CreXus Investment Corp. (CXS) presented its IPO in 2009 - just over three years ago - and began operating as a real-estate investment trust (REIT) primarily focusing on commercial mortgages and mortgage-backed securities (CMBS). CreXus is externally managed by Fixed Income Discount Advisory Company (FIDAC), a wholly owned subsidiary of Annaly Capital Management (NLY). In the relatively short span of its operations, CreXus has achieved 5-star Motley Fool CAPS status and has begun to stand out as an effectively performing commercial mREIT. In what follows, I would like to present some of the facts and figures about CreXus and discuss why this company looks like an investment worth serious consideration.
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The Basics: CreXus has a market cap of $828.37 million, placing it among the small-cap mREITs. By way of getting a feel for the company and its performance, I have prepared a comparison of CreXus with four other mREITs: Colony Financial (CLNY), NorthStar Realty Finance (NRF), Anworth Mortgage Asset (ANH) and American Capital Mortgage Investments (MTGE). Both Colony and NorthStar are commercial mREITs, while Anworth and American Capital are residential mREITs. While this may seem a bit like comparing apples to oranges, all are small-cap companies, and CreXus does include in its portfolio a small portion of residential mortgage-backed securities (RMBS), making a superficial comparison reasonable. (NOTE: an entry of 0.00 in the following tables indicates that that information is not available.)
CreXus does not stand out above the other four companies on an item-by-item examination except for two: with a debt/equity (leverage) ratio of .02, CreXus carries the least debt load of the group; its current ratio (the company's liquidity ratio) 18.18 indicates that CreXus can handily manage its current liabilities (while Anworth and American Capital Mortgage would have to finance the payment of their respective liabilities).
When considered across the board, however, CreXus exhibits solid figures; it may not shine like a stellar investment, but it gives every indication of being a steady performer - one that seems to be effectively and efficiently run. In terms of revenue, earnings per share and performance over the past 12 months, CreXus falls towards the middle of the group, although its profit margin comes in second to American Capital Mortgage at 86.03%.
Performance: Considering performance (for the past 12 months), the profit margin and the current ratio, one would get the impression that CreXus is, in fact, being run efficiently and effectively; the following table gives us a closer look at some performance data which can help us to determine the extent to which this is true:
In terms of return on assets, return on equity and return on investment, CreXus performs better than its peers (in some cases, significantly better). Each of these figures indicate a company that is utilizing its resources more efficiently than some of its competitors/peers, and is gaining for its shareholders a substantial return on their investment.
CreXus' price-to-earnings ratio of 7.61 is towards the middle of the range staked out by our group of peers. While this would indicate favorable investor outlook for the company, it does fall a bit short of the 12.57 claimed by Colony. With regard to the price-to-book ratio, most of our companies are below 1, which could indicate that either these stocks are undervalued or that they have fundamental problems in their operations. The latter case is certainly a possibility with NorthStar, which has a negative earnings-per-share, a negative profit margin, and negative returns on its assets, equity (-25.59%!) and investment. In the cases of CreXus, Colony and Anworth, however, the data would seem to support - at least at face value - the position that these companies are undervalued at present.
Indeed, considering CreXus' book-to-share value of $11.95, and cash-to-share value of $11.30, would seem to substantiate that CreXus is currently undervalued, as both figures exceed the current share price of $10.81. The undervaluing may not be substantial, but there is reasonable expectation for eventual increase in share price. This holds, as well, for Colony and Anworth, although to a lesser degree as their cash-to-share values are not as pronouncedly high as that of CreXus. Following this line of reasoning, American Capital Mortgage would seem to be overpriced, given that its book-to-share value is currently less than its share price by $3.05, or approximately 12%.
Dividends: One of the driving forces behind the popularity of mREITs recently has been the attractive dividend yields. It is hard to pass up the opportunity to make from 10% - 16% dividend yield, which is substantially higher than the yields offered up by the average company. Let's take a look at how our group stacks up in this regard:
The comparison to make first is between the earning-per-share and the annual dividend for each company. Ideally, earnings should exceed the actual dividends paid, although that need not be the case in all circumstances. In the event of a shortfall, many companies maintain cash reserves that can be accreted to the earnings-per-share to cover dividend payments, but the extent to which this practice can be implemented is dependent upon (A) the size of the reserve fund, and (B) the period over which earnings-per-share must be supplemented. In our group, only NorthStar falls short (in fact, it has negative earnings-per-share). All other companies are able to comfortably cover dividends (to one degree or another).
To focus on CreXus, it should be noted that, given the company's standing with regard to cash-per-share - as well as their returns - CreXus does seem to have a sustainable yield. Indeed, CreXus has been in the admirable position since its inception of being able to regularly increase - or at least maintain - its dividends. The only exception to this pattern coming in the first two quarters of 2012, when it had to implement a substantial $.08-per-share cut to $.27 in the first quarter of 2012 from $.35 in the fourth quarter of 2011. The lower level was maintained in the second quarter of 2012, but CreXus was able to increase the third quarter dividend to $.32. The chart below provides CreXus' dividend history:
Risk Factors: mREITs, by their very nature, involve a certain level of risk. They are, as it were, a balancing act between a portfolio of assets, on the one hand, and an accumulation of leverage-by-debt, on the other. At the same time, while many of these risk factors can addressed by the company, not all can. Yet all risk factors can affect the ability of the company to operate profitably. We can break these risks factors down roughly into four categories (a complete breakdown of risk factors would be more complex and detailed):
- Management: CreXus relies upon external management for its operations;
- Assets: The acquisition of MBS, and financing the operation of other businesses;
- Liabilities: The securing of resources with which to acquire and maintain the properties in its portfolio;
- Business Environment: The economic and legal constraints within which any company must operate.
Management: As mentioned at the beginning, CreXus is externally managed by FIDAC, a wholly owned subsidiary of Annaly Capital Management. Many of the senior managers of CreXus, as well as a number of Directors, are also employees of FIDAC/Annaly. At present, the management relationship is governed by a contract through December 31, 2013. Unless renewed by that time, CreXus would need to secure alternative management. Also at present, CreXus is reliant upon the business expertise and resources of FIDAC/Annaly, and any limitations to that expertise and those resources could adversely affect the operations of CreXus. Furthermore, Annaly is also an mREIT, and also serves in a management capacity for Chimera Investment (CIM), another mREIT. This presents the possibility that conflicts of interest between the companies may arise, with Annaly having substantial influence in any decisions made by any of the involved companies.
With regards to the continued relationship between CreXus and FIDAC/Annaly, Annaly presently holds approximately 12.4% of CreXus' common shares, thus giving it an interest in CreXus' continued operations (although Annaly is, at present, free to sell its shares). As one of the largest mREITs currently operating, Annaly has acquired significant experience in the business, and has a reputation for being a well-run, successful business in its own right. This expertise is applied to CreXus' operations through FIDAC. Finally, the focus of the three companies (CreXus, Annaly and Chimera) limits possible conflicts of interest: CreXus is a Commercial mREIT, Annaly is a Residential mREIT focusing on Agency-guaranteed MBS, and Chimera is a Residential mREIT focusing on non-Agency MBS. Should the management feel that conflicts of interest are inevitable between CreXus and the other two companies, it would perhaps need to consider engaging new management services.
Assets: Inasmuch as the vast majority of its portfolio consists of CMBS and commercial financing instruments, CreXus is vulnerable to the operations of those companies with which it is involved; the ability of CreXus to operate, and provide returns to its investors, is dependent upon the ability of its holdings to function effectively. The portfolio must be diversified to avoid a narrow market focus, leaving CreXus vulnerable to isolated market fluctuations. As with RMBS, commercial holdings involve a variety of factors that may diminish the value of the holding: declining property value, prepayments, defaults, economic slowdowns, and poor onsite management of properties resulting in diminished productivity. Senior loans to a company are at a disadvantage with respect to interest rates, while mezzanine and other subordinate loans - which may carry higher interest rates - may be inadequately covered by the value of the property in the event of default.
CreXus has displayed the willingness and ability to sell holdings that are not performing satisfactorily; and it does have, in some cases, the right to replace the management of a holding with more effective management. CreXus maintains a diverse portfolio consisting of hotels/resorts, multi-family residences, office buildings, retail structures, warehouses and other commercial real estate. It is the responsibility of CreXus' management to exercise due diligence in the purchase of CMBS, as well as in providing financing to commercial operations - this matter is addressed in greater detail in the section on "Management Approach," below.
Liabilities: All mREITs are confronted with the challenge of securing adequate funding at favorable rates; an upward change in interest rates for its debts will adversely effect the company's overall profitability and the capacity to provide returns to its shareholders. In addition, the commercial mREITs may require financing to cover its obligations to maintain and/or operate holdings in its portfolio.
CreXus follows practices common among its peers in terms of maintaining a reserve with which to cover any unforeseen eventuality that could result in a loss (it currently has over $189 million in cash and cash equivalents, for instance). With respect to debt in general, this is discussed below.
Business Environment: General economic conditions have far-reaching effects on the operations of any company; the employment situation, property values, manufacturing and production, retail sales, etc., will all have an effect on commercial properties. Government regulation, adjustments to monetary policy, taxation, etc., have direct influence on the operations of an mREIT, given its sensitivity to changes in interest rate and policies with regard to the operation of REITs. Even in the best of times the market places constant challenges to businesses in terms of competition and the availability of resources.
Many of the elements of the business environment are beyond the control of a company, including CreXus. What is required is a managerial approach that exercises due diligence, has experience, and is flexible enough to anticipate potential problems and respond in an effective and efficient manner. With this in mind, let us take a look at the management of CreXus and how it seems to approach its business.
Management Approach: According to their most recent 10-Q (2nd Quarter, 2012), CreXus had assets totaling over $967 Million, with liabilities totaling $51 Million, and stockholders' equity approximately $916 Million. Comprehensive income for the quarter was $14 Million, and cash and cash equivalents for the period totaled more than $189 Million.
One item over which analysts occasionally express concern is the debt-to-equity ratio, the concern being that a low ratio (and CreXus' ratio of .02 is very low) may indicate inefficient utilization of its current holdings to secure the leverage that would enable expansion of the portfolio. In their 10-K for 2011, CreXus mentions the likelihood that they could accept a debt-to-equity ratio of 2:1 to 4:1, depending upon acquiring such financing on favorable terms. In a recent earnings call (August 2, 2012) this issue was presented to the senior management of CreXus. The response offered was that CreXus was examining potential sources of debt with an eye to minimizing the costs associated with the debt. However, it should be noted that Annaly tends to be conservative in its business approach, and FIDAC would presumably maintain that conservatism in its work for CreXus. For its part, CreXus seems to have maintained a conservative approach to its operations in general.
The reluctance of CreXus to assume debt is, I believe, a commendable business strategy given the current economic conditions. In my recent analysis of MFA Financial (MFA) - MFA Financial: Worth a Close Look - I note that there is something of a dilemma confronting mREITs at present: Fed efforts at quantitative easing (I am reluctant to refer to the current plan as QE3, since - given its open-ended nature - many analysts are calling it QE∞) is aimed at lowering long-term interest rates, with short-term rates already at near zero thanks to the zero-interest-rate policy (ZIRP) currently being maintained by the Fed. This leaves companies such as CreXus vulnerable to prepayments due to refinancing as well as being vulnerable to adjustable-rate mortgages and hybrid long-term mortgages that have interest rates that may be adjusted to LIBOR rates (both types of mortgages being termed ARMs).
As it pertains to debt, holding a portfolio of properties that are at risk of either prepayment or adjustable interest rates leaves a company at the mercy of the interest paid on their own debts. While that interest rate may be low for the present, Fed officials are committed only to maintaining ZIRP into 2015, at which point short term rates will be free to rise. This could leave a company susceptible to either a flat or even an inverted yield curve, where interest paid out is equal to, or even higher than, interest being received. The effort to operate as close to debt-free as possible in the short term is one that can help avoid interest-rate conflicts.
Further indication of the conservative inclination of CreXus can be witnessed in its apparent willingness to distance itself from the RMBS market. Although its focus in residential mortgages has been exclusively on Agency RMBS, where both principle and interest is guaranteed by agencies such as Freddie-Mac, Fannie-Mae and Ginnie-Mae, it has acquired ARMS that - again - leave it vulnerable. During the August 2 earnings call managers were asked if they intended to pursue additional RMBS, and the company's response was that its intention was to focus on CMBS (implied - exclusively).
Focusing on CMBS enables CreXus to utilize a variety of financial means by which to secure significant returns. Beyond the income to be generated by purchasing CMBS, CreXus is able to offer financing to companies not only through first loans, but also through subordinated and mezzanine loans which, although they have lower priority than first loans, can carry higher interest rates and - especially in the case of mezzanine loans - can give CreXus proportionate ownership stake in the company whose loans are in default.
There is a measure of safety involved in CMBS with regards to prepayments, as well. Most commercial mortgages carry penalties, fees, or other instruments designed to compensate the mortgage holder in the event of prepayment. This has the added effect of (hopefully) dissuading the mortgagee from pursuing prepayment. However, in the current economic situation these instruments do not always work. During the August 2 earnings call CreXus management noted that some companies were willing to pay penalties in order to secure lower-interest mortgages.
Summary: I believe that CreXus' conservative approach with respect to acquiring debt to be used as leverage is a wise one. Given the uncertainty that exists with respect to income from their portfolio, a reliance on using their own available cash resources protects them from any abnormal interest-rate yield curves. If, in time, the company decides that some debt is desirable and practical, a debt-to-equity ratio within the bounds mentioned above would seem prudent.
The use of various instruments to provide substantial returns seems, for the most part, to be handled very well, although there is room for some concern. At the end of the 2nd Quarter, 2012, CreXus counted among its assets mezzanine-style commercial real estate loans of nearly $514 Million, putting approximately 74% of its loans, and more than half of its assets overall, in this form of loan. The clear advantages to mezzanine loans are the ability to charge high interest rates, and in the event of default, the lender may assume an ownership stake in the company equal to the defaulted amount of the loan. However, mezzanine loans are subordinated loans where, in the event of default, primary loans must be satisfied first; this means the lender may not realize full return of the value of the loan.
CreXus has managed its affairs in such a way as to minimize its liabilities and secure significant return on investment. It has managed, for the most part, to maintain a high level of performance and to offer shareholders a dividend that has, but for the first two quarters of 2012, increased; hopefully, the return to increasing dividends evidenced in the third quarter will continue. Anticipating that it will, I think that CreXus is an attractive high-yield investment.
Sources: As usual, I rely upon FINVIZ.com for most of the data presented; on the few occasions when that fails, I turn to Motley Fool, CNBC or Yahoo!. I have also used CreXus' 10-K (2011), 10-Q (2nd Quarter, 2012) and second quarter earnings call (August 2, 2012) for specific figures and insight into management strategy. (Note that the earnings call can be accessed on Seeking Alpha.)
Additional disclosure: This article expresses the author's opinions, and is not a recommendation to buy or sell any stock mentioned herein. Before investing, please use all due diligence.