Dividend Investor Boot Camp, Part 5: Commercial Mortgage REIT Fireworks

by: Philip Mause

In Part 3 of this series, I introduced the subject of Real Estate Investment Trusts, which invest primarily in commercial property mortgages (Commercial Mortgage REITs) and promised to go into more detail. In less than 2 months, there has been a lot of activity - secondary offerings, takeover attempts, lender issues,and one really big price appreciation story. Before highlighting these important developments, I want to review a few points and stress that dividend investors should be cautious in investing in this sector.

Commercial mortgage REITs invest in mortgages on office buildings, shopping centers, apartment buildings and other commercial properties. Some of them also hold equity in commercial properties and others have a certain level of other investments. Many commercial mortgage REITs employ special purpose entities (SPEs), which are essentially separate legal entities controlled in whole or in part by the REIT. The SPEs hold assets and various income oriented investors buy senior notes or tranches, which entitle them to be paid first on income generated by the SPE. The REIT normally retains a subordinate interest and gets paid only after the senior investors. In addition, the REIT often manages the SPE and gets paid a fee.

For a variety of reasons, the financial statements of REITs often consolidate the SPE's income and balance sheet into the REIT's producing some very misleading financial data and often making it difficult to determine whether the REIT is solvent, profitable or even viable. For example, the SPE's notes are generally non-recourse, which means that the note holders are not entitled to seek recovery from any source other than the SPE itself. However, those notes often are listed as liabilities of the REIT on the consolidated balance sheet. In addition, many REITs have multiple SPEs and the aggregate performance of the group may not tell you very much about the value of the REIT's interest. Several SPEs can be deeply under water but the REIT's interest can never be worth less than zero. There may be other SPEs that are doing fine and the REIT's interest may have considerable value. If you aggregate all of the SPEs, the numbers from the bad ones may swamp the numbers from the good ones and the aggregate numbers may look very bad despite the fact that the REIT actually has valuable positions in the SPEs that are performing well.

REITs vary in how they deal with this. Some of them provide supplemental disclosure in the notes to financial statements or in the management discussion. Even this additional disclosure usually fails to provide an investor with the information he really needs. REITs with SPEs should provide a short financial statement for each of the SPEs and a valuation of the REIT's position in each of the SPEs with an explanation of the methodology for reaching that valuation. The REITs own financial statement should include a balance sheet with each of these SPE position valuations as well as other assets on the asset side of the balance sheet and all recourse debt on the liability side(if some of the SPE debt is recourse then there should be a notation and a disclosure for each SPE of the assets available to satisfy that debt before there is recourse to the REIT assets).

Until something like this is done, investors are, to an extent, flying blind in this sector. It reminds me of being out in a small boat in Peconic Bay when the fog came in and I couldn't see a thing. I wanted to get to Shinnecock Canal but the entrance has rocks on both sides so I really had to be sure where I was going. I waited and finally a big boat passed heading in that direction. I figured that he must know what he is doing so I followed him closely. After about 5 minutes, he slowed down and circled back to me. He looked down at my little boat and asked; "Do you have any idea where Shinnecock Canal is?"

To a degree that is what is happening in this sector. Equity investors are watching what the big guys(the lenders to the REITs) are doing. Since I wrote Part 3 on March 28, Capital Trust (CT) finally reached an agreement with its lenders and restructured its major debt (virtually all of its recourse debt). CT traded at $2.38 when I wrote the article: Monday, it closed at $4.53. Oddly enough, it had $11 a share in income during the quarter (due to the extinguishment of debt). An investor who blindly follows income growth data would think that CT is the best income growth story in history and is trading at less than half the value of quarterly earnings. I am not sure how CT will do: I think it is an interesting story and may do very well on a go forward basis but there are uncertainties. On the other hand, I know that the blind application of valuation formulas to the $11 income number will give an investor a very misleading view of the company. The real reason the stock went up is that the lender issues got resolved and this means two things. First, that the company can go forward without immediate fear of being shut down by its lenders; secondly, it means that the lenders went over the assets and determined that there is real value and it is worth sticking it out. I hope they are not like the boat I tried to follow.

Gramercy Capital (GKK) has not been so fortunate. It has gotten a series of extensions from its lenders and recently announced that the last extension ran out and negotiations are still under way but the loans are coming or have come due.

Investors are likely watching the news every day to see if another extension has been granted (it's probably a little bit like the debt ceiling negotiations). One again, the lender's behavior is probably the most important factor for the stock.

Several of these REITS have had secondary offerings (as have the residential REITs). In most cases in this sector, the stock is now trading below the offering price - the three I am aware of are (offering price and then current price in parenthesis) - CreXus Investment (NYSE:CXS) (11.50) (11.14); Newcastle Investment (6.00) (5.26); and Resource Capital (NYSE:RSO) (6.90) (6.40). CXS rejected a buyout offer from Starwood Property Trust (NYSE:STWD) at $14 a share.

All of this tends to support my case that valuation in this sector is a bit unstable and transparency is not all that it should be. This generally creates both opportunities and risks. I have done very well investing in NorthStar Realty (NRF) shortly after it resolved issues with its lenders. I did very well with the bonds of iStar Financial (SFI) because they were trading below recovery value. I got my comeuppance in Anthracite (AHR), which went under. Currently, I still like NRF and CXS (someone smart thinks it's worth $14). I am continuing to kick the tires on Rait Financial (NYSE:RAS) and PMC Commercial Trust (PCC), which seems to have relatively conservative financials and is focusing on the origination of SBA loans. I would be much happier if this sector had the kind of easy to read financial statements that I have been used to in dealing with Business Development Companies (BDCs) but I guess I got spoiled. Dividend investors should be careful in this sector but it is worth doing some research because the rewards can be significant.

Disclosure: I am long NRF, CXS, AHR.

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