Resource Capital Corporation (NYSE:RSO) has been a difficult mortgage REIT for many investors and analysts to understand. I'm working on dispelling some of that confusion by breaking out how RSO should function in the future. This work requires comparisons to Blackstone Mortgage Trust (NYSE:BXMT).
In the last article, I demonstrated how RSO's plan calls for closing down or selling off the non-core business lines. As a mortgage REIT focusing on CRE (Commercial Real Estate), I believe RSO has quite a bit of upside. However, the company needs to make some significant changes to their capital structure as part of the change.
You may remember that during the earnings call, management indicated they did not expect to be actively repurchasing shares. Since they traded at a huge discount to book value, I wasn't too big on that decision at first. However, my view is softening in that regard because I believe there are some other activities that should be high priorities for RSO.
A Different Kind of Buyback
Rather than repurchasing common stock, I would like to see RSO seeking to buy back some of their bonds and preferred stock. Remember that the common stock dividend has been slashed to $.05 per quarter, but the costs on their bonds and preferred stock remain exceptionally high. Normally, a mortgage REIT would use preferred stock to acquire additional capital at rates lower than the dividends paid on their common stock. However, the preferred stock of RSO carries much higher rates. The coupon rates run from 8.25% to 8.63%. For comparison, BXMT does not have preferred shares.
Winning as a mortgage REIT over the longer time period is influenced very heavily by containing costs. The lower the costs are, the more capital there is available for investors. While many investors may love the idea of getting a 14% dividend yield, I don't believe earning a 14% return on equity is even remotely feasible at reasonable risk levels. Allow us to toss that pipe dream out.
Neither buying back preferred shares nor buying back bonds would be favorable for earnings unless the buybacks occur materially below call value (preferred stock) or face value (bonds) because the book values assigned to each category are less than the call value or face value.
This could be a difficult area because management may have to decide between maximizing these fees in the short-run and preparing the company to grow significantly longer in the long-run. The strategies are not compatible, choosing either one requires sacrificing the other. To quote page 81 of the 2016 Q3 10-Q:
"Base management fee is a monthly fee equal to 1/12th of the amount of our equity multiplied by 1.50%. Under the management agreement, "equity" is equal to the net proceeds from any issuance of shares of capital stock less offering related costs, plus or minus our retained earnings (excluding non-cash equity compensation incurred in current or prior periods) less any amounts we have paid for stock repurchases. The calculation is adjusted for one-time events due to changes in GAAP, as well as other non-cash charges upon approval of our independent directors. The base management fee decreased for the three and nine months ended September 30, 2016 as compared to the three and nine months ended September 30, 2015 due to decreased stockholders' equity, a component in the formula by which base management fees are calculated, primarily as a result of our repurchase of approximately 8.3% of our outstanding shares as part of our $50.0 million repurchase plan and quarterly dividend distributions in excess of earnings."
This structure of management fee is pretty standard for an externally management mortgage REIT. The ones doing CRE also often have incentive fees. RSO's contract includes incentive fees, but poor performance lately has prevented any charges.
The problem here is the management fee going onto all "capital stock" means it is also applied to preferred shares. Consequently, for the preferred shares to be a positive factor for the common shareholders is even more difficult. Using RSO's ending BV of $14.71 with their shares outstanding at 31,071.737 (decimal because this is in thousands) suggests total common equity of $457,065. Compared to total stockholders' equity of $719,752, the preferred equity must be $262,687. How many preferred shares are outstanding? 11,413.595.
Divide the preferred equity by the shares outstanding and you get the average preferred equity per share of preferred stock at $23.02 (rounded). Note that this is materially different from the standard call value of $25 per share.
Using RSO-A as an example:
The coupon rate of 8.5% is based on a value of $25. The annualized dividend should be $2.125, and the historical recorded value for dividends paid comes in at $2.13 (rounded). That math checks out. If we assume that the $23.02 base can be applied equally across all 3 series of preferred stock (a slight simplification), the cost for $23.02 comes out to $2.125 in dividends plus $.345 (rounded from $23.02*1.5%) in management fees. That comes to an annualized cost of $2.47 or an effective cost of 10.73% on the $23.02.
Remember that the common dividend was slashed to only $.05 per quarter despite a Q3 book value of $14.71. The yield on trailing book value for common stock is only 1.36% (rounded from $.20 / $14.71). Even if the business, after it is fixed, generates strong enough net interest margins to cover such a high effective cost on the preferred equity, it would only come at substantial risk because it requires significant leverage to earn yields above 10%. In my view as both a shareholder and an analyst, the level of risk relative to the level of potential reward is too low. Therefore, I'd love to see the company buying back shares of the preferred stock which have lately been seen trading between $21.50 and $22.50.
I believe a reasonable valuation on RSO would put them in the range of $9.50 to $11.00 per share. This would still leave them at one of the largest discounts in the sector. I find it hard to justify any scenario where RSO remains at a discount materially larger than any of the other mortgage REITs when commercial mortgage REITs are generally trading at materially higher valuations than the sector average.
This is another strong buy rating on RSO with shares recently trading around $8.40 per share.
To fix RSO and allow it to deliver excellent returns to shareholders, management will need to restructure the business to remove sources of financing that are simply too costly for common shareholders. That includes both bonds and preferred shares. The effective cost of preferred equity is exceptionally high because it includes both a high coupon rate and expands the base upon which management fees are levied.
I feel it is my duty to go beyond the disclosures attached to the article. As an investor, I own shares of RSO and shares of RSO-B. Which preferred shares would make the most sense for the company to repurchase would depend on the prices at the time of the transaction, but this kind of plan could increase the value of both the preferred shares and the common stock. As an investor, I would stand to benefit from gains in both areas.
Want to see these articles before they go public? Want to see the research I'm doing each week to pick the investments for my portfolio? Consider joining The Mortgage REIT Forum. For the cost of one lunch per month, you can get access to the research I'm using for managing my own investments. On average, I publish about 3 subscription articles per week. One is for calculating new estimated book value for several mortgage REITs and finding the current discounts to those estimates. Another covers the preferred shares for each mortgage REIT that has preferred shares. The third is used to either preview articles I'm working on for the public or to provide real-time updates on liquidity failures where prices for a small number of securities detached from other similar stocks. When RSO released their earnings and cratered, I was the first one there to spot shares under $8.00. I called it out when Resource Capital Corporation went on sale.
Disclosure: I am/we are long RSO, RSO-B.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. Tipranks: Assign buy rating