Commercial Mortgage REITs: 7 Small-Caps in This High Risk / Reward Asset Class

by: Zvi Bar
In reviewing mortgage REITs, real estate investment trusts investing in mortgages instead of the underlying properties, I have previously focused on residential agency mortgage REITs and non-agency residential mortgage REITs, but in so doing many commercial mortgage REITs have not been included. Generally, there is an industry divide between residential mortgage REITs and commercial mortgage REITs. Commercial mortgage REITs should hold mortgages on commercial properties such as office, retail, medical, industrial and warehouse buildings, while residential ones, of agency or non-agency breed, should hold residential mortgages on houses and apartments. Commercial mortgage REITs also tend to be on the smaller side, often as a small-cap ($300 million to $2 billion) or a micro-cap ($50 to $300 million).

Commercial real estate is believed by many to hold the greatest risk within the mortgage REIT industry, and possibly within the financial and real estate sectors that it straddles. Many bad loans and bad tenants complicate the industry, and history indicates that commercial real estate often suffers falls following ones in the residential real estate market. Several investors, as a consequence, are still expecting commercial real estate to sustain its own separate, subsequent and consequential fall on the back of failing businesses and a lack of new commercial business coming in to replace them. For example, Borders just filed for bankruptcy and it is unlikely that another large bookstore will want to occupy all those locations with which to compete against the Internet.

Below are seven small-cap REITs that have exposure to commercial mortgages, though not necessarily exclusively or to a majority, depending on their present portfolio mix. Many of these REITs can change their mortgage asset mix, and have in the past. The group offers yields ranging from zero to over 15%, and several with values near or well below book.
  1. Colony Financial (NYSE:CLNY)
  • Current Yield: 7%
  • Market Value: $600 million
  • Debt: $14.7 million
  • Price to Book Value: 0.56
  • Short Interest: 5.4%
  1. CreXus InvestmentCorp. (NYSE:CXS)
  • Current Yield: 8.1%
  • Market Value: $865 million
  • Debt: $172.5 million
  • Price to Book Value: 0.98
  • Short Interest: 7.1%
  1. iStar Financial Inc. (SFI)
  • Current Yield: None
  • Market Value: $773 million
  • Debt: $6.9 billion
  • Price to Book Value: 0.45
  • Short Interest: 18%
  1. NorthStar Realty Finance Corporation (NYSE:NRF)
  • Current Yield: 9%
  • Market Value: $346 million
  • Debt: $3.95 billion
  • Price to Book Value: 0.4
  • Short Interest: 7.6%
  1. Newcastle Investment Corp. (NCT)
  • Current Yield: None
  • Market Value: $397.5 million
  • Debt: $3.9 billion
  • Price to Book Value: 29
  • Short Interest: 3.6%
  1. Resource Capital Corp. (NYSE:RSO)
  • Current Yield: 15.3%
  • Market Value: $464 million
  • Debt: $1.48 billion
  • Price to Book Value: 1.1
  • Short Interest: 3.4%
  1. Starwood Property Trust Inc. (NYSE:STWD)
  • Current Yield: 7.8%
  • Market Value: $1.5 billion
  • Debt: $870.8 million
  • Price to Book Value: 1.16
  • Short Interest: 4.3%
Please note the reasonably high short positions on several of these names, even though some have sizable yields. Many investors believe an interest rate change or second real estate correction will reduce the value of the underlying properties and increase the probability of greater defaults. Moreover, higher rates will make it less profitable for future tenants to occupy commercial space, possibly keeping higher vacancies for an extended time-frame.

Commercial mortgage REITs are far more complex than residential ones, because their mortgages are more complex. The parties on both sides of the transaction are usually savvy and come to the negotiating table with lawyers, insurers and accountants. The terms are usually more complicated and the occurrence of incestuous relationships, where the borrower and lender have some close connections, is common. The issues make it difficult to conclude with any certainty when a default will trigger action, as terms are more likely to be re-negotiated between family and / or where no other tenant is likely to replace them.
Several of the above-mentioned names are below book, indicating that either much of the risk is already factored into the price or that the book value is not realistic relative to the market. Of course, market values are often capricious and volatile in times of such uncertainty. This is a risky asset class and many equity investors will end up investing in some bad mortgages. Nonetheless, higher quality mortgages with higher credit tenants and higher demand locations will probably perform well enough in the coming years, and offer inflation protected returns over time.
Generally speaking, this industry should probably not represent a large portion of any portfolio that is invested with the prudence required to maintain a fiduciary duty. Nonetheless, as secure fixed income is no longer so secure, and so much of the real estate market has sustained significant losses over the last five years, commercial exposure is likely an industry to which most portfolios have little to no exposure.

Some exposure could help improve the income returns to a portfolio, while also providing real estate based exposure that is not necessarily highly correlated to either the equity markets or residential real estate. Many value investors may appreciate buying a commercial REIT such as CLNY or NRF, both of which are well below book value and offering sizable yields. Nonetheless, their sizable short interest does indicate that many investors believe another shoe is yet to fall. Opinions may differ and are certainly welcome.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Data is derived from company filings. Each investment should be considered relative to the total portfolio and its objectives.