As the British comedian Douglas Adams once wryly noted, “Nothing travels faster than light, with the possible exception of bad news, which follows its own rules”. Indeed, the bad news careening through the financial services industry has now permeated every corner of the market, forcing even the once impermeable Bear Stearns (BSC) into a government-sponsored survival suit.
The well-publicized crisis in the mortgage market has by now forced write downs and write offs of anything that is mortgage related, never mind the near bankruptcy of Bear Stearns. Even once sacrosanct “agency mortgage securities”, those mortgages guaranteed by quasi-governmental Fannie Mae (FNM) and Freddie Mac (FRE), are trading at a discount.
For those prescient few who saw this coming, 2007 was a year to position for a correction. There are two primary ways to position for a downturn, and Northstar Realty Finance (NRF), an internally managed Mortgage REIT that invests only in commercial mortgages, took them both.
The first is to maintain deal flow but slow asset growth by underwriting only to the highest standards with the best sponsors and at appropriate and rational risk/reward levels. Thus, through deliberately prudent underwriting, Northstar intentionally reduced direct originations of real estate debt in 2007 by almost 50%, down from 74 new loans in 2006 to just 41 in 2007.
The second is to strengthen the balance sheet and raise cash. Northstar, in essence, went very long on cheap liabilities. The Company entered into a new $600 million term loan facility which eliminated mark to market risk based on credit spread movements and interest rate fluctuations, and sold $135 million in loan exposure, at par, which returned equity and reduced future funding commitments.
While not directly impacting the Company’s liquidity except through increased management fees, in February of 2007, NRF also launched N Star IX, an $800 million CDO, which is the ninth in its “N Star” series of managed CDOs. The N Star managed CDOs are absolutely beautiful things to behold from a credit perspective: the aggregate upgrade/downgrade ratio is a stunning 25:1
In addition to Northstar’s managed CDO’s, the Company has directly issued approximately $4 billion of term financing via its own issued CDOs. If Northstar’s managed CDOs are absolutely beautiful to behold, Northstar’s issued CDOs are pure gold, and Northstar is about to take it all to the bank.
Not only have these issued CDOs never experienced a downgrade and continue to perform as expected, but 15 classes of notes have actually been upgraded. Most importantly for shareholders, these CDOs are in their reinvestment period. This means that as the loans inside the CDOs mature and pay off, Northstar can reinvest the proceeds at vastly improved spreads over their average cost of funds, which have been locked in at about a 50 basis point spread over swaps. Northstar has almost complete discretion in determining how and when to reinvest these funds.
While the company says it is difficult to determine exactly how much capital may be recycled due to performance-related extension options, approximately $427 million of NRF’s funded loan commitments have their initial maturity date in 2008. This is an enormous advantage in an environment where the capital markets have virtually shut down, cutting off capital intensive REITs from the fuel they must have to grow earnings.
Because the current lending environment is so constrained, the terms on which NRF can invest these recycled proceeds have also improved dramatically. The market for floating rate loans, which make up almost 90% NRF’s portfolio, has increased from LIBOR plus 250-350 bps in 2006 to LIBOR plus approximately 400-550 bps today (depending on term, structure and LTV). These vastly improved spreads will flow directly to earnings as the capital is reinvested.
NRF also indicated its intention to monetize the above-book value of its healthcare and net lease portfolios in 2008. This will allow NRF another opportunity to recycle cash into higher yielding investments and boost its historically strong ROE of over 20% (net).
As of year-end, the Company’s careful underwriting has resulted in strong credit performance with no credit losses and no non-performing assets, not only in the N Star CDO series, but also across entire $7.4 billion managed asset base. Northstar has consistently grown its Adjusted Funds From Operations and dividend, which increased 19% and 12%, respectively, over 2006 results.
With a .36/share dividend declared in the fourth quarter, Mr. Market has priced the stock to yield in excess of 19%. While 2008 will undoubtedly bring more challenges and there is considerable uncertainty generally, NRF’s historically strong performance and 19% yield would seem to compensate even the most adventurous investor pretty well.
Disclosure: Author has long position in NRF; no postions in BSC, FNM or FRE