RAIT Financial Trust: Impact Of 2018 On The Underlying Value Of RAIT's Debt And Equity Securities

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About: RAIT Financial Trust (RASF), RASFN, RASFO, RASFP, RFTA, RFTT
by: The Owl
Summary

RAIT reported Q4 and full-year results for 2018 in late March, offering updated information on which to reassess the value offered by the exchange-traded debt, preferred and common shares.

RAIT has made solid progress in executing their Strategic Plan, published in February 2018, targeting suspension of loan origination and sale of most physical real estate.

RAIT appears to be past the middle point in winding down operations, so a reassessment of the potential of recovery for debt, preferred and common shares appears timely.

Assessments made in earlier RAIT articles appear to remain current, except that the transactions surrounding the redemption of D Preferred Shares has reduced potential for recovery for other preferred shares series.

Author's Note: This article is intended for investors oriented towards value-deep, value-distressed asset investing. Those seeking moderate- to high-risk value investments may have an interest in this article. Investments in this company at any level of the capital structure are unsuitable for those seeking retirement income, and I strongly discourage purchase of securities related to this company for retirement income accounts, where a focus on risk aversion should be paramount.

All tables and graphs have been produced by the author using source data from the RAIT Financial Trust IR Website, from which information from the RAIT SEC Filings were obtained, or from the Yahoo Finance Website.

Eight Conclusions and One Recommendation from Analysis of 2018 Results:

  1. The company has made strong progress in implementing the Strategic Plan, published in February 2018, with a target of securing some recovery for the value for the equity tier of the capital structure.
  2. From this analysis, the odds of any recovery for the common equity are very remote and, if any, will be very limited. I recommend against using the common shares even as a high risk, very low probability, very high return play and believe that the preferred shares will be vastly better for speculators than the common shares.
  3. From the analysis of the current (end 2018) balance sheet, it appears that the exchange-traded, 7.125% Senior Notes due August 2019 should be redeemed in a timely way at face value plus interest.
  4. From the analysis of the current (end 2018) balance sheet, it appears that the exchange-traded, 7.625% Senior Notes due April 2024 should be redeemed in a timely way at face value plus interest.
  5. In addition to Item 3 above, I expect that the April 2024 notes may well be redeemed early for the reasons cited in the discussion below. This would enhance total return/yield-to-call as these notes are currently selling at a 25% discount to face value.
  6. The preferred shares remain the fulcrum security, with significant potential upside, but also a reasonable probability of ending with a value of $0. Preferred shares should be viewed as a call option, having a strike price of $0 and no expiration, on a recovery of RAIT and the ability of Mr. Charles Frischer to create value at least to the level, if not beyond, what is reflected on the balance sheet at year-end 2018. If one wanted to speculate on RAIT Financial Trust, I would recommend speculating in the preferred shares as a much better vehicle for that purpose than the common shares.
  7. The overall set of conclusions above is consistent with those made in earlier articles in this series, other than the valuation estimates for the preferred shares. Not surprisingly, the valuation estimates for the fulcrum security have varied widely and will continue to do so. The recovery remains contingent upon the degree to which the market transactions are greater than or less than asset values carried on the balance sheet.
  8. While the sum total of liquidating transactions has reduced the total recovery for preferred shares to this point, the set of transactions surrounding the redemption of one class of Preferred Shares, the D Shares, taking them out with a very high recovery, has had the greatest impact on a reduction of recovery available for the other "pari passu' Preferred Shares Series.

Recommendation: The 7.625% April 2024 Notes look to this analyst to be the investment of choice for a value investor. After this analysis, I have added these RFTT Notes into my Retirement (not Risk) Account at prices near $17.50/share. I believe this security will go out at face value plus interest on or before the maturity date of April 2024, so I expect to recover my capital, pull in 10+% interest and secure a gain on this position within five years. I advise those holding this security to hold to call or maturity, rather than selling at a big discount to face value which I expect to disappear over time. This recommendation is ONLY appropriate for experienced value investors who can tolerate some volatility and will limit commitments in any single name.

Abbreviated Balance Sheet at the End of 2018, Compared to 2017:

Please find the Balance Sheet for RAIT Financial Trust (OTCQB:RASF) year-end 2018 and 2017 here:

Revised 2017 2018 Balance Sheet The reader can see some key issues immediately with this comparison:

  • Significant progress has been made to unwind and liquidate assets to redeem debt, with each having been reduced by nearly 60% in just one year.
  • Assets have come more rapidly than liabilities, a significant part of which is due to the transactions with ARS VI Investor I, also resulting in the redemption of the D Shares (which the reader can see have been eliminated from the capital structure by year-end 2018).
  • The amount of book value available for the common shareholder has decreased to a point where any recovery is unrealistic, based upon liquidation of the balance sheet. We will return to this below.

The Sale of FL5 and FL6 Interests and the Simultaneous Redemption of the Preferred D Shares Series:

In June 2018, RAIT conducted an intricate transaction with Melody RE II, LLC and ARS VI Investor I (owner of the D Shares). In this transaction, RAIT sold to Melody RE (the "FL purchaser") the interests that RAIT had in FL5 and FL6 VIEs for $54.8M, de-consolidating these entities from the balance sheet (as they were no longer the primary beneficiary) and booking an $8.2M loss on the transaction, given RAIT's original investment of $62.8M.

RAIT then used the $54.6M, plus the addition of A, B, and C preferred shares, with a liquidation preference (face value) of $16.7M to bring the transaction total to $71.3M, to redeem the series D shares series from the "D Shares Owner" or ARS VI Investor I. This resulted in the Preferred D Shares being redeemed and cancelled. The reader can see above that, while $78M D Shares were outstanding at year-end 2017, that there were no D Shares outstanding by the end of 2018.

This reduced net assets by $62.8M, eliminated the D Shares series and resulted in a dilution of the preferred shares series as seen in the following table:

Preferred 2018 v 2017 Again, total preferred shares have increased in liquidation value by $16.7M, resulting in there being nearly 10M preferred share in the three classes (A, B, and C) outstanding. We will return to a discussion of the preferred shares below.

I was a bit surprised that the D Shares, pari passu with the other three series, could be redeemed at such a high recovery while the other three series languished. There were likely legal obligations to do so; otherwise, I cannot imagine that Mr. Frischer would have disadvantaged his investments in common and other preferred shares to "bail out" Melody/ARS VI Investor I. If a legally supervised re-organization is needed in the future, I would not be surprised to see this transaction revisited and litigation result from a claim of a fraudulent conveyance (whether it is true or justified).

However, it appeared that the team managing the liquidation and the strategic re-organization needed to eliminate these positions and the influence from these investors, so it is now a fait accompli for the purpose of this analysis.

Earnings and Cash Flow:

Honestly, a detailed discussion of the earnings statement, given so many transactions superimposed on moving operations results as operations are wound down quickly, might represent an entire article. In addition, I don't believe that this would be particularly helpful in selecting or avoiding security investment. In the cash flow statements, with many non-cash transactions occurring, some of it is "unwound" in any event, undoing some of the complexity introduced in the Income Statement.

In my opinion, looking at the bottom line results of the combined Income-Cash Flow statements may be more useful for the reader as well as be used to confirm what already appears to be true from the balance sheet; that is, RAIT is making good progress in moving towards the Strategic Plan goal.

Here is a high level summary of the Cash Flow:

Income Cash Flow So, RAIT took a big earnings loss again in 2018. Some of it was due to net losses as positions in loans, extinguishing of the debt, sale of the retail property manager and so on, but much of it was due to depreciation, amortizations and impairments also impacted as many of investments and borrowings are unwound. Even with that loss, however, the company eked out a positive operating cash flow for the year, suggesting that there may still be attractive operating properties or portions of the business around which a smaller, downsized business could be built.

The Cash Flow from Investing, which might be better described as Cash Flow from Dis-investing, shows a substantial plus. This signals that investments are being reduced at a substantial pace (e.g., Loans Outstanding at nearly $400K being repaid) along with a small Loan Origination outflow, consistent with winding up the Loan Origination activity at RAIT.

On the other hand, Cash Flow Provided by Financing shows significantly negative cash flow, consistent with winding down of borrowings. That is, cash is flowing out from the company, being consumed to redeem or reduce debt outstanding. This is consistent with the changes that the reader can see in the balance sheet at the end of 2018 versus that of 2017, with a reduction of 55% of physical real estate and a full 62% reduction of mortgage loans outstanding having been effected in 2018.

Takeaway/Conclusion #1: RAIT has made significant progress towards their Strategic Plan goals in 2018, having delivered substantial reductions in the ownership of outstanding mortgage loans and physical real estate, then using those liquidations to reduce outstanding liabilities.

Detailed Balance Sheet at Year-end 2018:

Please find here a detailed balance sheet for the end of 2018 here, including a breakout of some categories that we will discuss below:

Detailed Balance Sheet The first thing to jump off this table was the last: the equity or book value available to common shareholders and the equity or book value available per common share is now decidedly negative as the total assets available have shrunk by nearly 60%.

If one looks at the Balance Sheet at year-end 2017 above, one sees that there was a modest shortfall of $53M to make the preferred shares whole, allowing the common shares to begin to get a recovery (pro-forma). So, with total assets of $1,792M, the book value would only have to be 4% too low relative to market values for the selling of the assets resulting in the first penny of recovery for the common shares.

Fast forward to the end of 2018, and we find that the shortfall for recovery for the preferred shares, which must be made whole for the common shares to get the first penny of recovery, is now $181M, up sharply from the previous year. At the same time, total assets have declined to $734M. This implies that the assets would need to be sold entirely at prices 25% higher than book to secure the first penny of recovery for the common shares.

While I can come up with reasonable scenarios to justify some recovery for the common shares, these scenarios are less likely and result in substantially less recovery than would be implied for the preferred shares. Maybe the board will sell the company or maybe there is a shipping container filled with gold coins not reflected on the balance sheet (or another asset not reflected on the balance sheet), but these alternatives appear remote and I don't think "percentage investors" would invest in them. Therefore, if one is inclined (which I am not recommending, but remains an alternative for those risk speculators seeking a substantial gain while accepting the "risk of zero"), then the preferred shares are a significantly preferable security for this speculation than the common shares, both having a substantially higher probability for recovery along with a likely higher recovery in almost all cases.

One last thing: keep in mind that the preferred shares are currently racking up accrued dividends each quarter, per this chart:

Preferred Payouts I believe it unlikely that they will be paid out, but these also represent claims senior to the common which are NOT reflected on the balance sheet. So, in addition to the $181M that would need to be made up to provide full recovery of face value for the preferreds, any common recovery requires that the accrued dividends must be paid out in full as well. These are racking up at a rate of $5M per quarter, so the remote chances for recovery of the common at this point continue to decrease each quarter.

Conclusion #2: The common shares do not appear to be an attractive vehicle, even if one is a speculator who is prepared to accept a total loss for a large upside. The preferred shares appear to be much more attractive, given their current 25:1 upside to downside, while securing the first ca. $200M of any recovery beyond book value.

Detailed Balance Sheet w/ Format to Focus on Preferred Share Recovery:

Given that it appears that continued evaluation of common shares is less interesting, I reformatted the detailed balance sheet to provide a more accessible evaluation of the impact of changes in the balance sheet on recovery of each preferred share, found here:

Preferred Recovery Detailed Sheet The bottom part of the sheet has been changed to reflect how assets net of liabilities impacts the value of each preferred share. Since there are 9,994K preferred shares, very close to 10M, the reader can simply divide the assets net of liabilities by 10M to calculate relatively closely recovery per preferred share.

At this point, if all assets were liquidated at book value and liabilities paid, recovery on each preferred share would equal $6.85/share, as compared to current market prices of about $1 per share for any one of the three preferred shares classes.

However, using this sheet, it is hard to visualize potential outcomes going forward, to model future recovery.

Simplifying the Balance Sheet to Focus on Key Variables:

There are two steps that can be taken to simplify the presentation of the balance sheet, without changing the contents, to enable better focus on key variables in the sheet:

  • The company holds in escrow funds to be returned to borrowers/customers. These funds are highlighted as a liability with a like amount of money held in escrow also in the assets category under restricted cash. As the reader can see, I have broken the "Restricted Cash" category down further into "Borrower Escrow" category and an "Other Restricted Cash" category. By simply netting the "Borrowers Escrow" cash asset against the ultimate liability, one can simplify the balance sheet and exhibit the remaining restricted cash available.
  • The balance sheet contains a few asset categories (Accrued Interest, Other Assets, Intangible Assets) which sums to a relatively small total asset (4% of total assets) and a similar situation with a couple of liability categories representing about 1% of total liabilities. None of these line items appears to be in a position to "move the needle" on future recoveries. In the interest of focusing attention on key items, these are lumped together into an "Other Assets" and an "Other Liabilities" category, respectively, to provide the following simplified sheet, allowing this analyst and hopefully the reader, to focus on a smaller number of significant line items (i.e., Mortgage Loan Assets, Real Estate, Cash, Restricted Cash and indebtedness as highlighted in emboldened text):

Simplified Sheet With this, we can now do scenario planning to look at the impact on preferred share recovery on reasonable outcomes for each of these key variables. We first discuss the Senior Notes, then will return to estimating recoveries for the preferred shares.

Status and Reasonable Potential Outcomes for Recourse Indebtedness:

Total assets still exceed total liabilities on the balance sheet. Because this is a consolidated balance sheet, not all assets can be used to offset liabilities and not all liabilities necessarily have offsetting assets, as a large percentage of both are held in the respective variable interest entities, or VIEs. In particular, creditors of RAIT cannot necessarily attach liabilities held in the VIEs, only those directly owned by RAIT (although the percent ownership by RAIT of the VIE may be fair game).

The debt that should be of concern to preferred and common shareholders is the direct, recourse debt on RAIT's balance sheet. It is worth noting that RAIT made good progress in 2018 in reducing this debt; specifically, RAIT reduced recourse debt by $125.9M, or 43.2% of the total, during 2018, representing good progress.

So, let's look at the recourse debt present on the RAIT balance sheet at year-end 2018:

Recourse Debt This table is much smaller than a similar table in earlier articles. The reader can see that RAIT now has only $165M in recourse debt outstanding, with the remaining indebtedness non-recourse mortgage debt on real estate or debt held within the VIEs.

At the present time, there is concern about the ultimate outcome for the two Senior Note tranches, which are discussed below:

a. 7.125% Senior Notes, Due August 2019 (OTCQB:RFTA): There remain $65M in Senior Notes outstanding that mature in three months for which there is a concern about whether they will be redeemed or not.

Currently, on the balance sheet, there is $42,453K in cash, presenting 65% of the cash needed to redeem the Notes maturing Aug 2019. Of course, not all of the cash can be used for this purpose as some cash is needed to conduct operations, but clearly, there is sufficient cash to fund a third to half of this redemption.

In addition, there is $31,724K in restricted cash excluding that for borrower's escrows waiting "to be released at our discretion upon the occurrence of certain pre-specified events, and to serve as additional collateral for borrowers' loans" (RAIT 10K, p. 74). Again, much of this is restricted to specific purposes other than to redeem the August Notes, but some of it may be freed up as RAIT continues to unwind operations.

Most importantly, there are $206,255K in mortgage loans owned by RAIT scheduled to mature in 2019. Some may mature after August, but all other things being equal, roughly two-thirds of that amount might be expected to mature by the end of August, a point two-thirds of the way through the year. This means that RAIT does not necessarily have to rely on selling something or taking action not completely in their control to be monetizing investments to free up cash to redeem this Note.

I suspect, in fact, that they were actively buying in the open market these notes; at least, someone appears to have been buying these notes in the open market at prices up to $23.

Please see the attached graph:

RFTA Pricing Correction In this graph, you see the RFTA pricing over the course of Q1 2019. As you can see, the upper bound looks to be about $23.20 while the lower bound started at the $22.20 level at the beginning of the quarter, but buying crept back in at ever higher "lows" as the quarter went on, appearing as if someone, RAIT or another buyer, was accumulating these notes over the course of Q1.

With arguably $25-30M already available to redeem these notes (leaving $12-17M to cover an ever-declining need for cash) and with $130M in mortgage loans on average coming due prior to that point eight months from the point at which these balances were established, it appears highly likely that these notes will be redeemed. The company clearly has the assets and will likely have the liquidity to redeem these notes on time at face value plus any interest owed.

Conclusion #3: The 7.125% Senior Notes Due August 2019 are likely to be redeemed on time at face value plus accrued interest.

b. 7.625% Senior Notes, Due April 15th, 2024 (OTCQB:RFTT): There remain $56,324K in Senior Notes outstanding that mature in April 2024 which are selling at a 25% discount to face value. These Notes become the single Senior debt outstanding that does not mature for almost five years.

After the borrower's escrows and 7.125% Senior Notes have been repaid, subtracting those amounts from assets, there will remain $637M in assets which would need to cover the $56M in Senior Notes; in addition, the company has a bit more than five years to assemble the cash. Below, we will discuss the impact of variation of value for the loan investments and real estate on the recoveries for the preferred shares. However, it is very unlikely that this variability will result in $637M in assets unable to cover the remaining $56M in Senior Notes, and there exists a significant amount of time to monetize assets to cover this redemption.

Conclusion #4: The 7.625% Senior Notes Due April 2024 are likely to be redeemed on time at face value plus accrued interest.

Timing of the Redemption of the 7.625% Senior Notes Due April 2024:

Not only do I believe that the 7.625% Senior Notes will be redeemed at face value plus interest, but I also believe that this security will be redeemed, in part or in whole, prior to the current maturity date:

  • This tranche represents the most expensive financing at 7.625%.
  • As they wind down operations and assets, this becomes not only expensive but unneeded.
  • This represents recourse debt against the company, so eliminating this debt reduces risk along with a significant liability and substantial interest expense. This also reduces the need and risk of a legally-supervised restructuring.
  • After the redemption of the 7.125% Notes, many of the restrictive covenants will remain in place by virtue of the last remaining Senior Note tranche, the 7.625%s. Once this tranche is redeemed, the covenants will be expunged and the latitude for action will be substantially increased. Just this should be a powerful motivation to take out this last remaining security at the Senior level
  • Once this tranche is redeemed, there will remain only $44M in recourse debt remaining for RAIT Financial Trust, and this is not maturing for about 10 years. In turn, after offsetting $121M of Senior Notes and $33M in borrower escrows, a total of $154M, with book assets as we had done above, there will remain $580M in book assets to be used to dispatch the remaining $44M in recourse debt.

I believe that the company will remain rightly focused on dealing with the imminent maturity of the 7.125% Notes as a first priority in 2019. However, once those Notes have been redeemed, I believe that the company will pivot to buying in as many of the 7.625% Notes as it can using cash as it becomes available through maturing investment loans or through asset sales. In addition, once the security approaches face value, I expect that the remaining outstanding RFTT shares will be called by the company to eliminate this tranche, avoid interest expense, and expunge the troublesome covenants associated with this issue.

In turn, this will provide improved returns for those holding RFTT, through an earlier redemption at face value for what is today a substantially discounted instrument, relative to a redemption five years hence. This also suggests that investors holding these Notes should wait until they are called to secure the full face value rather than selling the instrument early at more discounted prices.

Conclusion #5: I expect that the April 2024 notes may well be redeemed early for the reasons cited in the discussion below. This would enhance total return/yield-to-call as these notes are currently selling at a 25% discount to face value.

Recommendation: The 7.625% April 2024 Notes look to this analyst to be the investment of choice for a value investor. After this analysis, I have added these RFTT Notes into my Retirement (not Risk) Account at prices near $17.50/share. I believe this security will go out at face value plus interest on or before the maturity date of April 2024, so I expect to recover my capital, pull in 10+% interest and secure a gain on this position within five years. I advise those holding this security to hold to call or maturity, rather than selling at a big discount to face value which I expect to disappear over time. This recommendation is ONLY appropriate for experienced value investors who can tolerate some volatility and will limit commitments in any single name.

Spectrum of Possible Outcomes for RAIT Preferred Shares:

Before discussion factors which will contribute to greater or less recovery in the RAIT preferred shares, some info about the shares are included here as background. Here is a current summary of the share count for the three preferred shares series, the outstanding face or liquidation value and the annual dividend payments which are not being paid out at this time, but rather accrued:

2018 Preferreds While it is unlikely that the accrued dividends will be paid, the differing rates of accrued dividends does impact the degree to which individual preferred series have claims on the RAIT estate. Given that the "C Shares" (OTCQB:RASFN) have higher coupon than the "B Shares" (OTCQB:RASFO) and "A Shares" (OTCQB:RASFP), the claims will move subtly over time, as seen in the following table:

Senior Claims Preferred As the C Shares continue to accrue dividends at a bit faster pace than the A Shares, the claims for the respective shares series do evolve a bit over time, now based upon face value but also an increasing amount of accrued dividends. However, from this table, one also sees that the migration of claims is slow and won't move the claims much over the period in question, so differences in prices purchased will likely trump the migration of claims over time, if one is inclined to speculate on a preferred recovery.

Perhaps more important to point out, the preferred shares as a whole are accruing dividends at a pace of about $5M per quarter or $20M per year. These accrued dividends should be viewed as a liability to the common shares even as they are not carried on the balance sheet, so they represent an additional barrier for the recovery of the common shares. Even if recovery were substantially higher to exceed the face value of the preferred shares, the claims for accrued dividends would also have to be satisfied for the common shares to recover the first penny.

Now, let's consider the two remaining factors key to recovery for the preferred shares.

Two Key Factors Impacting Preferred Share Recovery:

Please find a headline view of the balance sheet here:

Simplified Sheet We have discussed use of cash to redeem earlier maturities of debt. The restricted cash will be used to make new investments on behalf of investors (converting the cash into a loan for investment, whereby the cash is reduced but an offsetting asset is created). The recourse debt has been discussed with the remaining debt non-recourse or is carried within one of the investment VIEs.

What remains to be discussed are two key elements, the liquidation of which will determine how much recovery will be secured for the preferred shares: Physical Real Estate and the remaining core of RAIT, the Mortgage Loan Investments.

a. Real Estate: At the time of my very first article on RAIT, published on December 21st, 2015 ("My Best Long Idea of 2016: RAIT Trust Retail Notes, 7.125% Due August 2019"), RAIT was carrying about $2.3B of real estate on the balance sheet. By September 2017, at which point I had written another article on RAIT ("RAIT Financial Trust: Which Securities Are Investment Opportunities and For Whom?"), that had declined to about $434,890K. At that point, there was a lively discussion about how much higher real estate prices could enhance recovery or by how much losses on property sales would depress recoveries.

At this point, there is $112,742K book value of real estate, with about $4.5M already for sale. The remaining portion may be held as investment or it may be sold, or a combination of the two, as suggested by the "Strategic Plan" (2018 10K, p. 3 in Business Strategy section): "The continuation of the process of selling a significant portion of our owned real estate, or REO, portfolio,...." suggesting that most but perhaps not all real estate will be sold. Be that as it may, physical real estate now represents only 15% of the assets of the company; while it may have an influence on the result, it is not likely to be the deciding factor. A breakout of the real estate held by RAIT is found here:

Real Estate with the total matching up to the "Real Estate" line item in the balance sheet above.

Occupancy suggests that the retail assets are impaired, so one might believe that the company can simply put these properties back to the entity having made the loan; unfortunately, for most of the properties, the loans are actually owned by RAIT directly or within one of the RAIT VIEs, so "putting the property" back to the lender does not result in an extinguishment of the loss. Against these properties are $40,742K of mortgages held by third parties and $80,562, totalling $121,304K, or $3,644K more than the physical assets held.

For the purposes of calculating reasonable potential recoveries, I have made some estimates of reasonable limits of real estate value for the portfolio. While individual properties can vary widely, portfolios of real estate tend to migrate to a range of book value when sold. So, I have included 20% upside and downside for limits for the office real estate and a 10% upside and a 30% downside for the retail properties:

Property Limits I know that some readers will complain bitterly that these limits are insufficiently high on the Low End, while others will argue with equal passion that the limits are too low on the High End, so I will offer readers an alternative when we use these limit values to calculate potential Preferred Recovery below.

b. Mortgage and Loan Investments: Mortgage and Loan Investments represent about 65% of the total assets of RAIT Financial Trust.

This table provides key input on probable outcomes for loan investment recovery:

Loans Currently, about $485M of assets are reflected on the balance sheet, with $4,873K held for sale and not included in this table. Excluding assets for sale, one starts with $502M in total loan assets. Through a recognition of $22M in loan loss allowance (again as recognized on the balance sheet), one nets to $480M book value (prior to amortization and adjustments), then adds back in the $4,873K in the assets to be sold.

That is, the company has estimated a $22M charge-off, recognizing most probable losses on the $47,440K of investments which are 90-plus days in arrears. This represents the probable best possible outcome for recovery from investment loans and is referred to below as the "Best-Current Book" scenario.

A second option is to reflect the losses on the full $93M for the non-accrual totals. This $93M, as shown in the table above, includes the $47M of the 90-plus arrears loans but includes those loan and preferred equity which are current on payment but for which there is a significant question about repayment of full principle. Using the same recovery factor as used in the analysis above, that would suggest a charge-off on the current loan portfolio of 0.4687 to yield a reduction of assets of $43,586K. Therefore, this would reduce the current $485M in assets to $464,261K and is referred to below as "Non-Accrual Impairment".

A final option is to reduce the current assets by the $183,807K amount of assets on RAIT's watchlist, assuming everything struggling in their portfolio goes bust. This is a bit of an extreme view, but it could approximate the impact on RAIT in the case of a downturn. Again, assuming the recovery factor used above, this would reduce assets by $86,150K and is referred to as "watchlist impairment".

So, the options considered for the future impact of loan losses on security recoveries are summarized in the following table:

Matrix of Possible Outcomes:

What we have now seen is that there are two variables that will drive recoveries on the preferred shares in the future, recoveries on real estate and recoveries on the loan investment portfolio, with the latter having the greatest impact upon future recoveries. For each as discussed above, there appears to be a reasonably defined spectrum of possible outcomes, as discussed immediately above and summarized in the following table:

Recovery Input One can use a simplified version of the balance sheet above (noting that the loan assets are slightly different than the balance sheet loan assets due to stripping out loan amortization or other adjustments and using face value only):

Simple 3 or an even simpler sheet to directly calculate the recovery from assets net of liabilities and the total number of preferred shares outstanding (or could even use a 10M preferred share count to make it simpler), as shown in the following table:

Simplest 3 One can use either table and create a table showing the breadth of reasonable outcomes for recovery for each preferred share by evaluating the alternative outcomes to produce this spectrum of preferred share recoveries by case:

Recovery by Case 2 So, calculating a spectrum of outcome for the preferred, we find that there is no recovery in the most negative of the nine cases where the "Watchlist Impairment" occurs and where the recovery for real estate is depressed relative to current book value. Even in the case of the "Watchlist Impairment", a relatively negative case, real estate recoveries at or higher than book value results in recovery for each preferred share relative to the degree to which higher market values are secured.

If the reader is dissatisfied with the cases that the author selected, one can now do one's own profile by replacing the loan asset value and real estate value with one's own choices, then easily calculate what one would recover on the preferred shares using these modified premises, using the simplified balance sheet/calculation sheet offered above. I had promised to offer those who disagree with my assessment of the real estate an alternative to use with their differing views of the value of those properties, and here it is:

Readers Choice Simply put in your estimate of mortgage/loan and real estate, then calculate simply a recovery to guide you in your decision about the preferred shares.

Comparing these recoveries to the current market price of ca. $1 suggests that there is a case to be made to take a "flyer" on the preferred shares. As they are the fulcrum security and as they absorb the first $68M of losses or absorb the next ca. $200M of gains, recovery calculations on these securities will vary substantially as liquidating transactions are complete. Note, however, that if Mr. Frischer were able simply to deliver market prices equaling current book value for real estate and current mortgage loan values net of the current allowance for loan losses, one would recover about $6+ for each $1 invested in any of the preferred shares.

Two other implications of this table:

  • Positive recovery of any amount for the preferred shares implies a full recovery for all RAIT recourse debt (but not necessarily the debt held in the individual VIEs which are non-recourse to the "mother ship") going forward. This table suggests to me that impairments, again as stated above, will not be so severe that the Senior Notes, RFTA or RFTT, will be negatively impacted and impaired, supporting the recommendation to buy RFTT above.
  • This recovery of $6 suggests that the recovery will be well below the $25+ recovery required for the common to receive the first penny of recovery. Again, reinforcing the observation offered above, it continues to appear unlikely that the common shares will secure any recovery once the smoke clears on the liquidation and redemption of many RAIT securities.

This entire analysis depends upon the balance sheet reflecting reasonably the opportunities to recover value. If the strategic team driving this process can secure substantially above balance sheet value for some undervalued asset (or an asset not reflected on the balance sheet), then this analysis could miss substantially on the recovery estimations. Alternatively, if there are drawers of off-balance sheet Krugerrands sitting around, this analysis will not reflect those additional, unbooked assets. Anything can happen, but this has seldom happened in my experience, and I don't recommend investing on that basis.

What Is The Owl Doing?

As indicated in the recommendation above, I have added the 7.625% Notes due 2024 to my Retirement (not Risk) Portfolio at a 3-4% level; in addition, I may choose to add more up to a level of 5%. I plan to hold these notes to call or redemption as I believe that they will be taken out at face value plus interest. In addition, I believe that they may be called early for the reasons cited above, driving up annual returns even if it reduces the income on a 10+% yield paid for a longer period of time.

Just prior to the publication of this article, the author also added the 7.125% Notes as well to the Retirement Account as well. Throughout most of the development of this article, the price of these Notes had hovered near $23; however, they had dropped in price in the past week, especially after the "ex-dividend" payment on the interest (as exchange traded debt) had passed, I used limit orders to keep all purchases below $21.50/share. As noted above, I had not been avoiding these Notes because I felt they would become impaired; rather, I had focused on the other 7.625% Notes as they offered much more upside. However, with the recent decline, the discount is now sufficiently large to take a position, doing so in my Retirement (not Risk) account. The bulk of my purchases remain concentrated in the other series of Notes.

I plan to wait for future earnings reports to see how the liquidation process continues in order to determine if I am going to take a "flyer" on the preferred shares. For these reports, I am less interested in the earnings themselves than the updated information on liquidations and redemptions. In turn, this allows a better expectation of the potential recovery, if any, as well as a better view of how long it will take to secure that recovery, equally important with the recovery itself. If the RFTA Notes are taken out and some additional loan or real estate can be liquidated, that suggests that market recoveries close to book value are being secured, I may choose to take a flyer on these shares at these depressed prices in my Risk Portfolio (definitely NOT my Retirement Portfolio). However, at this point, the reward-risk on the Secured Notes due 2024 look to have a superior reward-risk profile at this point and that is the security on which I am now focused for purchase.

Disclosure: I am/we are long RFTT, RFTA. 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: No guarantees or representations are made. The Owl is not a registered investment adviser and does not provide specific investment advice. The article is for informational purposes only. You should always consult an investment adviser.