Not for the Faint of Heart: Revisiting Non-Agency Mortgage REITs

by: Philip Mause

Many investors get confused about the Real Estate Investment Trust (REIT) sector. Most REITs are equity REITs which own properties (almost always subject to mortgages) and rely on rental income as a source of revenue. In addition, there are a significant number of mortgage REITs which own mortgages on properties owned by other entities and rely on interest payments on the mortgages as a source of income.

Within the mortgage REIT sector, agency mortgage REITs own mortgages and/or mortgage backed securities guaranteed by federal agencies (Fannie Mae, Freddie Mac) - these entities are usually viewed as being insulated from default risk and for that reason are able to employ a large amount of leverage. There are also non-agency mortgage REITs - these companies own commercial and/or residential mortgages which are not guaranteed by any federal agency. They also employ some leverage but it tends to be less than the leverage used by agency mortgage REITs.

The non-agency mortgage REIT sector has been very volatile and some of the stocks in the sector have seen substantial price declines in the last several weeks. The difficult question is whether this creates a buying opportunity for investors. There are several considerations to bear in mind on this issue. If we are about to head into another recession, default rates on commercial and residential mortgages will likely increase and this will affect both the cash flow and the balance sheet of a typical non-agency mortgage REIT.

On the other hand, some of the companies in this sector have restructured to reduce leverage or to rearrange things so as to reduce recourse debt. It is very important to focus on the distinction between recourse and non-recourse debt. Mortgage REITs can have large amounts of non-recourse debt which is secured by either properties or assets in CLOs but which can not be a claim against any of the companies' other assets. In that case, the worst that can happen is that the asset securing the debt can be wiped out.

Unfortunately, the financial statements of many of these companies are opaque and confusing and often give the impression of more leverage than actually exists. Investors are encouraged to read the financial statements themselves, develop an understanding of the business and asset base, and judge each company individually.

I am providing a list of some possible opportunities in the sector - after each name I will provide the symbol, Friday's closing price, the highest price in the last 6 months, and the yield.

  1. Capital Trust (CT) (2.60) (5.10) (0)
  2. Appollo Commercial (NYSE:ARI) (14.65) (17.09) (10.9)
  3. PMC Commercial Trust (PCC) (8.22) (9/40) (7.8)
  4. RAIT Financial Trust (NYSE:RAS) (3.67) (8.10) (6.5)
  5. Gramercy Capital (GKK) (2.39) (5.30) (0)

Some of these stocks have really taken a header and some of them may deserve it but each one of them has its own unique story and I suspect the market may not be differentiating properly.

CT had a lot of problems and went through a major restructuring this past Spring. It virtually eliminated recourse debt and transferred most of its assets into a new entity which it manages and of which it owns a large share of the equity. It has a fair amount of cash and has a book value of $3.73 per share. It appears that its management operation can throw off net cash of at least 30 cents a year which might support a valuation in the $1 to $1.50 a share range, it has more than a $1 a share in cash, and its retained position in the new entity appears to be worth about $2 a share. It appears to also have some subordinate positions in some CLOs but the financial statement is very unclear on this point. With little or no debt, this may be a bargain although the position in the new entity could decline in value if defaults increase on the loans which are the assets of the new entity.

ARI is interesting. It issued new shares at $16.66 net proceeds earlier this year and recently announced a buy back. If it can buy back its shares at $14.65, the net effect of the issuance and buy back will be accretive to NAV. Its book value is $15 a share so this isn't trading at a big discount to book.

PCC is different from many other stocks in the sector. A big part of its business is the origination of SBA loans. Again, the accounting for this activity and for its retained position is somewhat opaque. It does not have a great deal of leverage and is trading at a big discount to its book value of $14.15 per share.

RAS is trading at only 16% of book. It operates some CLOs and owns a number of apartment buildings so it is not a pure mortgage REIT. The stock has really been pounded lately although the company has been generating free cash flow and paying down its recourse debt. There has recently been a fair amount of insider buying. It recently had a reverse stock split so investors should take this into account in comparing current and recent prices.

GKK is the enigmatic Greta Garbo of mortgage REITs. There has been no press release on its website since the ominous notice on May 9 announcing the maturity and non-payment of a large mortgage it owed on its real estate assets. At this price, it is possible that an investor would not do too badly even if the real estate assets were wiped out because GKK has other assets which could well come close to supporting the current share price. It is trading at 36% of book but with the default looming it is hard to be confident of book value here.

This is a risky sector and not for the faint of heart. There may be a lot of money to be made here but there will probably be more bad news and more drops in the prices of some of these stocks. Let me stick my neck out, however, and say that if an investor diversifies by buying the group, he will probably do well if and when we ever pull out of this never ending economic slump.

Disclosure: I am long GKK, RAS, PCC.