Non-Agency Mortgage REITs: Part 2 - 3 Winners

Includes: ABR, BXMT, CLNS
by: Philip Mause

We now turn from the newbies to the oldies - NMREITs which were in existence at the time of the Panic of 2008. A few words of introduction are in order. The charts of these stocks bring back memories of a trip I had in the 1970s to Innsbruck. I was skiing down a mountain and couldn't read the trail signs because I had taken French rather than German in high school. I tentatively started down one trail and I heard a loud shriek - "Nein, Nein, Nein, Dat Ist Der Ski Yump!!" Fortunately, I climbed back up and went down a beginner slope. When I was at the bottom I could look up and see the cliff I had almost jumped (actually fallen) off - it looked exactly like the 2008-09 chart for any one of these stocks.

These stocks got absolutely crushed in the Crash. Commercial mortgages were one of the worst places to be in the credit crunch. There are several fundamental reasons for this and investors in the group must take the time to be aware of them. First of all, commercial mortgages tend to be of shorter duration than residential mortgages; property owners constantly have to "roll them over" and, if the credit market gets tight, the process can be painful or downright impossible. Secondly, the underlying assets - commercial properties - can be very volatile. I think that there are a number of reasons for this. Office space capacity can be added in big increments - when the World Trade Center first went up, it created a ruinous capacity glut in New York City. In addition, a recession can reduce demand for office space much more dramatically than it can reduce demand for housing. The workers fired by investment banks still have to have some place to live; they no longer have to have some place to work. Some of the most important markets for office space are in New York and Boston and both of these markets were heavily affected by the troubles of the financial services industry.

The result was that heavily leveraged NMREITs with lots of commercial mortgages on their books were absolutely massacred in the Crash. Some, like Anthracite (AHR), failed. Others went through extensive restructuring. Investors lost tons of money and "revulsion" set in. While the fundamentals justified declines in the stock prices, the market overreacted and overshot on the down side. The financial statements were impenetrable and it was hard to reach a point at which an investor could determine whether these companies would actually survive, let alone whether they would prosper.

I wish I could give you a neat mathematical formula for approaching this group, but I honestly can't. I can tell you the approach I have used and how I believe that it applies to the stocks today, but the "fog" of uncertainty that has lingered over this sector has not completely cleared.

I have generally looked at several things in approaching this sector. One of the most important factors is "lender behavior." Almost all of these companies borrow a lot of money and frequently have to roll over loans. I try to observe whether the lenders are extending reasonable terms to these companies and whether any "new" lenders are getting involved. Old lenders may be playing the game of "extend and pretend," new lenders have no reason to participate unless they are convinced the company is a good risk. The terms of the loans are also important because they define the most important cost element for these companies as well as serving as an indicator of the lender's assessment of the credit risk.

I try to assess "adjusted book value" although sometimes it is impossible. Let me explain. Most of these companies have SPEs which, in turn, have enormous assets and liabilities and GAAP book value consolidates all of this onto the NMREIT balance sheet. If the liabilities are non-recourse (which is not always clearly disclosed), I try to remove the SPE assets and liabilities from the balance sheet and analyze what is left. This is what the company will be worth if the SPE turns out to be worthless from the NMREIT's point of view. If the SPE is "performing" well enough to produce income for the NMREIT's subordinate tranche, I may try to assign a value to that tranche. But, if the debt is non-recourse, an investor can be sure that the SPE cannot be worth less than zero.

I also try to examine insider behavior. If insiders have a big stake in the company and/or if they have been buying recently at prices similar to the market price, this is a very positive sign because, presumably, the insiders understand the confusing financial statement and have decided that there is value to be had.

In the last year or so, some of these companies have had secondary offerings of stock. In that case, I look at the secondary offering price. Typically, this reflects some assessment of value although there is a "blind leading the blind" aspect to this methodology because the buyers in the secondary offering tend to look to the market price for guidance. If I can buy the stock for less than the price in a recent secondary offering and there is no indication that anything has happened in the interim which would undermine the case for the stock, I consider that to be a plus factor.

I did very well in 2009 with iStar Financial (SFI) debt (I will deal with SFI in a future article). I have done very well with NorthStar Financial (NRF) and Capital Trust (CT) which has recently paid a huge one time dividend. I have recently done well with Arbor Real Estate (NYSE:ABR). I will discuss each of these in more detail below. For each of these three companies, the table gives Monday's closing price, the pre-Crash high, the low reached in the Crash, the current dividend yield, and, where applicable, an estimate of the adjusted book value per share.

NRF $7.42 $17.60 $1.39 9.2% $5.13
CT $2.06 $49.94 $1.10 ------ $2.40
ABR $6.56 $34.05 $.65 6.7% $10.54

Now, you can see why I am reminded of the Innsbruck Ski Jump. And I don't want to see any nasty comments pointing out the Website's name is "Seeking Alpha", not "Seeking Beta" - that would be a really cheap shot. These stocks got absolutely crushed in the credit crunch crash. The level of investor revulsion for the group is huge. There are probably people who bought CT in the 40s because it was considered a "safe" dividend stock and sold it for less than $2 a share and have sworn that they will never buy a stock again.

Of course, it would be great to go back to March 2009 in a time machine and buy ABR for 65 cents. Is there a way we can find a "virtual" time machine so that we can find the stock that is now trading the way ABR was 4 years ago? More about that in a future article. An investor viewing this Table might also conclude that it would have been smart to simply buy all of these stocks in March 2009 (when everyone else was hiding in their cellars). Although this is probably true, it is also true that there is a real "survivorship bias" associated with such an analysis. There were other companies like Anthracite (AHR) that looked a lot like these three in March 2009 and ultimately went bankrupt. Because they no longer exist, they are not included in the stocks analyzed in this series of articles.

NRF is recovering nicely. I was attracted to it because it was able to refinance a lot of debt on attractive terms relatively early and, when I bought it, was trading way below book value. The adjusted book value I have used is an "all in" number including all SPE assets and liabilities. NRF is trading at a big premium to book but NRF has more than $5 a share gross book value in operating real estate outside SPEs. This asset consists of buildings in which NRF owns the equity. NRF has many other assets and liabilities and most of its assets are mortgages; net book value is only $5.13 because there is considerable leverage as well as book value assigned to preferred stock holders. Book value is not a good methodology for valuing owned real estate because book value is generally based upon depreciated acquisition cost and fair market value is usually considerably higher (but can be lower). Thus, NRF's real estate may now be and may in the future become worth considerably more than book value. I have made a lot of money on NRF and would buy on dips but at this price level I am holding rather than adding to my position.

I have written about CT before and have recommended it at $2.78 and $3.38. In December, CT paid a one time special $2 a share dividend and so I look at my position as having a value of $4.06 when comparing it with acquisition cost in the low twos. The question for investors today is the value of the "stub" or what remains of CT after the complex transaction involving the sale of some assets to Blackstone, the issuance of new stock to Blackstone at $2 a share and the payment of the dividend. My calculation of adjusted book value is based upon my earlier assessment of CT as adjusted for the removal of the assets sold in the transaction and the adjustment to balance sheet cash due to the transaction. It may be a bit optimistic. CT may now have the problem is being "too small" which I will address in more detail in a future article. Companies in this sector that fall below a certain size range can find that certain operating costs eat up interest income and make it hard to generate attractive returns. Careful investors should wait for the first financial report and conference call of the "new" CT but I think that there is very little downside and moderate upside in this position.

My favorite of the group for investors today is ABR. I wrote it up in December in this article when it was trading at $5.08. One factor which encouraged me was the fact that it had recently completed a secondary offering at $5.80 a share; I always like to buy in at less than the price in a recent secondary. I also liked the book value. ABR has since moved up but it is still trading well below adjusted book value of $10.54 a share. The basis for the adjusted book value calculation is described in my earlier article and in the conference call referenced in the article. There has also been extensive insider buying. ABR seems to have gotten its act together and has successfully set up a non-recourse CLO. I think it is a solid position for a yield oriented investor although I liked it more at $5.08 than at $6.56.

Disclosure: I am long NRF, CT, ABR. 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.