RSO Dividend Going the Way of the Snail Darter?

SNAIL DARTER
(Percina (Imostoma) tanasi)

FAMILY: Percidae

STATUS: On October 9, 1975, this species was officially classified in the Federal Register as endangered.

Resource Capital Corp reported yesterday. Ominously, REIT taxable income for the quarter was less than its declared dividend, and RSO reduced future dividend guidance to .37-.39/quarter. Still, RSO year-to-date earnings are ahead of its year-to-date declared dividends, so it may be too early to sound the red alarm. On the surface, RSO’s earnings were not too disimilar to Northstar’s (NRF), which last quarter also reported AFFO that was just below its dividend (Northstar reports Q2 earnings on Thursday, August 7th).

The similarities end there, however. Northstar is an internally managed REIT that focuses on one thing: commercial real estate. RSO is externally managed and has a “diverse” – real estate being the largest component – portfolio of cats and dogs that includes everything from equipment leases to real estate loans, bank loans and even REIT TruPs. I love the fact that RSO has both issued TruPs (as a borrower) and invested in them (as a lender).

Regrettably, RSO also commenced operations in 2005, which meant that they faced intense competition for quality assets amidst a frenzy for yield. As a result perhaps, some of their “bank” loans (but not all) carry spreads of up to 6.75 over LIBOR, which indicates a pretty frightening borrower risk profile.

So it shouldn’t be surprising that RSO’s earnings pressure came partly as a result of both specific loan loss reserves and charge offs, and an increase in general reserves, as well as a huge miss on loan exit fees and loan repayments. Even clumsy IStar (SFI) didn’t have such a bad showing on forecast repayments. Unfortunately, this means that RSO’s IRR-driven borrowers have been unable to execute their exit strategies with either (1) asset sales or (2) refinancings. In contrast, Northstar’s earnings pressure came simply from the fact that they were sitting on a big pile of uninvested cash. Like RSO however, Northstar management believes that “best investment opportunities we have seen in years will occur later this year.”

I also loved the juicy RSO conference call. The CRE portfolio manager spent the bulk of his time detailing events around one defaulted mezzanine loan with an underwritten debt coverage ratio of 1.18% and a coupon of treasuries plus 765 yikes! but management curiously spent almost no time explaining why they had increased general reserves on the rest of the portfolio, which includes those other “bank” loans at LIBOR plus 675 yikes again!

The best part of the call was the characterization of the mezzanine borrower as “disengaged” and the collateral as a case of “good property gone bad” malls gone wild! with “sudden vacancy issues”. Truthfully, and in all fairness to RSO, these particular malls may have been good properties when they first opened. But that was back in 1969, a few years after sputnik.

Now, almost four decades hence, both were Brady-Bunch era relics having a difficult time competing with the brand new “lifestyle” shopping centers that had just opened down the street. Suddenly, treasuries plus 7.65 is looking cheap! quick, where do I sign? These new shopping destinations siphoned off tenants from the old fallout shelters malls securing the RSO loans, including the anchors, which led to the “sudden” vacancy issues they referred to in the conference call. Going in, everybody knew about the lifestyle centers….but that was then and we all know about then now.

As for the disengaged borrower, this is a guy who started out twenty years ago with a couple of brownstones in Brooklyn, I jest not, and by 2005 he had grown his company into one of the largest privately held owners of real estate in the country by using you guessed it! OPM. That led to his nearly $8 billion purchase of the “limited service hotel chain” from Blackstone AT THE PEAK!, and the now “distressed” multi-billion dollar loan related to it.

The Usual: Delay of Game

How disengaged was he? Well, first of all it wasn’t his money, so the term implies he was really engaged in the first place. That aside, he was pretty disengaged. At the end of March, he had been saying for weeks that he was close to reaching a deal on $31 million in defaulted unsecured corporate bonds related to the hotel deal (he defaulted on March 15).

Then, he said it was really just a matter of a simple family vacation. “My luck — the guy who is in charge of it [the workout], he called me and said, ‘Look this is not very important to us and I’m on spring break with my kids. And let’s just finish it when we get back.’ “

This is the same guy who was negotiating a work out stuff job with RSO. S&P was not fooled, amazingly enough, and placed the senior bonds (CMBS) secured by the malls on negative watch at the same time (March). In response, the borrower offhandedly said that the mall loans “likely will be worked out”.

According to the RSO conference call, the senior lenders took a “significant hit” to principle when they finally foreclosed on the malls. This was no surprise, and it flicked RSO’s junior mezz loan into the bin as a result. Given that the senior underwriting probably anticipated debt service coverage of at least 1.30% (and look what happened!), how unreal do you think RSO’s pro forma junior 1.18% was??

It’s just another reminder not to eagerly swallow every morsel offered up by management Let’s face it: the collateral here is older than the CEO. Everybody is struggling to get it right, but in this environment getting it right is just about impossible. If RSO’s borrowers are currently unable to sell or refinance, it means that those deals are not working as planned either, and that could lead to even more reserves and charge-offs down the road.

MANAGEMENT AND PROTECTION: The Snail Darter Recovery Team recommends that there should be at least five separate viable populations to eliminate the threat of extinction.