Non-Agency Mortgage REITs: Part 4 - The Recovery Room

Includes: GPT, RAS
by: Philip Mause

This section will deal with two NMREITs which are in, what I call, "recovery mode." It is very important for investors in this sector to be aware of risk. These companies all own assets which can depreciate rapidly in value and use a fair amount of leverage; thus, there is always a downside. The Crash devastated the sector, and many companies were clearly on the ropes. Most of them have recovered, although they are nowhere near Pre-Crash highs. In evaluating companies in this sector, there are signs that an investor can identify which suggest that a company is on the way down and there are signs that it is on the way up.

Here are some of the "on the way down" signs;

1. The company stops making new investments and devotes incoming cash flow to debt service only; 2. The company stops paying dividends on common equity; 3. The company stops paying dividends on preferred stock; 4. The company is in violation of "debt covenants;" 5. The company fails to file a quarterly financial report; 6. The company announces that it has received notice that it may be "delisted;" 7. The photographs of the officers and directors are removed from the company's website; 8. In the company's executive washroom, industrial toilet paper is substituted for regular toilet paper; 9. The company incurs a large legal expense for research into the extradition treaties between the United States and a number of other countries.

These are all signs of trouble, and a company which exhibits 3 or more of these "symptoms" is one which exhibits serious risk. A number of companies in this sector went through this down-cycle and then recovered during the past few years. The signs of recovery are:

1. Lenders extend loan terms, and increase amounts lent; 2. New lenders make loans to the NMREIT; 3. SPEs begin performing well enough to generate cash flow for subordinate tranches; 4. Financial statements clearly distinguish recourse and non-recourse debt, and the assets which are not encumbered by non-recourse debt are substantially in excess of recourse debt; 5. Cash flow is deployed into new investments; 6. Dividends are resumed.

Let me identify another important indicator. When I was in college and law school, we had the choice of typing or handwriting our exam response. I have terrible handwriting and I have trouble typing. I always chose handwriting the exam response. My general procedure was that, the less I knew about the topic and the more unsure I was about my response to a question, the longer answer I would provide and the less legible version of my handwriting I would use. I believe that many of these companies follow a similar process with their financial statements. If they are in bad shape, the financial statement will be a totally incomprehensible jumble of numbers and letters. If they are in good shape, they will generally tell a coherent story. It is not really hard to understand why.

The two companies dealt within this section - Gramercy Capital (GKK) and Rait Financial (NYSE:RAS) - are both on the road to recovery. I think that they are both beyond the point at which there is a real danger of failure. On the other hand, issues remain, some dilution is a potential, and valuation of some assets are still problematic. The table provides Friday's closing price, the Pre-Crash high, the Post-Crash low, the current yield, and an estimate of fair value per share.

Price High Low Yield Value
GKK $3.10 $35.84 $.80 ------ $1.90 +
RAS $6.20 $111.06 $1.83 6.4% $6.65

GKK is in arrears on the dividends for its preferred stock. It had real problems emerging from the Crash and omitted financial statements for a few quarters, but it is doing better now. I conservatively calculated value by backing out all SPE assets and liabilities and subtracting the face value of the preferred stock and the dividend arrears from remaining net asset value. GKK has plans to sell off its SPEs. In its recent conference call, the CEO expressed some optimism concerning the amount it could receive in return; I have not included the possible proceeds of that sale in my estimate of fair value, so my value estimate is definitely on the low side. GKK's long-term plans are to transition into becoming an equity REIT focused on "net lease" properties - primarily in the office building and industrial sectors. The next quarter or two will be crucial, because they will reveal how much GKK receives for its SPEs (which are CDOs) and how GKK addresses its preferred stock dividend arrears. GKK will ultimately leave the ranks of NMREITS as it becomes an equity REIT.

RAS is somewhat further along on the road to recovery. Its numbers are stated to reflect a reverse stock split that occurred since the Crash. It is now paying a nice dividend. In a recent earnings call transcript, RAS estimated adjusted book value at $6.65 a share. RAS now has nearly thirty percent of its gross assets in REO, and so it is somewhat of a hybrid. A number of its properties are apartment buildings, and rental housing has become an attractive area, so the book values may be understated and there may be significant opportunity for growth and appreciation. RAS has engaged in a number of dilutive transactions but - on balance - these have probably benefited shareholders as they have strengthened the company financially and have allowed it to move forward in to investments at an opportune time.

I own both GKK and RAS, having obtained them at lower prices. I would recommend RAS here for a dividend investor and GKK as a more speculative entry. I think GKK may do reasonably well on its sale of CDO assets, and this may give the stock a significant uptick in the next quarter or two.

In the past, some readers have asked me to comment on Municipal Mortgage & Equity (MMAB.PK) and other companies which are not really REITs. I will comment upon them in a separate article at the end of the series, but MMAB definitely would be in the "in recovery" category if it were a REIT; the way I would describe it is that RAS is home and having a periodic visit from a visiting nurse, GKK is in rehab, and MMAB is still in the ICU.

I am also going to do an article on this sector's numerous preferred stock offerings at the end of this series and GKK's preferred stock (symbol - GKK-PA) will be addressed.

Disclosure: I am long GKK, RAS, MMAB.PK. 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.

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