I’m no big fan of U.S. REITs (or MLPs). I can’t count the number of excitable headlines/articles I’ve read about REIT/MLP yields … but still wonder if there’s a decent investment amongst the entire bunch?
You’re certainly not going to find one in the non-traded REIT sector. You may have never heard of these, but you can bet they know all about them down at the senior centre. What’s the sales pitch for this garbage? Hey, we’ll take 10% up-front in commissions, we’ll charge you again to redeem (if we even let you redeem), you’ll have no idea what your shares are really worth … but, gee heck, look at the yield!! Oh, and we’ll never point out that much of your yield is simply a return of capital. Perfect for the old dears … Read this entertaining REIT forum. But this isn’t just a U.S. phenomenon, there’s plenty of similar horror stories in Europe too.
Ugh, I feel dirty now. Almost makes property REITs seem like your fuzzy best friend. OK, get a grip – I’m not too enamored with these either. Far too many property REITs are highly levered, serial issuers of shares, and usually over-valued. Oh, and their dividends are often part capital return and/or funded with debt. Mortgage REITs are even scarier, with sky high leverage and giant bets on the yield curve and/or credit spreads.
You know, the premiums on U.S. listed property companies (and closed-end funds) always shock me. Invariably, companies/funds listed in London/Europe, with lower leverage, trade at a significant discount to their counterparts in NY. This continues to puzzle me. But a good thing to observe, if you’re an issuer you want to ‘sell’ in the US, and if you’re an investor buy outside the U.S.!
However, there’s one bunch of REITs that really interests me. Launched in the past couple of years, they target distressed assets in the banking and real estate industries. Their primary focus has been the US, but some are keen to do more business in Europe. If you’re on board with a smart investor, distressed asset investing offers a great opportunity to participate in cheap assets, and to reduce correlations/risk in your portfolio. Let’s take a look at some of their vitals:
- PennyMac Mortgage (PMT): Price $15.86, Return on Equity 11.3%, Price/Book 0.83, Div Yield 12.6%, Liabilities/Assets 54%
- Starwood Property (STWD): Price $17.74, RoE 5.9%, P/B 0.93, Yield 9.9%, Leverage 30%
- Apollo Commercial (ARI): Price $13.60, RoE 6.8%, P/B 0.80, Yield 11.8%, Leverage 63%
- Colony Financial (CLNY): Price $13.97, RoE 6.9%, P/B 0.71, Yield 9.4%, Leverage 12%
PennyMac: Led by an ex-Countrywide team, they’ve assembled a magnificent compensation/ incentive package for themselves … So rich they’re actually losing money on an underlying basis – yes, loan write-ups are the only reason for the positive stats here. Ugh! Apollo’s from the Leon Black stable. He’s had his fair share of issues over the years, but is a PE/distressed investing whiz – my main objection is his usual fondness for leverage. Starwood’s run by the inimitable Barry Sternlicht, another superb investor – but I just don’t see enough value in the stock.
This led me to Colony Financial: Run by Tom Barrack & Colony Capital, with low leverage, a cheap price, a great yield and a portfolio that’s still in the build-phase. Colony has had its share of knocks, but has a superb longer-term record as a distressed investor. Its main focus is real estate, but it’s also made some unusual investments such as lending to (and foreclosing on) Michael Jackson’s Neverland ranch, and even lending to the notorious photographer/spendaholic Annie Leibovitz. Here we’ve a great opportunity to buy into a premier investor vehicle at a great discount, and before most of its assets gain in value/pay off. With such low leverage, some extra debt can still be added to juice returns. Meanwhile, there’s a very attractive 9.4% yield to keep you ticking over. Perhaps most exciting is Colony’s interest in Europe. They’ve done a couple of deals there already, and are keen to take advantage of the tidal wave of distressed assets to come in Europe. That might be slow to come, but will hopefully offer Colony the chance to eventually recycle U.S. realizations into European assets. Looks compelling, but as a reality check (and a bit of fun), let’s compare CLNY to two other well known stocks:
- Goldman Sachs (GS): Price $91.75, RoE (Adj) 6.0%, P/B 0.70, Yield 1.5%, Leverage 93%
- Kinder Morgan Energy (KMP): Price $77.12, RoE (Last FY) 6.5%, P/B 3.34, Yield 6.0%, Leverage 67%
I have to admit, I’ve huge admiration for Goldman. If I was forced to buy one bank, and hold it blind for 5 years, it would be GS. Especially at today’s price/valuation. But look at the leverage! And that’s the problem with all banks. Yeah, sure, maybe GS will trade again at 3 times Book (when?!), while Colony probably won’t ever reach that kind of premium. But so what? Who needs to take on that kind of leverage when Colony offers a cheap stock with plenty of upside, a similar/potential RoE, low leverage, and a running yield that’s six times higher?!
Now, for fun, let’s look at an MLP: KMP. Despite choking on serial stock issues, investors keep pyramiding this higher. If you read the press releases, everything seems normal – they’re just paying out all their earnings in dividends. But Net Income is identified before the General Partner’s Interest is deducted! Yes, we’re all owners in this together, but I’m just going to take most of the earnings for myself … So, true shareholder RoE is pretty anemic, despite the aggressive leverage. It also means only about 30% of the dividend is actually Net Income, the rest is basically a return of capital. Unfortunately, shareholders can’t seem to grasp this (no help from KMP management), and insist on valuing the stock based on a 6.0% dividend yield.
Completely WRONG!: If the annual $4.64 dividend is 70% capital/30% income, the capital component’s worth $3.05 ($4.64 * 70% * 94% 1 year PV). The balance can perhaps be more correctly valued at 6% which is worth $23.20 ($4.64 * 30% / 6% yield). This equates to a Fair Value of $26.22. But let’s make it even simpler: KMP RoE is 6.5%. This suggests KMP’s worth about 0.80 P/B, equating to $18.47. Taking the average, the best Fair Value estimate I arrive at is $22.35. KMP is horribly over-valued. The only positive is that management gets to keep selling more shares at a ridiculous premium! But they also keep investing/acquiring and adding more leverage. I’ve no idea how long this treadmill can keep running, but when it ends it will be ghastly…
So, yes, Colony is my favorite investment in this space. In light of premium U.S. valuations (over time), and expected strong performance, I’m comfortable putting a Fair Value 1.15 P/B target on this stock. This gives me a $22.49 price target, and an Upside Potential of 61%. I’ve now invested 2.0% of my portfolio in CLNY, with further purchases likely. Obtain your own tax advice, of course, but if you’re a non-US investor submit a W-8BEN form to your broker to reduce the tax bite. If you’re a U.S. investor, a 401k/IRA is a great home for this high yielding stock.
- Colony Financial
- Mkt Price: $13.97
- Mkt Cap: $453.6 mio
- P/B: 0.71
- Yield: 9.4%
- Tgt P/B: 1.15
- Tgt Price: $22.49
- Upside Potential: 61%