting basis but $1.15 a share income on an "adjusted" basis and still different results on a REIT taxable income basis.

The charts of some of these companies look like they were calculated based on Fukushima real estate prices over the last 30 days. There has been some real carnage in this sector and it may not be over. Investors are warned that they should do their homework and analyze each company carefully.

One important indicia of a company's financial strength is the lender behavior and the bond pricing - some companies in this sector have essentially been shut down by lenders. If the lenders are renewing loans on reasonable terms, then it is more likely that the REIT will be able to realize value in the neighborhood of its book value. Of course, uncertainty, complexity and a history of large losses often sets the table for a big payoff when a stock is priced very, very cheaply. Careful investors may find some of those opportunities here.

Disclosure: I am long NRF, AAPL.