In Search Of Yield: IRR Of 11% To 14% For Gramercy Capital Preferred A

| About: Gramercy Property (GPT)

A potential investor seeking capital appreciation and willing to forego current income along with accepting some event risk (i.e. potential capital loss) might want to consider investing in Gramercy Capital Preferred "A" (hereafter "GKK-A").

GKK-A is a "8.125% Series A Cumulative Redeemable Preferred Stock" with a $25.00 liquidation preference. The annual dividend is $2.03125 per share or approximately 8.125% of $25; with an original issue date for the preferred of July 15th, 2007. Gramercy Capital (GKK), the parent company, issued approximately 4 million shares or $100 million worth before costs and expenses.

GKK-A preferred holders are currently owed approximately five years of accrued dividends, and they continue to accrue. The GKK-A became redeemable on April 18th of 2012. The last sale in the preferred is currently $30.70.

Business Overview

Gramercy Capital (hereafter "GKK") is a self-managed, integrated commercial real estate investment and asset management company. GKK's "Gramercy Realty" division currently manages approximately $1.9 billion of commercial properties leased primarily to regulated financial institutions and affiliated users throughout the United States. The "Gramercy Finance" division manages approximately $1.8 billion of whole loans, bridge loans, subordinate interests in whole loans, mezzanine loans, preferred equity, commercial mortgage-backed securities and other real estate securities, which are financed through three non-recourse CDOs, and whose GKK is headquartered in New York City.

Brief History

GKK over extended itself, made some bad decisions, during the commercial real estate boom prior to 2008, and then could no longer pay either common dividends or for that matter preferred dividends. At the time of the GKK-A issuance, GKK was focused on the direct origination and acquisition of whole loans, subordinate interests in whole loans, mezzanine loans, preferred equity and net lease investments involving commercial properties throughout the United States. Gramercy Capital was externally-managed and advised by GKK Manager LLC, which was a majority-owned subsidiary of SL Green Realty Corp., a publicly-traded Maryland corporation (NYSE: SLG). At the time of the offering of the GKK-A, SL Green owned approximately 25% of the outstanding shares of the GKK common stock. Since then, SL Green has made sales and reduced its insider ownership. GKK qualified as a REIT for the fiscal year ending December 31, 2004

Investment Thesis

This is a distressed investment in a preferred stock of a highly leveraged real estate investment trust ("REIT"). GKK is in process of restructuring its balance sheet through the sale of assets, and shifting its business strategy.

My investment thesis is that the company will avoid bankruptcy, pay the accrued dividends, and then continue to pay the dividend on a regular basis or redeem the shares within the next two years. .

My confidence is based on several observations and assumptions: (1) there is a new, very talented, management team where the new CEO has acquired 2 million shares; (2) the new management team has experience with the new business strategy, that is the triple net lease business; (3) the company has approximately $200 million in unrestricted liquidity to build the new business with; (4) the company currently has the $40 million in unrestricted funds to pay the accrued dividends on the GKK-A; (5) GKK announced that it is shopping the legacy loan portfolio using Wells Fargo.

In summary, I am speculating that the key event will be the sale of the loan portfolio to put management in a more comfortable position to pay off the accrued dividends.

Catalysts for Paying the Preferred

There have been, and will be, several catalysts operating that might lead to paying off the preferred. The first is the new management and a desire to lower its cost of capital and improve profitability. The second will be the sale of the legacy loan portfolio which will provide further liquidity for the company.

Strategic Review and New Management

On August 2 of 2012, the GKK board of directors announced that they had completed their strategic review and they had elected Gordon Dugan as GKK's new Chief Executive Officer. With the new CEO, GKK announced a new business strategy and that is to focus on building value by deploying capital into income-producing net leased real estate. The new investment criteria will focus on single tenant net lease investments with durable credits across a wide variety of industries in markets with strong demographics. The investments initially will be funded from existing financial resources. GKK indicated that it expects to raise additional debt and/or equity to further growth.

DuGan comes to GKK with over 20 years of senior management experience in the real estate industry. He spent five years as CEO of W.P. Carey & Co. LLC (NYSE: WPC), with approximately $12.5 billion of assets under management, and considered to be one of the leading providers of net lease financing for corporate properties. Prior to that, Mr. DuGan served in various capacities with W.P. Carey, including President and Head of Investments. During his tenure as President and CEO, W.P. Carey's assets grew from approximately $2.5 billion to approximately $10.0 billion. He is a former member of the Board of NAREIT. DuGan received a B.S. in Economics from the Wharton School at the University of Pennsylvania.

DuGan has brought along Benjamin Harris, as President, and Nicholas Pell, as Managing Director, as new members of the senior management team. DuGan, Harris and Pell have worked together for the last five years. This is good.

Mr. Harris was the head of U.S. Investments for W.P. Carey and has over 10 years of experience sourcing, underwriting and closing sale-leaseback and net lease transactions. Mr. Harris graduated with joint degrees from the University of King's College and Dalhousie University in Canada. He is a CFA charter holder.

Mr. Pell was a Director in the Investment Department of W.P. Carey and has over five years of experience. Prior to joining W.P. Carey, he spent three years as a Director of Business Development at Sony Pictures Entertainment. Before he worked at Sony, he spent three years as an analyst at J.P. Morgan & Co., including two years in the mergers and acquisitions group. Mr. Pell received a B.A. in Economics from Duke University and an M.B.A. from Harvard Business School. These are "real guys" who know this business.

Alignment of Shareholder Interests with Management

As part of his employment, DuGan agreed to purchase 1,000,000 shares of the Company's common stock from the Company on June 29, 2012, for an aggregate purchase price of $2,520,000, or $2.52 per share. The per share purchase price is equal to the closing price of the Company's common stock on the New York Stock Exchange on the day prior to the date DuGan entered into the subscription agreement with GKK.

Voting Rights of the Preferred

Like most preferred shares, owners of the GKK-A generally have no voting rights. However, according to the prospectus, if dividends on the Series A Preferred Stock are in arrears for six or more quarterly dividend periods, as they are now, (whether or not consecutive), the holders of the Series A Preferred Stock (voting separately as a class with the holders of any other series of parity preferred stock upon which like voting rights have been conferred and are exercisable) will have the right to elect one member to serve on our Board of Directors until such dividend arrearage is eliminated.

In addition, certain changes that would be material and adverse to the rights of holders of the Series A Preferred Stock (including the issuance of a senior stock) cannot be made without the affirmative vote of holders of at least two-thirds of the outstanding Series A Preferred Stock and all other series of parity preferred stock upon which like voting rights have been conferred and are exercisable, voting as a single class. If any such changes would be material and adverse to holders of some but not all series of parity preferred stock, a vote of at least two-thirds of the holders of only the series materially and adversely affected would be required.

These rights can only serve as an incentive to pay off the dividend.

Selling the Legacy Portfolio

At the end of the 3rd quarter of 2012, GKK engaged Wells Fargo Securities LLC to assist in the potential sale of CDO management contracts, CDO securities and CDO equity. This is approximately $1.8 billion of whole loans, bridge loans, subordinate interests in whole loans, mezzanine loans, preferred equity, CMBS, and other real estate related securities which are financed primarily through three non-recourse CDOs. A sale of the business line would allow the company to: 1) focus the business on net lease investments; 2) increase its liquidity and capital availability; and 3) decrease its cost structure. This appears to me to be the key event in order to be in a position to pay off the accrued dividends to the preferred.

Risks to this Investment

The current price of the preferred reflects some expectation that the preferred will eventually make good on the accrued dividends. There is approximately $10 in accruals, the last sale is $30.70 per share and the redeemable value is $25, so before any discounting the preferred is worth $35 per share. Anything which might hold up the restructuring process is likely spook investors, and cause the preferred to decline from its current level. Moreover, a disruption in the capital markets like we saw in 2008 would also likely interfere with the GKK's restructuring and lead to a decline.

Forecasting Potential Returns

It is unclear when the accrued dividends might be paid. The table below lays out a series of the potential IRRs for various time horizons. I arbitrarily assume that the dividends will be paid off before the end of 2014 which would be equal to 14% IRR.

Year Description 6 Mo 2013 2014 2015 2016 2017 2018
0 GKK PRA Buy 1000 shares at 30 Annual Div Cumulative -30000
2008 Dividends accrued at 2.03 2030 2030
2009 Dividends accrued at 2.03 2030 4060
2010 Dividends accrued at 2.03 2030 6090
2011 Dividends accrued at 2.03 2030 8120
2012 Dividends accrued at 2.03 2030 10150 35150 -30000 -30000 -30000 -30000 -30000 -30000
2013 Dividends accrued at 2.03 2030 12180 37180 0 0 0 0 0
2014 Dividends accrued at 2.03 2030 14210 39210 0 0 0 0
2015 Dividends accrued at 2.03 2030 16240 41240 0 0 0
2016 Dividends accrued at 2.03 2030 18270 43270 0 0
2017 Dividends accrued at 2.03 2030 20300 45300 0
2018 Dividends accrued at 2.03 2030 22330 47330
IRR Calculation 34.3% 23.9% 14.3% 11.2% 9.6% 8.6% 7.90%

This would assume that the company completes the sale of the legacy portfolio in the next 12 months and the improvement in liquidity serves as an incentive to replace the preferred with lower cost capital. Management could potentially issue a convertible bond where the interest expense would be tax deductible along with a much lower coupon. This would likely improve its profitability and the company would be closer to restoring the dividend on the common.

Disclosure: I am long GKK. 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: Should not be considered an investment recommendation to buy or sell any security. Author is long GKK-A

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , , , Property Management
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here