The last year has been a tough one for RAIT Financial Trust (NYSE:RAS). Shares have lost approximately 40% of their value and the dividend was chopped in half. Excessive balance sheet leverage has been a concern. Even good news such as the $120 million sale of their managing stake in Independence Realty Trust (NYSEMKT:IRT) has been ignored. Not surprisingly, an activist investor has been attracted by this combination of poor stock performance and a major cash windfall.
RAS is a diversified REIT. They are an active commercial real estate lender. They are a property REIT that owns $2.2 billion of property with a focus on owning and managing apartment complexes. RAS is an asset manger that built IRT and manages $5.5 billion of assets. RAS has an extremely complex balance sheet that includes the consolidated assets and liabilities of IRT. Leveraged CDO and CMBS securities managed by RAS are also included on the consolidated balance sheet even though RAS only owns a relatively small equity stake in these issues. Given this complexity, it's little wonder that the RAS issues are so misunderstood. This article will compare the 11.9% yield of RAS, the 9.2% yield of the RAS-PA preferred stock and the 9.4% yield to maturity of the RFT debt issue.
What is RFT?
RFT is a par $25 exchange traded debt issue that matures on 4/15/2024. It has a 7.625% coupon and interest is paid quarterly. See prospectus for additional details. At a recent price of $22.76, RFT is trading at a cash yield of 8.3% and a yield to maturity (calculated from my Excel model) of 9.4%. Various free web tools such as this one can be used to calculate the yield to maturity. RFT has an average daily trading volume of approximately 10K shares. Limit orders and patience are recommended when trading.
I currently favor RFT, but some investors may prefer the shorter maturity of the RFTA exchange traded debt issue. See my RFTA article for more information. RFTA matures on 8/30/2019 and now offers a 7.2% cash yield and an 8.1% yield to maturity (calculated from my Excel model) at a recent price of $24.63
What is RAS-PA?
RAS-PA is a par $25 cumulative preferred issue with a 7.75% coupon. Dividends are paid quarterly and RAS-PA now yields 9.2% at a recent price of $21.10. It's a perpetual issue, which means that the company has no obligation to call it. RAS-PA may be called at par at any time. See prospectus for additional details. RAS-PA, RAS-PB and RAS-PC are similar cumulative preferred issues with equal seniority. RAS-PA is the largest of the 3 preferred issues and has an average daily trading volume of approximately 15K shares. Limit orders and patience are recommended when trading.
Why did RAS need to deleverage its balance sheet?
Prior to 2016, RAS maintained a very aggressive payout ratio on its common stock. High dividends supported the stock price and enabled capital to be raised through repeated secondary offerings. Secondary offerings were completed on 12/8/2012, 3/28/2013, 1/14/2014 and 7/30/2015. Things changed when Kinder Morgan Inc. (NYSE:KMI) was forced to cut its dividend in December 2015. This sent shock waves throughout the high yield sector. Mr. Market demanded a more sustainable dividend model.
RAS responded by slashing it's quarterly dividend from 18 cents per share to 9 cents per share in order to retain more cash. There was also a large looming debt issue to deal with. RAS has $142 million of convertible 4% bonds (CUSIP #749227ABO) outstanding. The 4% bonds mature on 10/1/2033, but bondholders have an option to put them to RAS at par on 10/1/2018. This is a low coupon issue and RAS is trading at less than 1/3 the $9.57 conversion price. Most bondholders are expected to demand repayment on 10/1/2018. RAS must ensure strong liquidity is available to prepare for this.
IRT stake sold for $120 million
RAS started the balance sheet deleveraging process with a dividend cut to retain more cash. The sale of 8 properties in Q1 and Q2 for $66 million further improved liquidity. The sale of the Independence Realty Trust shares and asset management rights for $120 million put them well over the top. RAS now has more than enough liquidity to deal with the $142 million 10/1/2018 put option.
RAS still has almost 2 years ahead of the 10/1/2018 debt maturity. Funds will be invested, but with a shorter term horizon. As President Scott Davidson notes in the press release: "It allows us to internally generate capital to support our leading real estate lending platform..."
Why is Highland Capital targeting RAS?
According to this 10/6/2016 SEC filing, A group of funds controlled by Highland Capital Management has acquired a 2.4% stake in RAS. The filing states that Highland intends to play an activist role including:
"The Reporting Persons intend to engage in discussions with the Company and Company's management and board of directors, other stockholders of the Company and other interested parties that may relate to the governance and board composition, business, operations, cost structure, management, assets, capitalization, financial condition, strategic plans, and the future of the Company"
This is an ideal time for an activist investor to target RAS. RAS has underperformed it's peers as the REIT sector has rallied. A vacuum has been created as both the CEO and CFO will be departing to IRT. Shareholders are still upset about the recent dividend reduction. RAS is flush with cash as a result of the $120 million windfall from the IRT sale.
RFT trades at a discount to the 2031 bonds
RFT appears to be undervalued as compared to the larger ($115 million par value) 7% convertible bonds maturing on 4/1/2031 (CUSIP #749227AA2). At a recent price of $85, the 2031 bonds are trading at a yield to maturity of 8.8%. RFT offers a 9.4% yield to maturity with a more desirable 2024 maturity. The conversion option on the 2031 bonds at $7.70 per share (adjusted for the 1:3 reverse split on 7/1/2011) is far out of the money and appears to be of little value with RAS now trading at around $3. Many retail investors prefer easy to trade baby bonds such as RFT as compared to bond market issues.
Balance sheet leverage is over-stated due to consolidation
RAS calculates the Q2 2016 interest coverage (See schedule I) of it's debt as 1.83X. The coverage of interest and preferred is calculated as 1.46X. However, these ratios are based on total consolidated debt including non-recourse debt. For example, all IRT debt and assets were consolidated on the Q2 balance sheet. As of 6/30/2016, RAS had total consolidated debt of $2.98 billion, but only $480 million of that total (See Schedule 1) was recourse debt. This balance sheet consolidation of "non-recourse debt" for GAAP accounting purposes creates a rather misleading view of balance sheet leverage. Effective leverage and implied credit risk are grossly over-stated.
A breakdown of non-recourse debt is provided on page #27 of the 2nd quarter 10Q filing. Non-recourse debt includes $756 million of CDO notes and $587 million of CMBS securitizations. The maximum actual risk to RAS is it's small equity stake in each of the CDO's and CMBS issues it manages. There is also $856 million of loans payable on real estate. This includes properties owned by IRT as well as RAS. The maximum risk to RAS is it's equity stake in IRT (which has subsequently been sold) and it's equity stake in each specific property.
1.4X dividend coverage for RAS
Cash available for distribution is a useful metric that many REIT's use to measure the cash available to pay common stock dividends. RAS generated cash available for distribution of 26 cents per share for the 6 months ended 6/30/2016. With the quarterly common dividend at 9 cents per share, the dividend coverage is now (26 cents / 18 cents) = 1.4X. Some cash flow will be lost from the sale of 8 properties and the IRT stake. However, this lost cash flow should be replaced shortly as additional capital is put to work making real estate loans. The 1.4X dividend coverage for RAS is very good for an issue with an 11.9% yield.
2.8X dividend coverage for RAS-PA
For the 6 months ended 6/30/2016 RAS had cash available for distribution to the common stock of 26 cents per share on 92 million shares which is $24 million. The combined preferred stock dividends for RAS-PA, RAS-PB, RAS-PC and the privately held RAS-PD amounted to $13.7 million for that 6 month period. The preferred stock dividend is senior to the common. Therefore the preferred stock dividend coverage is now (24+13.7)/13.7 = 2.8X. This is a good preferred coverage level given the 9.2% yield.
Note that the cash available for distribution coverage ratio is calculated at the holding company level. I believe that this CAD metric is more meaningful than the 1.46X coverage preferred dividend and interest coverage ratio calculated in Schedule 1 of the Q2 earnings report. The Schedule 1 ratio is presented in the required GAAP accounting format. However, this is misleading since it does not differentiate between recourse and non-recourse debt on the consolidated balance sheet as discussed above.
Could RAS declare a special dividend?
RAS should have a windfall gain from the IRT transaction given that they received $43 million above the fair market value of the IRT shares to reflect their asset management rights. The successful efforts by RAS to launch and develop IRT over several years finally paid off. RAS is sitting on a nice honey pot from the IRT sale. This may have helped to attract the attention of Highland Capital. Activist investors frequently demand special dividends when excess cash is available and that could be one of their goals here.
What are the risks?
While the activist investors might reach an amicable agreement with RAS management, it would be expensive if there is a hostile proxy fight. Like other REIT issues, RAS is vulnerable to any potential disruptions of the real estate or financial markets. RAS will lose some top management to IRT including Chief Executive Officer Scott Schaeffer and Chief Financial Officer James Sebra. While this could be disruptive, the planned appointment of a new CEO (the current President) has already been announced. Even with the balance sheet deleveraging in progress, RAS still has significant leverage.
Few compelling valuations are currently available elsewhere in the REIT sector and RAS offers 3 different ones to choose from. RAS has a hefty 11.9% dividend yield with 1.4X coverage. The emergence of an activist investor could pressure RAS into paying a special dividend. RAS-PA is less risky than RAS. The 9.2% preferred stock dividend has 2.4X coverage as calculated using a cash available for distribution methodology. RAS-PA has the potential for capital gains as well as an attractive dividend. The RFT debt issue offers a generous 9.4% yield to maturity with less credit or interest rate risk than RAS-PA.
Note: My Panick Value Research Report is focused on high-yield preferred stocks, exchange traded debt issues and other undervalued high-yield opportunities. Members receive an advance look at all my articles as well as continued coverage. Readers are invited to check out the 2-week free trial in the Seeking Alpha Marketplace. Subscriber reviews can be viewed here.
Disclosure: I am/we are long RAS, RFT,RAS-PA.
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.