2023-08-21 07:35:00 ET
Summary
- Commercial real estate companies have suffered due to predictions of a collapse, but experts recognize that this crisis has not yet occurred.
- BrightSpire Capital (BRSP) has acquired properties through foreclosure, and their current book value reflects a potential increase in value if the properties are leased up.
- Ares Commercial Real Estate (ACRE) has a conservative approach, with low leverage and the potential for future dividend growth. They are selectively opportunistic in their loan origination.
Co-authored with Treading Softly
It is a simple fact that there are vast fortunes that are formed in economic crises. During the Great Depression in the United States, many families established generational wealth that would continue to this day. During World War Two, various individuals who had less scruples were able to amass great wealth for themselves within Europe. Furthermore, the fall of the Soviet Union helped forge what is now known as the Russian oligarchy – individuals who hold vast power because of the collapse of the Russian economic system.
All throughout 2020 and beyond, there has been a frequent call that commercial real estate will utterly collapse due to the movement of working from home. This has caused many companies that invest in commercial real estate or do commercial lending for real estate to suffer and languish, even though their earnings continue to be quite strong. Source
Experts who called for such a fall are starting to recognize that this crisis has never occurred yet. The share prices of many of these companies have still cratered, providing an awesome opportunity to collect high yields.
As professional income investors, we look beyond just market sentiment and look at the fundamentals of various companies to understand what is really going on. While we recognize that sentiment can make a powerful movement in the short term, we understand that fundamentals drive the long-term performance of companies.
Today we want to look at two companies that have been beaten up by sentiment and whose fundamentals are strong, yet have been beaten down. Blood in the street!
Let's dive in!
Pick #1: BRSP – Yield 12.5%
During the last quarter, BrightSpire Capital, Inc. ( BRSP ) acquired two properties in Long Island using "deed-in-lieu of foreclosure". Then subsequent to quarter end, BRSP received a third property in Oakland. This means that the borrower was unable or unwilling to continue paying the mortgage, and instead of forcing BRSP to go through a court process, the borrower voluntarily signed the deed over, in exchange for BRSP forgiving the remaining loan.
BRSP previously recognized a specific CECL reserve on these loans, and the market reacted negatively at that time. In Q2, the realization of the "loss" did not have an impact on book value because it was already recognized. That didn't stop the market from treating it like a new issue.
Here is what these two loans looked like in Q1: Source
BRSP was reflecting $35 and $34 million in value on its books, while the borrower owed $68 million on each one. Both were underwritten at slightly under 60% loan to value, implying that the buyer originally paid $113 million for each property in 2019.
So BRSP was owed just under $137 million on two properties that were sold in 2019 for about $226 million. BRSP recognized a paper loss writing the value down to $69 million. So for BRSP to recognize the current book value today, it would need to sell the properties for about 30.5% of what they sold for in 2019. This is why investors shouldn't panic when they see dramatic numbers like "This building sold for 70% less than it sold in 2019!!!" If that poor result occurs, BRSP's book value would be exactly the same as it is today, as that size of loss is already included in book value.
A 70% decline in the value of a property does happen sometimes, but it is not something that always happens. One thing that separates mortgage REITs from banks, is that mortgage REITs have a lot more flexibility to own properties for an extended period of time. For various regulatory reasons, banks have a very strong incentive to dump properties quickly, often at very poor prices. They have other segments of their bank they need to worry about, so the emphasis is on extracting capital as fast as possible. Mortgage REITs aren't in a hurry. BRSP has properties in its portfolio that it has held for many years.
BRSP already owns and operates properties, some of which have been held for over 10 years. The Long Island Properties will join the category of "other real estate", a segment that provided BRSP positive net operating income of $3.6 million last quarter. Source
When an mREIT acquires a property from a borrower, its loan turns into an acquisition. The mREIT then has the option to sell it quickly as a bank would and just eat a loss, or if there is potential in the property, the mREIT can own the property. Remember, the borrower was paying over 8% interest on the $136 million in principal on the loan. How much interest does BRSP have to pay? Not a penny. BRSP owns the property free and clear, which creates a much lower hurdle for the properties to become cash-flow positive.
Here is what CEO Mike Mazzei said about these Long Island properties:
"But that building is unique because it sits right on top of a subway station and a rail station and a block away from a major subway line. So we've gotten a lot of inquiry on that. What we're finding is that when you do a short sell process, you're attracting low bids because they sense -- the buyer sense distress and rightfully so, I don't begrudge them that.
So we felt like taking these assets over to demonstrate that they're in stable hands, and more importantly, that leasing brokers are going to get paid. And that's key. So now that we own these properties, we are getting inquire on that. I think for an exit on that, we'd have to start to see some level of stabilization, some leasing activity where if we have LOIs in place that are strong and we have maybe tenant improvement program for that tenant up and running where a buyer or a prospective buyer can see that the property could at least sustain its operating expenses and the negative carry on that is less."
The current carrying value that these properties were written down to reflects an estimate of what the properties could sell for today "as is". If BRSP is successful at leasing up some of the space, the value of the properties will be increased, and BRSP will be able to sell at a higher price than is currently reflected in book value.
There is execution risk. BRSP will have property-level expenses, it might decide it needs to invest some cap-ex to fix up the property and make it attractive to tenants. But management believes that they can increase the value of the property, and ultimately be able to sell it for a much higher price than it can right now. If it can, any amounts above the current carrying value will result in a gain for book value.
BRSP does an excellent job walking investors through each property that is on its watch list. The watchlist is currently composed of 7 loans that are risk level "4" which means they are still paying interest, but the property level finances are underperforming BRSP's expectations. Only three properties are level 5, which means they are not paying. Note that the CECL (Current Expected Credit Loss) reserves declined materially quarter-to-quarter as BRSP resolves troubled loans one way or the other.
Of the three risk-level 5 properties, BRSP received the deed of the Oakland property, and expects to receive the deed on the Washington, D.C., property – an office space that BRSP has engaged with developers to consider redeveloping the property to an alternative use. The third is a mezzanine loan that has already been written down to $0 in carrying value.
Lending money is a credit risk. Borrowers don't always repay. Every lender under the sun deals with that reality. For investors, the question is always how severe defaults will be, and what the recovery will be. After all, BRSP's book value is $11.53/share after the $107 million CECL reserve. In other words, BRSP's current book value is assuming that it loses $107 million in credit losses. The current price is $4.50/share lower than that – for book value to decline that low, BRSP would have to realize another $585 million in losses.
BRSP's entire loan portfolio is carried at $865 million. So the market is assuming a loss rate on BRSP's equity of 70%, not just across BRSP's distressed loans, but across every loan in its portfolio.
The market is selling the headlines, but it clearly is not doing the math. Meanwhile, BRSP management has taken the appropriate steps to decrease leverage to 1.9x equity, among the most conservative in the sector. BRSP has plenty of cash on hand to manage its balance sheet, and substantial capacity to originate loans when there is an opportunity to do so. The best part is, BRSP is operating with such a conservative positioning while covering its dividend by 125%. Investors can sit back and collect the dividend with confidence while waiting for the commercial real estate market to stabilize.
Pick #2: ACRE – Yield 13.6%
Ares Commercial Real Estate ( ACRE ) is another commercial mortgage REIT that has opted for a very conservative approach to 2023. ACRE's leverage is currently at 1.9x. Its distributable earnings came in at $0.35, comfortably covering its dividend. Source
ACRE is the first commercial mREIT we follow that has decided that the discount to book value that the market is providing is compelling enough to justify buybacks, repurchasing 536,000 shares at an average price of $8.58. ACRE was previously paying out excess cash-flow as a $0.02/quarter supplemental dividend. Management has decided to redirect that capital into buybacks. So we do not anticipate further supplements. Although, when ACRE decides to leverage back up, there could be opportunity for future dividend growth.
The question is when will ACRE decide to leverage up? Here is what management said when questioned about opportunities to grow the portfolio in the earnings call :
"I wouldn’t say that the market is in equilibrium yet, so it will be more sporadic in nature. But I think you can assume a further increase throughout the following couple of quarters as buyers and sellers of real estate come to agreement on price and also just that maturity wall that has been well advertised, I think, as kind of a headline risk, but we really see it as an opportunity.
So what we will focus on, just to add a little bit finer point, are kind of going up in credit. So the spread associated with the loan that we made this quarter was probably a significant increase from where it would have been 18 months, 24 months ago, but south of what’s available in the market, just given the credit metrics associated with it.
But when combined with the legacy liability structure, it produces a really interesting yield premium to historical norms. So I wouldn’t say it’s a normalized market, but I think you can expect more of the same moving forward from here."
Later on, CEO Donohoe described their origination philosophy in this environment as "selectively opportunistic". Reading between the lines, we can expect that ACRE is going to maintain its conservative positioning and try to pick up only what it views as the most attractive risk/reward loans to maintain leverage around 2.0x. It will take a more fundamental shift in the economy for them to be comfortable with really picking up the origination pace and leveraging up. The most obvious catalyst for that to happen would be some sign that the Fed is definitively done hiking rates and that rates could start coming down in the foreseeable future.
Until then, ACRE is playing defense, making sure it stays ahead of any mortgages that are struggling with higher interest rates, and ensuring that ACRE's balance sheet is solid enough to weather any storm.
During the Great Financial Crisis and COVID, companies entered into those difficult times with high leverage, running at full speed. There is recession risk today, but companies like ACRE are operating at historically low levels of leverage, with an abundance of caution. The main risk for a lender is not borrowers defaulting. The main risk is the lender being forced to deleverage and sell loans at poor prices. By being conservative, ACRE is taking that risk off the table. If a borrower defaults, ACRE can just take the property and has the balance sheet strength to hold it on the books until the real estate market recovers and it can sell for a profit. They are essentially "buying" properties at a 40-50% discount to what everyone else has spent the past 5 years paying.
A difficult real estate environment is a risk when highly leveraged. When you have cash and a lot of liquidity on hand, it is an opportunity. ACRE is well positioned to benefit.
Conclusion
With ACRE and BRSP, you can gain exposure to commercial real estate through a safer means than trying to go out and buy property on your own. Both of these companies being REITs, are, in essence, pooling the money of various investors together under a skilled management team to be able to operate a portfolio of holdings or loans that provide you with excellent income. The very REIT structure requires that they pay 90% of their taxable earnings to you, the shareholder. So there is no easy way for them to try and enrich themselves while not enriching you at the same time.
The market has priced these companies as if the commercial real estate collapse has already occurred, but experts are already recognizing that the call for such a collapse was foolhardy and too early. While many of the unknowns from 2020 allowed a lot of workers to work from home, companies are not just dropping buildings left, right, and center, as not all properties are office properties. While I agree that office space is still being heavily unused or underutilized, and many of those properties will probably not see their loans successfully renewed or matured, both of these companies have moved heavily out of that sector. At the end of the day, a skilled management team operating a skilled company can find success where others have failed. I think both of these companies have skilled management teams.
That way, when it comes to your retirement, you don't have to worry about being a landlord and managing hundreds of properties to try and make ends meet. You can own companies like these, enjoy the paycheck that comes in the mail, and not have to worry about cleaning out the toilets. You can even make so much money that you might be able to pay somebody to clean out your own toilet. Wouldn't that be true Financial freedom? Freedom from house chores. It's all possible.
That's why I love my Income Method. That's why I love income investing
For further details see:
Buy The Dip When Blood Is In The Street