Newcastle, RAIT Financial: The Long Case for REITs

What is the best thing in the world? Perhaps it is a stock with upside potential of, say, 300% in two years, while at the same time paying you in excess of 20% just for holding it. Not to mention very low risk in comparison to how much one stands to gain.

I just read in the Wall Street Journal that several big-name small cap mutual funds are now accepting new money for the first time in years. The reason: ridiculously low valuation on many small cap companies. The REITs that I mention below are exactly the type of companies that these mutual fund managers are looking at, and it is also why these institutional investors are looking for more cash.

Let's face it - the credit crisis is pretty much over. Yet, although REITs have bounced off their recent lows, their valuations are not fully reflecting the new market sentiment. Although regional banks have had their earnings clobbered in recent quarters, many REITs have maintained, and even increased, their profits. Yet the market is grouping them all together and applying very similar multiples.

Newcastle Investment Corp. (NCT) is my favorite commercial REIT right now. Although it payed a $0.72 quarterly dividend in 2007, it was cut to $0.25 in the first quarter of 2008 in order to raise liquidity. In addition, they greatly reduced their recourse debt (the debt that subjects NCT to margin call). NCT reported earnings May 12 and they booked a loss of $0.84 per share - but that was mainly due to one-time charges on their subprime portfolio (only 8% of their overall holdings). If you look at their actual performance, they generated a profit of $0.56 per share - better than what analysts predicted ($0.49).

In addition, Newcastle's fair book value is over $16 per share - thats a 60% premium from where the company is trading today. Not to mention the dividend. Sure, Newcastle may pay a 25-cent dividend for the next quarter or two, but it certainly will raise it once management is sure that the credit markets are on solid ground. If NCT raises their dividend back to 2007 levels, the effective yield would be close to 30%. Even if NCT cannot afford those levels and raises it to, say, $0.50 per quarter, the yield is still around 20% - not to mention the pop you will see in the stock price when this is announced. I am certain that it is not a matter of IF Newcastle will raise its dividend, it is a matter of WHEN.

RAIT Financial (RAS) is another REIT with huge return potential. Currently, the dividend yield is over 20%. It reported first quarter earnings on May 6 and booked a profit of $0.52, compared to $0.34 a year ago. In addition, Friedman Billings Ramsey analyst Merrill Ross wrote in his research report that the company has proved its dividend is viable. The dividend is currently 46-cents per quarter, all of which is being paid with cash generated from its business. This is important - RAIT is not dipping into reserves to pay its dividend. But wait? I thought that pretty much all CDOs were worthless? Well... I guess not.

A few other names worth taking a look at are Northstar Realty Finance (NRF), Anthracite Capital (AHR), and Crystal River Capital (CRZ). However, in my opinion, none of them represent as good of an opportunity as NCT or RAS.

One last word: never put all your eggs into one basket, no matter how convinced you are in a particular stock - make sure you diversify within and among industries. I love NCT and RAS, but I own other REITs as well (AHR and NRF). It is vital that you don't endanger your financial future by throwing the proverbial Hail Mary. That, my friend, would be simply foolish.

Disclosure: author holds position in NCT, RAS, AHR and NRF

Comments

[The Devil is in the Details]

This would be the first financial ever with negative book value to boost the dividend ever. You should check out page 29 of 10-Q for the 1Q08 that highlights how close NCT is to triggering covenants on its funding

[Index_Is_Hard_To_Beat]

Generally agreed but this analysis completely discounts any problems with NCT's commercial real estate loans (most of their portfolio) as we are heading into a recession and there will not be clarity on that for several quarters.

[Uncommon Sense]

Devil, you should listen to the conference call - they explain the negative book value. The GAAP book value only reflets market value changes for securities and derivative and does not mark their loan investments or debt. Because of dramatic spread widening in the quartrer, the GAAP book value was negative. However, the number in no way represents the the company's true economic book value. A beter metric to use is the adjusted book value, which for Newcastle comes out to $16.23 and is equivilent to FAS 159.

I hope this answers your question...

[The Devil is in the Details]

Positive fair value adjustments based on declining prices for a company's liabilities implicitly assumes that a company has the capital (or access to it) to repurchase those liabilities at a discount to face and issue new liabilities at par. Last time I checked, NCT cut its dividend to preserve capital, sold $1.3bn of assets at a loss (including $700m+ of GSE paper), and made little new investments. If NCT could get funding to to repuchase its current debt obligations below par and issue new funding instruments and arb the spread, why is the company so focused on reducing its recourse funding rather than repurchasing its debt?

[Patrick1980SC]

I'm also a RAIT shareholder, and I was very encouraged by the conference call. RAIT is continuing to grow its portfolio through European deals and the operating earnings are more than covering the dividend. I think it will be another year before RAIT raises the dividend because they elected to treat the last dividend of 2007 as belonging to 2008 for tax purposes. Thus RAIT will need sufficient taxable income to cover effectively five dividend payments for 2008, which I can't really envision at this point.

[stretcho44]

Fair Value adjustments for liabilities is an improvement that will soon be required of all U.S. companies the way it is for foreign companies today. FASB will soon require it. Migration has been underway since 2002.

The application of Fair Value does not imply any need to repurchase the liabilities. It does however give a much better current value of the company when comparing asset values that are required to be marked to market value.

The NCT $1.3bn from the sale of assets was used to pay down liabilities. The liabilities were not paid off at face value. The liabilities were paid off at market value.

[Jimbo nd]

Nearby was a Levitz which is no more. Closer still is a Linens & Things that will close soon. In between is a Starbucks that is underperforming.

Facing a rent increase, a neighbor's company sent much of their staff home (to work remotely, that is) and now occupies just half the space for even less than half the previous lease amount.

These alone don't indicate a huge problem but they certainly appear as caution flags to my eyes.

[Jimbo nd]

So, how are your NCT and RAS buys working out for you? Looks like maybe the credit crisis really isn't "pretty much over."