Gramercy Capital's (GKK) delinquent financials are hiding two big events since September 2010: A large 1 million preferred shares buyback in November 2010 (not retired yet) and the sell to SL Green (SLG) of several New York leaseholds owned by Gramercy Corporate, including the famous Lipstick building.
I also considered that the unrestricted cash in Gramercy Realty was part of the mezzanine collateral and most probably lost in case of losing the division. This is my best estimate of the current unrestricted cash considering the lack of information since September last year.
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There are two aspects to consider when valuing the preferreds:
- Suspended dividends accumulate: Gramercy suspended preferred dividends in December 2008 so it has accumulated 10 quarters of dividends. That is $5.07 per preferred share in arrears.
- December buyback: Gramercy offered to buy 4 million of the preferred shares for $15 per share. That is a 50% discount if arrears are included ($25 par + $5.07 arrears = $30.07) and 1,074,178 shares were tendered
Considering both events, this is an estimate of the new shares count and their total obligation. Let me remind you that the preferred equity is the only obligation at the corporate level.
Marketable Securities and CDO Buybacks
The following is an estimate of the Gramercy CDO bonds that Corporate currently owns:
Corporate Real Estate
The two properties in Gramercy Corporate’s portfolio were the result of distressed transactions. Gramercy and Lehman Brothers took ownership of Whiteface Lodge in Lake Placid on April 23, 2008 by a deed-in-lieu of foreclosure. Later on in July 2010, Gramercy acquired Lehman’s 60% equity interest financed in part with CDO proceeds. Makalei Golf and Land in Hawaii was foreclosed by two of Gramercy’s CDOs and Corporate took the opportunity and acquired it in an auction with a discounted credit bid.
The allocated loan amount per fractional interest of Whiteface Lodge is $23,039, and the allocated loan amount per lot at Makalei is $83,799, so both properties might be worth much more than book but are still distressed. In November 2009, these properties were appraised on a stabilized value basis for $145 million.
Both transactions testify for the available opportunities in distressed properties especially when you know the assets in depth.
Other mREITs are following aggressively this route and I would not be surprised that Gramercy follows that path too. Arbor Realty Trust ABR is one lender that is taking advantage of this type of opportunities over the next quarters:
Additionally, as we mentioned in our last call, we started to acquire some of the real estate securing our loans and investment taking Type 2 properties in the first quarter totaling $132 million subject to $55 million our first lien debt. Paul will take you through the accounting related to these transactions in a moment.
Additionally, we acquired two sets of properties in the first quarter that were securing certain of our loans in the normal course of our lending operating. One of the acquisitions happened in February and was related to an $85 million performing loan secured by six resort hotels in Florida. The loan had a weighted averages interest rate of approximately $3.75% and a net carrying value of $71.6 million prior to the acquisition.
As a result, we recorded this asset on our books as real-estate owned at fair value and eliminated our loan in consolidation (RR: same thing happens with Makalei and Whiteface, you have to dig for the loan amount since it does not appear in the 10K) and we are now recording net operating income from this property including depreciation expense instead of interest income.
This is a tremendous benefit for Gramercy: It is both a lender and operator of real estate assets. Compared to banks, Gramercy can take control of properties in foreclosure and not be forced to sell to comply with regulatory guidelines. While compared to an average developer, Gramercy has long-term low-cost financing to finance the transaction with CDO 2007 still in its reinvestment period. I that reinvestment period has ended, they can still use the replacement strategy for some financial wizardry.
Interest Coverage Test
Some CDO experts may wonder why I did not mention the interest coverage test -- the other important test that can redirect cash flow. The reason is that it does not matter much in the current low interest rate environment.
The IC test is the ratio of the CDO interest cash flows against the interest payments due to the CDO bondholders. Its goal is to make sure that there is enough cushion to ensure interest payment to bondholders. However, with CDO 2005 and 2006 being variable rate instruments and a Fed’s zero interest rate policy, the denominator is very low. The IC test is passed easily.
There are other portfolio requirements to ensure basic geography diversification and avoid concentration in exotic or risky real estate instruments. Both CDO 2005 and CDO 2006 pass them and any short term failure can be cured with a replacement strategy.
CDO Bonds Discount
One concern that I have heard in similar situations is that debt discounts signal significant problems for the equity. Well, a good margin safety especially outside the CDOs, as in this case, should be enough to dispel this concern. Even more, I think sometimes discounts do not signal anything about the underlying assets.
To understand what is going on, it is good to remember that senior CDO bonds were AAA securities with very low interest rates when issued despite being non-recourse, non-marked to market, and long term financing. A very good deal to the borrower, if you ask me.
Let’s move forward in time. Having gone through one of the worst financial crisis ever, CDO bonds liquidity is much lower, despite being marketable securities, and their AAA has gone away. Actually, there has been no CRE CDO bonds issuance since the start of the crisis. Most financial institutions are faced with regulatory restrictions on what securities can be used for repos, and CDO bonds are not being used for that purpose any more. Also critical stakeholders, burned by other CDOs, just want to leave this episode in the past.
So you have a double whammy where institutions that bought these bonds very expensive are willing to sell them back to Gramercy for reasons beyond the current quality of the security. The compounded effect is a large discount to par just at the precise moment that Gramercy and other mREITs would like to buy them. And Gramercy does not need to buy 100% of those bonds, it just needs a small number of institutions under these very common set of circumstances.
In other words, there is not much demand beyond Gramercy’s own and there is supply. It is not like retail investors can or want to buy CDO bonds.
Also, Gramercy has perfect information of what is inside the CDOs. Not many people can or want to do a detail analysis of the assets inside them. Despite CDO 2005 and 2006 demonstrating through out the crisis a good performance compared to other types of CDOs, panicky bondholders can have other reasons not to buy.
Concluding, Gramercy sold its lenders the CDO bonds at the equivalent of Florida real estate prices in 2007 and is buying them back at 2011 prices.
Foreclosure Legal Costs
This potential risk was mentioned in the “Risks” section, but it might be important to discuss it in a little more depth. Despite the mezzanine loan being non-recourse, a foreclosure could still carry costs. Exceptionally, these procedures can get messy -- especially if the borrower, in this case Gramercy Realty, decides to fight the foreclosure. The reason is that the threat of a messy foreclosure procedure is their negotiation card while discussing the terms of a died-in-lieu of foreclosure.
None of the parties would want a messy outcome. But still, if the negotiations break down because of either party overplaying their cards, Gramercy might be pushed to start a legal fight. The lenders in turn would probably sue under the bad boy provisions or a possible fraudulent conveyance even if these have no merit. See for example the legal fight that iStar Financial is enduring with Rittenhouse.
This sounds worse than it really is and the legal costs should be more than affordable with the current cash hoard. But still, the legal costs can make some some dent on the margin of safety. My comfort is that I do not see Gramercy following this route if they think it could compromise the viability of the company.
- January Reports here.
- Summary CDOs here.
- CDO Trustee Reports (not uploaded by me) here.
- Presentation 2007 here.
- Presentation AFR acquisition here.
- Prospectus Preferreds here.
- Redemption Strategy, Concord (Winthrop Realty Trust) vs Bank of America here.