Note: This piece was previously available for subscribers. Since publication, adjusting for dividends, RSO is up 2.22%, RSO-A is up 9.86%, RSO-B is up 8.87%, and RSO-C is up 6.96%. As of the most recent closing values, the opportunity in this pair trade has narrowed substantially. In the case of RSO-A and RSO-B, it is largely wiped out for the moment at least.
There is a small opportunity left (I'm estimating around 2% to 4%) using the values for RSO-C. At the present time, I believe RSO-C is the most attractively priced of the preferred securities. However, I still wouldn't want to buy any of them without having an excellent hedge in place.
Therefore, this is a point where investors using RSO-A or RSO-B should be looking to close down the pair trade and investors in RSO-C should be watching for the exit point since a range of 2% to 4% could happen suddenly.
Original article follows.
Resource Capital Corporation (NYSE:RSO) is a REIT that invests primarily in loans and other paper assets and borrows money to fund those operations. Because their fundamental operations are effectively equivalent to a mortgage REIT, I am considering RSO as a mortgage REIT.
Further Clarity of Language
This article will discuss several preferred shares and will use the term "par" value to refer to the stated liquidation value of $25 per preferred share. The preferred shares were technically issued with a different par value but the liquidation value per share is the value investors are usually discussing with the term "par value".
In the case of RSO, the preferred shares are issued with a par value of $.001. See the green box below.
This is merely an accounting choice. I'm using the term "par value" to refer to liquidation value because it is common in the industry.
Weak Mortgage REITs Are Candidates for Pair Trades
The mortgage REIT sector can be a very interesting place to invest because there are some fundamental market failures that can be identified. That makes this part of the market very appealing for pair trades, but it can be difficult to find a great candidate for a pair trade when the company that should be a short-target already trades at around 74% of trailing book value. Investors simply shorting the security take on substantial risk because of the high dividend yield, the ability of shares to move back to trading at a smaller discount to book value, and the potential for a buyout to suddenly change the valuation.
There are few things as ironic as a great pair trade opportunity that uses one part of a company to hedge against the risk of shorting another part of the company. This analysis is designed on the basis of a pair trade that involves shorting the common shares and buying the preferred shares.
Why is RSO a Viable Target for Shorts?
RSO has exceptionally high expenses relative to their equity which drives down the amount of net interest income that would be expected to make it through the income statement. In economic theory it is assumed that investors can easily short securities, but the real world makes it more difficult. The ideal short-candidate is one where the results are fairly predictable. The most predictable result would be a situation where operating expenses are devouring the capital.
The company has a dividend that I found to be unsustainable. By my calculations the portfolio should be expected to produce sufficient net interest income to cover operating expenses, preferred dividends, and about $0.32 per year in dividends on each common share. The current dividend rate on the common shares is $0.42 per quarter. Notice that the value I calculated is materially lower; it is also an annual value instead of a quarterly value. The disconnection between the dividends I would project as sustainable and the current rate is huge. This difference leads to two implications. The first is that the dividend may be slashed within the next year. The second is that the current common dividends should be seen as reducing the book value of common equity.
Better and Better
Remember that RSO's common shares are trading at a price to book ratio of around 74%. The funny thing about book value is there are different ways to calculate book value. I'll start with the GAAP book value as of the end of Q1 of 2016:
The GAAP book value per common share at the end of Q1 of 2016 was $17.12. For simplicity sake, I added an orange circle. Management made that fairly clear in their presentation. However, they also provide "economic book value per share". This image has quite a few boxes I added to highlight different aspects:
The Balance Sheet Vs. The Highlighted Aspects
The previous image for economic book value per share assumed that preferred stock equity takes up $269.977 million of total equity. It also assumes that shares outstanding are 30,306,625. For a quick comparison, let's take a look at part of the "Equity" section from the balance sheet:
The balance sheet has 31,217,415 shares of stock outstanding. It includes 910,790 shares that are unvested and restricted, but I don't see them as fundamentally non-existent.
Colorado Book Value
If I wanted to calculate the book value per share for RSO, I would prefer to use the liquidation value of the preferred shares rather than the proceeds from issuance. It is standard practice to look at the proceeds from issuance, but investors that don't see the current incarnation of the company as being a viable long term investment may prefer liquidation values.
The liquidation value across the 3 series of preferred stock is roughly $285.339 million. That is materially higher than the $269.977 million used in the economic book value. I would also want to use the entire value of shares that were outstanding. Those two adjustments combined would indicate a "Colorado Book Value" of $16.12. Using a book value of $16.12 with a recent share price of $12.64 suggests a trailing price-to-Colorado book value ratio of 78.41%. A discount of about 22% is easier to handle for a short candidate.
There are a couple catalysts that could make this trade a big winner. The first is that a large cut on the common dividend could drive common share prices materially lower for at least a short period which would allow traders to exit the position at a material profit. The second is that a material cut in the dividend would cause the position to become cash flow positive because the preferred dividends would start to outweigh the common dividends. The third is that maintaining the common dividend would result in bleeding out the book value on common equity. If the discount remains at the same percentage it would indicate share prices declining because of a decline in book value per share.
Perhaps the most impressive thing about this trade idea is that it fundamentally changes the way a buyout would be viewed. Normally shorting a mortgage REIT at a discount greater than 20% to book value would be a losing proposition if the REIT announced a buyout the next day. If a buyout is announced, I would expect it to make this trade a huge winner.
Pair Trading - What Happens to Preferred Shares
For your convenience:
- Prospectus Supplement for Series A
- Prospectus Supplement for Series B
- Prospectus Supplement for Series C
In most cases there are several prospectus supplements for each class of preferred shares. I simply selected one for each class so investors could check for any specific issues. All three are cumulative redeemable preferred shares.
The three shares of preferred stock each include a fairly standard option for the company to call the preferred securities at par + accrued dividends during a change in control. The coupon rate on par value ranges from 8.25% to 8.625%. If RSO were bought by a much larger mortgage REIT such as Annaly Capital Management (NYSE:NLY), investors could reasonably expect that Annaly Capital Management would probably want to pay off the issues at par value. If they didn't pay off the issues at par value, they would be expected to trade above par value.
Annaly Capital Management already has 3 series of preferred shares. The original coupon on them runs from 7.5% to 7.875%. As of the morning of 05/30/2016 all 3 series of preferred shares for Annaly Capital Management trade at a premium to par value. I'm not saying Annaly Capital Management will buy up RSO, but NLY's management has been talking about increasing their exposure to credit assets.
If a major mortgage REIT were to buy RSO, it would indicate a high probability of the preferred share holder receiving par (referring to the liquidation value of $25 per preferred share) plus the accrued dividend or being able to sell at a share price in excess of par value.
Pair Trading - A Deeper Look at the Securities
The following charts incorporate the trailing book value using the "Colorado Book Value" figures that value preferred equity at par value and use the number of shares that were outstanding on 03/31/2016 with no exceptions for unvested restricted stock. The chart may seem a little overwhelming at first.
Update: Due to price changes since the article was originally prepared, a new table has been calculated and is shown below.
Returning to original article:
The current yield on RSO's common shares is 13.29%, but my last article demonstrated how the yield was unsustainable and was effectively paying out book value. Because the common shares have a materially higher dividend yield this pair trade will at least initially suggest a negative monthly cash flow. By my estimates the cash cost of the common dividends would be $1,329.11 on a position with an entry price of $10,000. However, I'm also estimating that about $1,079.04 of that would be driving a decline in book value per share all else equal.
If the common dividend was decreased from $.42 per share per quarter to $.316 per share per quarter the trader's annual dividend outflow on the common shares would drop to $1,000 per year. That would put the position in a very slight positive position for cash flows.
The book value acquired for $10,000 if we use the liquidation values on par and the number of shares that were outstanding (including those unvested and restricted shares) would be $12,756.75. However, if a buyout were to happen management would collect a termination fee. By my estimate that termination fee would be about $55.694 million. That would reduce the book value per share by about $1.78 per common share. On a position of 791.14 shares the decline would cut the book value by about $1,411.45. That leaves $11,345.3 as the amount of book value allocated to 791.14 shares.
I believe any discussion for a buyout of the mortgage REIT would start no higher than this value. Based on previous deals in the mortgage REIT sector I think the buyer would want to only offer about $.90 on the dollar. The might negotiate as high as $.95 on the dollar, but that is the most optimistic scenario I can see for common shareholders.
If a buyout came to fruition at 95% of the remaining book value after all adjustments the trader shorting RSO would be stuck paying $10,788 to close the position. At 90% they would be stuck paying $10,211. On the other hand, their preferred shares would be worth around $12,000 to $12,350. The capital gain on closing out the pair trade would be expected to run around $1,200 to $1,550.
The Pair Trade Cash Flows
The following chart shows the expected cash flows for a pair trade. I'm using RSO-C for the example, though an investor could still use RSO-A or RSO-B. I picked RSO-C because it offered a stronger yield. The notional value for the pair trade is demonstrated at $10,000. I expect traders subscribing to my service would intend to swing larger balances in a pair trade but the $10,000 figure makes it very easy to scale the values.
Update: The chart below has been updated based on the new values from the top chart which include prices as of 07/06/2016.
The text following this chart will refer to the numbers from the original chart. The case for making this trade now has weakened materially relative to the case when the article was initially published.
Returning to original article:
Without a buyout and with common shares continuing to trade at around a 25% discount to GAAP book value the position would create a negative annual outflow of $286.94 per year. Since I believe the dividend is unsustainable, I would expect the common dividend to be draining book value. The estimated decline in book value is reflected as a decline of $1079.03. Adjusting for the 75% discount to GAAP book value the decline in share price is only 75% of the decline in book value. The result is a projection for share price decline on 719.14 shares to provide gains of about $809.23. After subtracting the outflow for the dividends the annual expected gain would be $522.33. That isn't too bad for a position that includes hedging with shares from the same REIT. In the event of a buyout announcement I would expect the position to generate a fairly sudden capital gain of $1,305.13 to $1,872.36 per $10,000.
If a dividend cut is announced for common shares it would be very favorable. It could fix the quarterly net dividend cost. Since a decline in book value is only valued as reducing share price by 75%, a decline in the dividend would be substantially better since 100% of the savings would be realized immediately.
If a common dividend cut is announced, there is also a material chance of common shares falling hard enough for traders to close out the position and pocket a significant gain. I believe there is a fairly substantial chance that this is how the pair trade ends. If investors are up 12% to 15% on the trade, then I believe they should close out the trade and walk away. Because price swings can be fairly substantial, this would be a good candidate for keeping an active order to automatically close the trade if the target gain can be locked in.
The Next Dividend Announcement
RSO regularly declares their dividend near the end of the quarter. The dividend for June has not been declared yet so there is a chance for the cut to occur in June and to drive this trade to a quick close. If the dividend is maintained there could be a temporary rally in common shares. Any rally that sees common move higher relative to preferred shares would be another great entry point or a time to double down. If management sustains the dividend, the cost to book value should still drive down the book value to create gains on the position over time.
The caution on this trade is that investors need to be fairly patient with it. There are several catalysts that could drive the trade to completion and I believe it will produce excellent results. However, it could take several months or even a year to play out.
When a mortgage REIT trades at a significant discount to book value it can open up some unique pair trading opportunities. In a very interesting twist the risk of shorting RSO's common stock can be hedged with the preferred shares. The reason this trade is possible is because RSO has high operating expenditures relative to shareholder's equity and a large termination fee if the REIT breaks the management contract. This trade is designed to capitalize on the very costs that I expect to drag down returns for shareholders of the common stock.
Since this article provides extensive details on how to analyze and execute an effective pair trade strategy, I want to emphasize that absolutely no investment advice has been provided, is being provided, or will be provided. This article only contains my thoughts on the subject and all analysts will occasionally make mistakes.
I believe there is substantial risk in both the common and preferred shares of RSO. The only way I could reasonably suggest buying into this opportunity is using a pair trade. Because this pair trade gives investors the security with higher seniority and multiple catalysts I believe it is one of the best pair trades I've found.
Offer for Subscribers
Since the Mortgage REIT Forum is a new exclusive research platform, the first 100 subscribers will be able to lock in their subscription rates at only $240/year. My investment ideas emphasize finding undervalued mortgage REITs, triple net lease REITs, and preferred shares. With the market at relatively high levels, there is also significant work on finding which securities are overvalued to protect investors from losing a chunk of their portfolio.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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