The credit crisis has claimed victims far and wide and caused wholesale capital flight from anything related to financial services. With their mix of high leverage and complex balance sheets loaded with real estate assets, the credit intensive Mortgage REIT sector has certainly not been spared in this financial firestorm.
In many cases, this capital flight is justified. As the poor quality of the portfolio cash flows have become apparent and the almost near-certainty of credit losses have diminished or eliminated the intrinsic value of the underlying investments, many Mortgage REIT equity values have plunged.
In other cases however, where the mortgage meltdown and the associated lack of liquidity have combined to discount even strong, predictable cash flows associated with high quality, income-producing collateral, the dislocation of a lifetime is occurring. As Larry Goldstone, the embattled CEO of Thornburg Mortgage (TMA), put it succinctly last month: “In this environment, the current market price of assets has become disconnected from their underlying recoverable value.”
One Mortgage REIT that is not suffering as much as TMA, but has nonetheless seen its equity value disconnect from the underlying value of its strong portfolio cash flows is Anthracite Capital (AHR). Anthracite is an externally managed Mortgage REIT that focuses solely on commercial real estate, unlike Thornburg. Although AHR invests up and down the credit spectrum, and directly originates commercial real estate loans on its own, the Company’s focus is on underwriting and acquiring below-investment grade Commercial Mortgage Backed Securities (“CMBS”).
AHR is not without risk, but if you can’t handle that I have a heavy mattress for you to lift instead. Because its investment focus is on “controlling class”, or lower rated CMBS tranches, its portfolio is squarely in the cross hairs of the current fears related to large scale CMBS defaults.
Also, while most of the portfolio is funded via long term, non-recourse match funding arrangements, 18% of its portfolio is subject to mark to market risk (i.e. margin calls). AHR has thus far been able to meet its margin requirements, but the Company is working to reduce this risk.
In a significant move that should help, AHR yesterday announced that it plans to issue $93.5 million in common and convertible preferred stock to DLJ Capital Partners. Its parent and external manager, the bond behemoth Blackrock, has also shown recent support in the form of a $60MM secured loan. Along with short-term credit facilities from Deutsche Bank and Morgan Stanley, as well as $100 million in unrestricted cash on the balance sheet at year end, the Company’s liquidity position is healthy.
From an investment perspective the most interesting aspect of AHR is also true with other Mortgage REITs: as the market spreads on its portfolio of CMBS investments have widened out to unprecedented levels, mark to market accounting requirements have forced AHR to mark down the value of these securities, even though the assets themselves continue to perform just as expected.
Therefore, despite the large GAAP declines in book value, AHR’s portfolio continues to produce strong operating earnings. Operating earnings is an accounting euphemism for cash, and cash is the stuff we like because it lands in our accounts in the form of dividends.
Consequently, the question one must ask is whether AHR’s currently strong portfolio cash flows (and yield) will be impacted by default levels that are anywhere even close to the levels that the spread widening in the CMBS and CMBX markets imply. In essence, could the market actually have it wrong? Some analysts and real estate professionals believe so.
Earlier in January, while the CMBX continued to soar (up is bad with the index, it implies higher defaults), Fitch Ratings was moved to write a research note calling the default rates implied by the most recently issued CMBX index ”extreme”. They noted the index was implying a CMBS default rate that was three times the ten-year cumulative average. Fitch said they do expect CMBS delinquencies to rise simply because they are now at historically low levels, but not to three times the historical norm.
While the financial markets declared a nuclear winter on real estate debt, and the CMBX continued to jump throughout February and the first half of March (it has since come down some), commercial real estate fundamentals have remained solid. Vacancy levels are still low because new construction in this cycle has been muted, unlike the previous boom in the 1980s when massive new supply hit the market. Thus, rental growth has remained steady.
Following the Fitch note, in a more recently issued report entitled “Debt Market Panic Overstates Risk in Commercial Real Estate Market”, an analyst at CBRE Torto Wheaton Research echoed the theme, arguing that current CMBS valuations imply “doomsday” loss rates. He said loss rates would need to jump by historic proportions this year, and then be sustained at the highest levels ever recorded for several years in order to justify current CMBS pricing.
Steve Graves, Managing Director and Chief Operating Officer of Principal Real Estate Investors, the real estate lending subsidiary of the Principal Financial Group which manages $311 billion in assets, agrees. “A lot of what you’re seeing today is really fear of what might happen rather than what is happening,” he said,
Alas, I cannot simply serve the creamy pudding without actual proof of the market’s irrationality. Thus, I must give you this: according to Fitch, the cash flows produced by commercial property are still attracting capital from commercial real estate lenders. Defaults are currently not nearly as widespread as the markets feared.
Fitch Ratings decided to look into this very issue and issued a March 25 report examining the default rate of maturing CMBS deals (they all have balloons that must be refinanced on maturity). Fitch found that ninety-nine percent of recently matured U.S. CMBS loans have been successfully refinanced.
Broken down further, a total of 3,354 U.S. CMBS fixed rate loans with a balance of $21.4 billion have been refinanced successfully since the credit crunch began in August. The lenders were mostly insurance companies and regional banks. Tangentially, I personally know of at least one major insurer that has allocated $10 billion to commercial real estate loans for 2008.
Consequently, the cogent answer to our question must be yes, the market does have it wrong. The CMBX has been relentlessly shorted by hedge funds, and the default risk implied by that market completely distorts actual commercial property fundamentals, which remain healthy. Thanks to effects of this dislocation, and the requirements of mark to market accounting, now is the buying opportunity of a lifetime in Mortgage REITs.
In addition to AHR, other match-funded Mortgage REITs to consider are Northstar Realty (NRF). RAIT Financial (RAS) is also interesting as is Newcastle (NCT), though the latter has reduced its dividend. For the full smorgasbord, and it’s a real mess, see this Mortgage REIT list, which includes current, updated yields.
Use discretion though. It will be months, if not years, before any Mortgage REIT can resume strong growth again, so this is for longer-term money. However, with these yields and the power of compounding, you could be cashed out in three years anyway.
(NOTE: For an update on Anthracite, please see High Risk, High Yield Strategy Keeps Anthracite Under Pressure, including the comments.)
Click here for an updated list of Mortgage REITs, including current yields
Disclosure: Long AHR, NRF and RAS at the time of publication
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