Non-Agency Mortgage REITs: Part 5 - Is Small Beautiful?

by: Philip Mause

The noted economist E.F. Schumacher wrote a book in the 1970s entitled "Small Is Beautiful" and it became a kind of cult classic among environmentalists, alternate life proponents and assorted "troublemakers". He had some very good points and championed the notion of "appropriate technology." It was one of those books which led a reader to note that the author had some truly brilliant insights without ever coming into total agreement with the thesis. Anyhow, small is NOT beautiful when it comes to NMREITs.

The best way to understand this is with a pro forma. Let's say an NMREIT has $100 million in gross assets in the form of debt instruments and has borrowed $50 million. This would make it quite small by the standards of this industry. Let's assume that its debt instruments produce average interest income at 10% and that its borrowings carry an interest expense of 5%. Let's make the generous assumption that it is never "stuck" with cash between loan deals and always has all of its assets deployed in interest earning loans. The company will have net interest income of $7.5 million.

The problem is that there is considerable expense associated with being a public company. SEC filings, directors' and officers' liability insurance, directors' compensation, holding annual meetings, mailings to shareholders, legal fees, and especially the preparation of audited financials add up to a minimum of $2 to 3 million when there are no special problems. Then, there is the expense of running the company itself - compensation to executives and support staff, insurance, rent, utilities, etc. etc. As a result, at this size level, even with no defaults on the loans and no special problems, the company will have a lot of trouble earning any amount of money at all, let alone a reasonable risk-adjusted return of $50 million in equity. And the expense associated with an extraordinary event like a lawsuit, an SEC investigation, or a bad loan will be ruinous and guarantee one or more very bad years.

It will also be hard to grow. The stock will probably trade at a multiple of its dividend or its earnings and this will put the market cap well below $50 million. Trading at a level well below book value, it will be difficult to raise funds through a secondary offering. Retained earnings will be slender and REIT tax rules require that 90% of earnings be paid out as dividends.

Size also creates operational problems. If the company comes across an opportunity to make a $30 million loan on attractive terms, it may have to pass it up because of lack of capacity or a concern that such a large loan would constitute an imprudently large percentage of total assets. Executives who see these opportunities wither away because of the "smallness" problem may jump ship (or, more accurately, raft) for greener pastures (sorry for the mixed metaphor!).

When you add all of this up with the fact that the stock trades at a huge discount to book value, it begins to sound like a paradigmatic "value trap." The stock is always trading at a big discount to book and so it looks like a bargain but it never really materializes into something profitable for investors.

There is probably some minimum size for this sector and I am frankly not sure what it is. I am pretty sure that it is north of $100 million in total assets but I am not sure that it is as high as $500 million. Companies well below the floor must think long and hard about trying to be acquired, merging or coming up with a credible growth strategy. Unfortunately, management interests are not always perfectly aligned with shareholder interests and management may perceive a takeover as a threat and be satisfied collecting compensation while the company underperforms.

Before I paint too grim a picture, let me add a couple of caveats. Companies in this sector are acquiring more and more REO in the form of fully owned real estate properties. Book value is an unreliable guide to actual value or to earnings potential so that a company can earn a tolerable level of income on a relatively small book value. In addition, a number of these companies earn fee income for managing assets - often in SPEs but sometimes completely off the balance sheet. A company which is largely dependent on fee income need not have some minimum book value to be viable. That said, many companies in this sector earn the overwhelming majority and, in some cases, all of their gross income in the form of interest payments on debt instruments held on their balance sheets.

We are going to look at five companies dealing with the "smallness" problem. Two of them are clearly viable and one has grown to a sustainable size and may be a good investment here. The other three passed over the "event horizon" limit on the way into the "Black Hole" of value traps. For PMC Commerical Trust (PCC), BRT Realty Trust (NYSE:BRT), Vestin Realty Mortgage I (NASDAQ:VRTA), Vestin Realty Mortgage II (NASDAQ:VRTB) and Bimini Capital (OTCQB:BMNM), I am providing Friday's closing price, the Pre-Crash high, the Post-Crash low, the dividend yield, the book value per share, and the amount of gross assets. All financial data is based on SEC filings; stock price data is derived from Yahoo Finance.

Price High Low Yield Value Assets
PCC $7.36 $16.40 $5.55 6.5% $13.40 $254M
BRT $6.40 $31.17 $2.03 ---- $10.50 $386M
VRTA $1.25 $6.70 $.76 ----- $3.49 $22M
VRTB $1.56 $15.42 $1.19 ------ $3.98 $98M
BMNM $.15 $163.00 $.14 ------- $.54 $146M

PCC specializes in making SBA and other loans to relatively small hotels and motels and its business functions reasonably well. It is not overleveraged and does not appear to have had abnormal default issues. But the size problem can ambush you in a number of ways. In 2011, PCC embarked on a strategic alternatives study in order to decide whether it should try to be acquired or take other structural steps. Through the first 9 months of 2012 PCC spent $3.6 million on the study. This would be fine for Microsoft (NASDAQ:MSFT) or Ford (NYSE:F); the $3.6 million would be lost in their income statements. But PCC's total revenue for the first nine months of 2012 was $12.6 million and it incurred interest expense of $2.6 million, so the $3.6 million put a big dent in cash flow. The result was that for the first nine months of 2012, PCC had a loss as compared to net income of $3 million in the first nine months of 2011. The fourth quarter of 2012 may not be any better because it will likely include a $2.2 severance payment to the departing CEO. Not surprisingly, the result of the strategic study was a conclusion that PCC should grow. I could have told them that for $3.5 million and I would have thrown in a free lunch. It's really hard to tell where PCC is headed from here. The strategic study was a one time event and so earnings should resume in 2013 but there may be other "one time events." PCC has to get bigger to produce income consistent with its book value. It is difficult for a REIT to do this but there are a variety of strategies it could pursue. This is definitely a potential value story worth watching but it also illustrates the problem of smallness.

BRT has grown rapidly from $191 million in gross assets a year ago to its current size of $386 million. Roughly half of its total assets are REO mostly in the form of apartment buildings which it is renting. The actual value may be higher because book value is a bad metric for the actual value of real estate equity. I am not sure when BRT will resume dividends but, when it does, the stock is likely to take a nice pop. BRT is an example of a management which has proactively addressed the size issue and has reached the "long term viable" level. Its discount to book value which may understate the true value of its real estate equity holdings makes it attractive here.

VRTA and VRTB both decided to discontinue being REITs in early 2012. I am including them because they were REITs in the past and illustrate the point of this article. They are each involved in mortgage lending, primarily in Nevada. VRTB has a large number of properties it has acquired through foreclosure on its balance sheet. I would not recommend these to any investors but they may be worth a look for private equity folks thinking of a private deal.

BNMB is another company on life support. Its $146 million in assets (largely mortgage securities) are matched by $140 in liabilities (largely repurchase agreements). It is sobering to think that this 15 cent stock once traded at over $160 a share. Another important note of caution for yield-oriented investors.

The smallness problem is not unique to this sector. There are closed end funds and business development companies that are in similar situations. Some can just trudge along, continue to compensate management and barely cover costs indefinitely. It must be a little bit like Tom Hanks in Cast Away - eking out survival on coconuts and an occasional rain, or Norman Bates operating the Bates Motel - waiting around for a catalyst.

Anyhow, BRT may be a good bet here and PCC could have an upturn as earnings almost inevitably improve in 2013 (unless they decide to do another strategic study!).

Disclosure: I am long PCC, MSFT, F. 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.