Non-Agency Mortgage REITs: Part 1 - The Newbies

Includes: ARI, CLNS, CXS, STWD
by: Philip Mause

This series of articles will deal with "non-agency" mortgage real estate investment trusts ("NMREITs"); I have identified roughly 30 stocks in this "group." This is an important group of companies for both income-oriented and speculative investors to understand. The group has gone through a rollercoaster ride of precipitous declines followed by recovery in the past few years and offers solid prospects for further appreciation, but also dangers of nasty pull backs in "risk off" squalls. It also offers many stocks, which provide high yields with the prospect of dividend increases going forward.

The stocks in this group are REITs and are generally subject to the regulations applicable to the group. Income (properly defined for tax purposes) is not taxed at the corporate level, but 90% of income must be distributed as dividends to shareholders who, in turn, are taxed on the dividends at the ordinary income tax level. The group generally invests in mortgages, but generally avoids agency guaranteed mortgages and mortgage securities (there are "hybrid" companies in the group that buy some agency mortgages). This makes them very, very different from "agency mortgage REITS" like Annaly Capital (NYSE:NLY) in several respects. If you see a list of REITs comparing some of these companies with agency mortgage REITs or equity REITs, it is very important to be aware of the fundamental differences.

First of all, while agency guaranteed mortgages generally are immune to default risk, the mortgages owned by this group of companies are very much subject to default risk. Because agency mortgage REITs hold mortgages that have no default risk they can, and do, use a great deal of leverage. This group of companies usually has less leverage and, when leverage is employed, it is often in the form of CLOs, which we will discuss in more detail below. The mortgages owned by this group generally pay higher interest rates than agency guaranteed mortgages - this also explains why less leverage is employed. Finally, the complex prepayment issues often experienced with agency mortgage REITs are less of a problem here; most home mortgages in the United States can be repaid without a prepayment penalty, the same is not necessarily true of commercial mortgages.

The stocks in the group vary enormously. Some own some real estate properties (either because of foreclosure on bad loans or by design), some specialize in commercial mortgages, and others buy CMBS and RMBS securities. Many use "special purposes entities" ("SPEs"), which are essentially separate entities (in many cases, CLOs) which, in turn, own a pool of mortgages.

As a general matter, an SPE sells tranches of securities with different levels of seniority, and then distributes the interest and principal repayment payments from the mortgage pool to the owners of the tranches in order of seniority (very much like the RMBS securities, which were a big factor in the notorious Panic of 2008). The NMREIT generally retains a very junior tranche for itself and gets a fee for managing the CLO. While the senior tranches are considered debt, in most cases, the debt is "non recourse," which means that the owner of the tranche cannot collect directly from the NMREIT itself if the assets in the CLO are not sufficient to pay him back. However, accounting rules require that the SPE's assets and liabilities be consolidated onto the balance sheet of the NMREIT. This, in turn, leads to the impression that many NMREIT's have huge mountains of debt; in reality, in many - but not all - cases the debt is non-recourse and should not be a great concern to investors.

You can see that it has already taken me quite a while to describe the group in general terms and to distinguish it from other groups of stocks. To analyze an individual NMREIT financial statement can be a daunting challenge; they are usually written in impenetrable prose and unfortunately do not always distinguish important things - such as whether debt is non-recourse or not. I was going through a couple of them yesterday and, to give myself a "break," I pulled out some recent hospital invoices and insurance forms and spent an hour trying to resolve a disputed invoice. The exercise seemed like "fun" in comparison with the analysis of an NMREIT financial statement. The bad news is that these stocks can be very, very hard to figure out; the good news is that this confusion can lead to situations in which stocks are seriously underpriced.

My own experience with the group has been mixed, but generally very positive. I made a lot of money on iStar Financial (SFI) debt in 2009, and I have more than tripled my money in NorthStar Financial (NRF) over the past few years. I recently had a big run-up in Capital Trust (CT) and Arbor Real Estate (NYSE:ABR). I got wiped out in Anthracite (AHR) and have slugged along with Gramercy Capital (GKK) and Rait Financial (NYSE:RAS). On a net basis, I am way ahead. Of course, what is really important is "where do we go from here?" - more about that in this and future articles.

I have separated out the "Newbies" (companies created after the Panic of 2008) for several important reasons. The companies that existed before the Panic made investments in the euphoric conditions that prevailed in that bygone era, many of which went very, very bad in 2008 and 2009. The Newbies were not burdened by those problems and, if they own any mortgages originated prior to 2008, they bought them at Post-Crash discounts. Analysis of the Newbies is also interesting, because it gives us a window on the Post-Crash real estate finance situation. Finally, the Newbies tend to make less use of SPEs, because it has been harder to attract investors to the tranches of CLO non-recourse debt in the Post-Crash environment.

I have identified four companies in this category: Colony Financial (CLNY), Starwood Property Trust (NYSE:STWD), Apollo Commerical Real Estate (NYSE:ARI), and Crexus Investment (NYSE:CXS). For each company, the table below provides Friday's (1/4/13) closing price, the current dividend yield, the lowest price reached in 2011, and debt as a percentage of gross assets.

Price Yield Low Price in 2011 Debt
CLNY $20.04 7.0% $12.06 9%
STWD $23.83 7.5% $16.40 38%
ARI $16.96 9.4% $12.22 36%
CXS $12.46 10.3% $8.30 2%

All of these stocks (indeed, the entire sector) took a big dive in the Fall of 2011, and this created a nice buying opportunity for opportunistic investors with strong stomachs. I have noticed that, with this sector as well as with BDCs, there are periodic buying opportunities, and an investor who has a good understanding of particular stocks can jump in when it becomes clear that a bargain has become available.

CLNY has very low leverage. It has used the post-Crash environment to buy existing loans well below par, as well as to generate new loans with attractive terms. CLNY stands out as following a strategy involving a significant focus on the "single home rental strategy" - buying individual homes and renting them out. CLNY has acquired quite a few of these homes, particularly in the Southwestern states. CLNY has also been successful in accessing the capital markets - raising roughly $600 million in 2012.

STWD is one of the largest, if not the largest, player in the entire group, with roughly $3.8 billion in assets. It has purchased some existing CMBS debt ($529 million) and some RMBS debt ($338 million), but primarily holds mortgages it originates or purchases from others. Like many in the group, it has focused on the fact that a huge amount of commercial real estate (CRE) debt is coming due in the next few years, and believes that this creates attractive opportunities for players with strong balance sheets and the ability to raise capital. STWD has been a very aggressive player - buying mortgages, CMBS securities and even attempting to buy CXS in early 2011. Thus far, this strategy appears to be working well.

ARI has bought a large amount of senior CMBS debt with AAA ratings. CMBS holdings now constitute nearly half of ARI's total gross assets. Most of ARI's borrowings are secured by these relatively strong assets, and so its leverage should not be a serious problem. In October of 2012, ARI completed a secondary offering of 7 million shares priced at $16.81 a share.

CXS is managed by an NLY subsidiary and is 12.5% owned by NLY. In November, NLY made an offer to buy the remaining shares of CXS for $12.50 a share and CXS has hired a financial advisor to advise it on responding to the proposal. It will be interesting to see what happens. STWD offered to buy CXS in early 2011 for $14 a share; there may be some investor morale problems associated with accepting less now.

The relative health of these companies demonstrates that the post-Crash CRE finance market is not generating a lot of new bad loans. I don't think an investor will make a huge windfall on any of these, although I think solid returns are reasonably secure. Looking at the big dip these stocks took in the Fall of 2011 suggests that investors should put these stocks on a list of things to check out if the market goes through a big "risk off" dip in the near future.

I own CXS, and I think that the two recent proposals to buy CXS out will likely put a floor under the price and create the possibility of some nice short swing profits, if negotiations drive the price higher than $12.50 now offered by NLY. I think that STWD is one of the premier companies in the space, and is a relatively safe investment for the long-term yield oriented investor. I like CLNY's single home rental strategy - especially given the current real estate market. I don't have a strong conviction on ARI. I will continue to hold CXS pending the buyout negotiations. I will watch the other three and would be a buyer on any significant pullback in the share price.

Disclosure: I am long CXS. 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.