After Work Seminar: Mortgage REITs in Europe?

Transcription

1 After Work Seminar: Mortgage REITs in Europe? Moderator:- Hans Vrensen, Global Head of Research, DTZ Panellists:- Marion Cane, Executive Director Real Estate, Hospitality & Construction Tax, Ernst & Young Peter Denton, Head of European Debt, Starwood Capital Europe Joshua Barber, Vice President Research Analyst, Stifel Nicolaus

2 Mortgage REITs in Europe? I. What is a Mortgage REIT? II. Lessons Learned in the U.S III. Who Invests in Mortgage REITs? IV. Should Europe Have Mortgage REITs? 2

3 What is a Mortgage REIT? There are 3 Categories of Mortgage REITs 1. Agency REITs Invest in residential mortgage backed securities (RMBS) guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae Pure spread, no credit risk 2. Hybrid REITs Invest in agency RMBS, non-agency RMBS, CMBS, among other assets Various risk profiles depending on asset and leverage composition 3. Commercial Finance REITs Invest in commercial real estate debt (whole loans, B-notes, mezzanine loans, bridge loans), preferred equity, and commercial mortgage backed securities (CMBS) Financing structures range from securitization to credit lines For purposes of this presentation, we will focus mainly on commercial finance REITs (CFRs)

4 Agency REITs Brief Overview Target Assets: Agency-guaranteed RMBS or Collateralized Mortgage Obligations (CMOs) backed by year fixed loan Adjustable rate mortgages (ARMs) Debt Financing: day repurchase agreements priced at a bps spread over LIBOR Hedging: Fixed-pay vs. LIBOR interest rate swaps of 3-7 years as well as numerous other hedging instruments Leverage: About 7-8x debt-to-equity (high-80% leverage) Drivers: Prices/yields of agency RMBS, steepness of the yield curve, mortgage prepayment speeds (reinvestment risk), QE policy Risk Factors: Rising short-term interest rates, flat yield curve, high rates of prepayments, disruption in the repo funding market

5 Hybrid/ Non-Agency REITs Brief Overview Target Assets: Agency-guaranteed RMBS, non-agency RMBS, CMBS, securitized residential mortgages, whole loans Debt Financing Utilized: day repurchase agreements, bank credit facilities, securitizations Hedging: Fixed-pay vs. LIBOR interest rate swaps of 2-5 years as well as numerous other hedging instruments Leverage: About 3-5x debt-to-equity (75-85% leverage) excluding non-recourse mortgage securitization debt Drivers: Economic/housing trends, legacy RMBS prices, demand for new RMBS, steepness of the yield curve Risk Factors: Rising short-term interest rates, flat yield curve, high rates of prepayments, disruption in the repo funding market, deteriorating housing market conditions

6 Agency & Non-Agency REIT Universe PRICING DIVIDENDS BOOK VALUE Hi/Low/Short 11/20/12 P/E Div. Div. Book Price / 52 Wk 52 Wk Short Ticker Rating Mkt Cap Price (TTM) E 2010 MRQ Yield Value Book Hi Low % Agency REITs Annaly Capital Management Inc. NLY Hold 14, % American Capital Agency Corp. AGNC Buy 10, % MFA Financial Inc. MFA Buy 2, % Hatteras Financial Corp. HTS Buy 2, % CYS Investments Inc CYS Buy 2, % Capstead Mortgage Corp. CMO Buy 1, % Anworth Mortgage Asset Corp. ANH Hold % Armour Residential REIT Inc. ARR 2, NA N/A N/A % Average % Median % Non-Agency Mortgage REITs Chimera Investment Corp. CIM 2, % Invesco Mortgage Capital Inc. IVR Buy 2, % Redwood Trust Inc. RWT 1, % Two Harbors Investment Corp. TWO 3, NA % Walter Investment Management Corp. WAC 1, NA % PennyMac Mortgage Investment Trust PMT Hold 1, % AG Mortgage Investment Trust Inc. MITT Buy % Apollo Residential Mortgage Inc. AMTG Buy % American Residential Mtg MTGE NA % Walker & Dunlop Inc. WD Buy % Average % Median % Source: Stifel Nicolaus Mortgage REIT Research

7 Commercial Finance REIT Definition Commercial finance REITs (CFRs) meet all IRS REIT qualification tests Every CFR has a unique business approach - portfolio contents vary widely Pure CFRs invest in mortgages and commercial mortgage-backed bonds Some also invest in direct real estate, real estate entities, and NNN leases Most do some origination, and purchase loans or participate in loans originated by others, or through brokers CFRs are distinct from residential mortgage REITs, subprime lenders, and anything housing-related, but sometimes move in sympathy due to dependency on the bond market, use of high leverage, and historical volatility We divide the CFR universe into two categories; each has distinct investment risks and merits 1 st generation finance REITs, which existed prior to the financial crisis; these companies generally carried higher leverage and utilized securitization structures, and went through years of loan troubles 2 nd generation finance REITs, which went public in 2009 to take advantage of the distress in commercial real estate debt

8 Commercial Finance REITs Brief Overview Target Assets: Commercial whole loans, B-notes, mezz loans, bridge loans, preferred equity, CMBS Debt Financing Utilized: Collateralized debt obligations (CDOs), TALF loans, and bank credit facilities Leverage: About 3-4x debt-to-equity (75-80% leverage) for companies in 1 st generation CFR s, 25%-50% for 2 nd generation Drivers: General economic conditions, property values, balance sheet and leverage, CMBS/CDO market liquidity, and investment spreads over cost of capital Risk Factors: Asset value depreciation, credit market disruption, style drift (investing in riskier assets to maintain spread as the investment cycle progresses), externally advised structure rewards asset growth potentially over value creation

9 Commercial Finance REIT Universe 11/20/2012 Target SN Market Interest Dividend* EPS Price/Earnings Value Price/ Total Equity 1Y Total Company Ticker Price Price Rating Cap (mil.) (days) $ % 2011A 2012E 2013E 2014E 2011A 2012E 2013E 9/30/12 BV/NAV Debt (mil.) 09/30/12 Return 1st Generation Arbor Realty Trust ABR $5.09 NC $ $ % (1.50) NE NE NE NE NE NE $ $ 1, % BRT Realty Trust BRT $6.25 NC $ $ % 0.45 NE NE NE 13.9 NE NE $ $ % Capital Trust CT $3.54 NC $ $ % NE NE NE 0.3 NE NE -$1.6 NE $ % Gramercy Capital GKK $2.80 NC $ $ % 6.50 NE NE NE 0.4 NE NE -$8.4 NE $ 2, % Newcastle Investment NCT $7.94 $9.00 Buy $1, $ % 1.45 NorthStar Realty NRF $6.15 Hold $ $ % 1.60 (4) (2) (4) (2) (4) (2) (4) (2) $ $ 2, % $ $ 3, % RAIT Investment Trust RAS $5.38 NC $ $ % (1.35) (2.44) 0.61 NE NE NE 8.9 $ $ 1, % Resource Capital Corp. RSO $5.85 NC $ $ % NE NE NE $ $ 1, % istar Financial Inc. SFI $7.59 $12.00 Buy $ $ % (0.73) (1.79) (1.44) (1.44) NE NE NE $ $ 5, % 1st Gen Sector Weighted Averages/Total $4, % % 2nd Generation Apollo CRE Finance ARI $16.18 Hold $ $ % 1.59 (2) 1.56 (2) 1.70 (2) 1.85 (2) $ $ % Ares CRE Corp. ACRE $15.84 $19.50 Buy $ $ % NE NE $ NA Crexus Investment Corp CXS $12.40 NC $ $ % $ $ % Starwood Property STWD $22.19 $24.00 Buy $2, $ % 1.70 (2) 1.94 (2) 2.07 (2) 2.27 (2) $ $ 1, % 2nd Gen Sector Weighted Averages/Total $4, % % Hybrids Colony Financial Inc CLNY $19.15 $ Buy $ $ % 1.49 Winthrop Realty FUR $10.77 Hold $ $ % 1.74 (4) (1) (4) (1) $ $ % 1.49 (1) 1.63 (1) $ $ % Hybrid Sector Weighted Averages/Total $1, % % Overall Sector Weighted Averages/Total $9, % % (1) FFO (2) AFFO (3) FAD (4) Core Earnings (A) Actual Note: ACRE dividend is annualized based on the initial dividend EPS figures are Stifel Nicolaus estimates for companies under coverage and First Call estimates for the remainder Sources: FactSet, First Call, SNL, Thomson One, Stifel Nicolaus & Co. estimates

10 Commercial Finance REIT Assets CFR investments generally consist of: Short-term loans: Can be fixed or floating rate Mezzanine loans - subordinated loans, generally on value-add properties Bridge loans - first mortgages, generally on value-add or transitional properties Construction loans first mortgage loans with intensive management and drawing processes Floating rate character makes the lender agnostic on interest rate direction cash spreads are maintained Most CFR s will swap out their fixed and floating credit line exposure Primary risk is borrower execution, property performance, and economic conditions at maturity Longer-term fixed rate instruments: Generally first mortgages Sometimes repackaged into asset-backed or mortgage-backed securities (CMBS) and derivatives (CDOs) In a CMBS or CDO transaction, the REIT sells the credit-rated tranches or places them in CDO s for resale. The REIT may retain the first-loss tranches (B-pieces) and/or equity positions in the mortgage securitization The REIT makes a cash spread due to market inefficiency Prepayment risk is mitigated: Prepayment penalties are a deterrent (unlike in residential mortgages)

11 Management Commercial finance REITs add no real estate value they do no development and don t generally touch the real estate Management s primary task is spread investing to obtain returns over the company s cost of capital Investors rely on commercial finance REITs to do four things well: 1. Establish a Growth Pipeline Source positive spread investments through internal origination or relationship network 2. Underwrite Credit Risk Minimize default risk 3. Understand Real Estate Invest in buildings/locations that can be re-tenanted or sold in the event of default 4. Manage Capital Sources Minimize interest rate risk by employing debt, preferred equity, common equity, and derivative capital to match risk and control corporate-level capital structure blow-up potential Provide a stable, growing dividend and moderate share price appreciation over time Credit underwriting and balance sheet are the 2 primary keys to surviving and thriving through cycles, in our view

12 Advised vs. Internally Managed We prefer fully integrated REIT management Executive interests are aligned with shareholders The employees are dedicated, not splitting time they live and die with the REIT s success Externally advised REITs can be conflicted Fees are often based on assets under management, not performance The overhang of a potential internalization suppresses shareholder returns Management succeeds no matter how the REIT performs Some CFRs external advisor structures are acceptable The business is asset accumulation and spread investment (value creation is secondary to paying high dividends) Some advisors have affiliated businesses with synergies to the CFR Fee structures are often performance-related Advisors are dedicating staff to the REIT with related incentives (options, restricted shares) Advisor compensation sometimes includes REIT shares A few advisor contracts have reasonable formulaic buy-out terms The advisor fee load can be cheaper than an internally advised G&A structure Advisors may have resources that are not available to a smaller internally advised structure

13 Mortgage REITs in Europe I. What is a Mortgage REIT? II. Lessons Learned in the U.S. III. Who Invests in Mortgage REITs? IV. Should Europe Have Mortgage REITs?

14 Commercial Finance REIT History Mortgage REITs were formed in 5 cycles: Enabling legislation signed in 1962 led to first round of mortgage REITs Values dropped 65% in due to poor underwriting and resulting defaults Shares fell 43% from due to declining property values and resulting defaults The Russian bond crisis and Long Term Capital Management disaster crisis created mortgage REIT kill-off in 1998 Bankruptcies and liquidations were cause by squeezed duration strategies The mortgage assets were fine but mortgage REITs failed when their loans were called The most famous melt-down was Crimmie-Mae, a major B-piece investor Most of today s 1 st generation commercial finance REITs came public after the 1998 crisis All suffered through the financial crisis and were plagued by the loss of securitization markets as well as rising loan defaults & impairments All CFRs eliminated or cut their dividend by substantial margins Several went bankrupt, and all that have emerged have done so very slowly The second generation CFRs were formed after the most recent financial crisis

15 Lessons Learned? What makes this CFR cycle different than prior cycles? It is NEVER different Is risk lower? Leverage levels are well below prior peaks But debt today is recourse warehouse lines as opposed to non-recourse structures Real estate market information is more visible Loan underwriting has been more conservative Will underwriting truly be better? CDO bid has gone away Lenders are not dis-intermediated from borrowers Cycle is likely to be simpler this time around, keeping pure arbitrage away But is the yield sustainable over a cycle? We doubt it When aggressive players with a lower cost of capital return in size, it will be impossible to maintain dividends without taking additional credit risk or leverage probably both The non-bank financial conundrum

16 The Core of the Issue: The Non-Bank Financial Conundrum At their core, CFRs are non-bank financials Almost as a rule, non-bank financials have a higher cost of capital than banks They have no deposit base, insurance float, or access to Fed Funding How do they compete? Early in a cycle, bank lending is constrained, and opportunities abound, even with low leverage As time goes on, though, other lenders come back, driving down returns The initial solution is to lever up slightly or take additional credit risk, which allows the company to maintain earnings power But eventually a crossover point is reached: take on too much credit and/or leverage risk, or cut the dividend? Neither is particularly appealing Cycles still matter Our preferred solution: diversify by owning property and get an investment grade rating Offers income stability and forces leverage to stay low A sustainable and growing 5% yield is better than an unsustainable 10% yield Investors know this and price the stocks accordingly CFRs trade at much higher yields than equity REITs The key is surviving down cycles intact and maintaining capital access

17 Credit Quandary What s In Their DNA? What Can Investors Truly Know About CFR Assets? Compared to Equity REITs, asset disclosure is limited Many second generation CFRs have made excellent strides in this department But the short portfolio duration and high turnover make this a moving target As companies grow, this becomes more difficult Securitization immensely complicates matters; companies become individual silos Credit will overshadow interest rates in determining returns Beware We do credit better than our peers No one really knows and the sector is likely to trade as a group if one CFR trips Small amounts of defaults and losses can cause disproportionate losses and cash flow triggers GAAP financials become irrelevant Investors may focus on yield until credit stress emerges - it will be too late then CFR portfolio credit quality will control long term returns Real estate returns and intensive asset management are keys not just financial engineering

18 Our Overall CFR Investment Thesis The primary reason to own Commercial Finance REIT shares is the 8.2% average dividend yield Despite some additional risk-taking, there are no stress indicators so far CFRs appear to be in the sweet spot today Underwriting and leverage is reasonable Dividend yields and price/book valuations are attractive Capital access is improving Mortgage securitization is slowly returning Balance sheet management and scale creates value Yield investors are increasingly buying CFR shares High dividend yields may support values, but there are no bargains We believe several CFRs understand risk mitigation sufficiently to deserve investor interest The paradox of finance REITs is that the shares tend to perform best when underwriting is the worst; the inverse is true as well

19 CFR Stock Picking Thesis Risks Interest and cap rates are quite low A spike in rates could push assets above underwritten exit cap rates There are no bargains anymore on the asset side Credit markets are healthy, but EU problems could quickly change that Booming real estate values combined with easy credit is a prescription for disaster, whether commercial mortgages, leases, or housing loans We re not there yet, though Real estate fundamentals are cyclical defaults will eventually emerge as growth supersedes quality considerations Most CFR s trade above book value, which may be a ceiling if credit defaults emerge indicating 20% - 50%+ downside in a stressed market No finance REIT has successfully survived and thrived through a cycle 1940 Act

20 Stifel Nicolaus Commercial Finance REIT Ratings Drivers Price/Book Value Relative Valuation Unlike Equity REITs, there s little or no asset value beyond book Balance Sheet Risk Debt/Equity Ratios Term & Interest Rate Sensitivity Strategies: Matching Warehousing Hedging Dividend: Yield Coverage Growth EPS/FFO/FAD Equity Return targets & track record Growth pipeline & financing strategy expected spreads Underwriting Methodology & Credit Risk Management: Internally Managed vs. Externally Advised Real Estate DNA & Track Record Stability, creativity Pipeline Quality In-house Origination Network Relationships Affiliates

21 Mortgage REITs in Europe I. What is a Mortgage REIT? II. Lessons Learned in the U.S. III. Who Invests in Mortgage REITs? IV. Should Europe Have Mortgage REITs? 21

22 Who Invests in Mortgage REITs? REIT dedicated investors Yield-oriented funds Financial funds Hedge funds External Managers Retail Investors

23 Equity REIT & Mortgage REIT Historical Performance Many REIT investors are wary of mortgage REIT investing due to their long-term volatility and underperformance NAREIT (The National Association of Real Estate Investment Trusts) has tracked both the mortgage and equity REIT universe via separate indices since the early 1970s Equity REITs have consistently outperformed mortgage REITs over virtually all time periods with materially lower standard deviations (calendar year data are detailed on the next page) although there have been periods of significantly stronger returns out of the mortgage group It s worth noting that the composition of the mortgage REIT universe has changed materially over time given the number of blowups and bankruptcies that have occurred in the sector Below, we present the returns from 2000 until October 2012 for equity REITs and CFRs. Despite several years of significant outperformance, finance REITs gave it all back, and then some, starting in 2007 This reinforces our view that CFR investors must be especially nimble Equity REIT & Finance REIT Total Returns, Equity REITs CFR's % 25.6% % 37.4% % 38.5% % 84.7% % 7.5% % -16.1% % 30.3% % -48.8% % -74.8% % -41.0% % 42.0% % -11.3% 2012 (YTD) 14.1% 39.4% Total 334.2% -30.8% Source: NAREIT

24 Dec-99 Apr-00 Aug-00 Dec-00 Apr-01 Aug-01 Dec-01 Apr-02 Aug-02 Dec-02 Apr-03 Aug-03 Dec-03 Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07 Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10 Apr-11 Aug-11 Dec-11 Apr-12 Aug-12 Total Return Index Equity REIT & Finance REIT Historical Performance, Total Return Index, Equity REITs vs. Commercial Finance REITs Source: NAREIT CFR's Equity REITs

25 Mortgage REITs in Europe I. What is a Mortgage REIT? II. Who Invests in Mortgage REITs? III. Lessons Learned in the U.S. IV. Should Europe Have Mortgage REITs?

26 Should Europe Have Mortgage REITs? Why Not? Current European distress likely to create many years of opportunity Europe has not developed robust non-bank financing for commercial real estate CMBS financing does exist As does structured lending & senior/junior structures But banks still dominate commercial real estate lending Similar to these U.S CRE market around 1990 Real estate investors and funds have been on the Continent for a long time But virtually none of them are dedicated lenders The vast majority are distressed/opportunity funds The current cycle offers a chance to take lending share from traditional players This is limited to commercial finance REITs, which is similar to U.S. markets The very different dynamics of European residential mortgage financing makes those REITs an entirely separate discussion

27 Should Europe Have Mortgage REITs? Issues to Consider REIT Structure and Tax Issues in Europe Qualifying assets Taxable REIT subsidiaries Currency Hedging Cost and capital reserved can impact gross returns Differing tax and bankruptcy rules by country Foreclosure process varies greatly Default remedies far more difficult and less standardized than in the U.S. Institutional sponsorship Need deep knowledge of many markets and sub-markets Dedicated team of local professionals Existing relationship with local real estate players Size and scale required are prohibitively expensive for a start-up Less focus on yield than in U.S. Primary domestic investor is yield focused Blind-pool property REITs have been disappointing

28 Important Disclosures & Certifications Important Disclosures and Certifications I, Joshua A. Barber, certify that the views expressed in this research report accurately reflect my personal views about the subject securities or issuers; and I, Joshua A. Barber, certify that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendations or views contained in this research report. For our European Conflicts Management Policy go to the research page at Stifel, Nicolaus & Company, Inc.'s research analysts receive compensation that is based upon (among other factors) Stifel Nicolaus' overall investment banking revenues. Our investment rating system is three tiered, defined as follows: BUY -For U.S. securities we expect the stock to outperform the S&P 500 by more than 10% over the next 12 months. For Canadian securities we expect the stock to outperform the S&P/TSX Composite Index by more than 10% over the next 12 months. For other non-u.s. securities we expect the stock to outperform the MSCI World Index by more than 10% over the next 12 months. For yield-sensitive securities, we expect a total return in excess of 12% over the next 12 months for U.S. securities as compared to the S&P 500, for Canadian securities as compared to the S&P/TSX Composite Index, and for other non-u.s. securities as compared to the MSCI World Index. HOLD -For U.S. securities we expect the stock to perform within 10% (plus or minus) of the S&P 500 over the next 12 months. For Canadian securities we expect the stock to perform within 10% (plus or minus) of the S&P/TSX Composite Index. For other non-u.s. securities we expect the stock to perform within 10% (plus or minus) of the MSCI World Index. A Hold rating is also used for yield-sensitive securities where we are comfortable with the safety of the dividend, but believe that upside in the share price is limited. SELL -For U.S. securities we expect the stock to underperform the S&P 500 by more than 10% over the next 12 months and believe the stock could decline in value. For Canadian securities we expect the stock to underperform the S&P/TSX Composite Index by more than 10% over the next 12 months and believe the stock could decline in value. For other non-u.s. securities we expect the stock to underperform the MSCI World Index by more than 10% over the next 12 months and believe the stock could decline in value. Of the securities we rate, 50% are rated Buy, 47% are rated Hold, and 3% are rated Sell. Within the last 12 months, Stifel, Nicolaus & Company, Inc. or an affiliate has provided investment banking services for 22%, 14% and 8% of the companies whose shares are rated Buy, Hold and Sell, respectively.

29 Additional Disclosures Please visit the Research Page at for the current research disclosures and respective target price methodology applicable to the companies mentioned in this publication that are within Stifel Nicolaus' coverage universe. For a discussion of risks to target price please see our stand-alone company reports and notes for all Buy-rated stocks. The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. Employees of Stifel, Nicolaus & Company, Inc. or its affiliates may, at times, release written or oral commentary, technical analysis or trading strategies that differ from the opinions expressed within. Past performance should not and cannot be viewed as an indicator of future performance. Stifel, Nicolaus & Company, Inc. is a multi-disciplined financial services firm that regularly seeks investment banking assignments and compensation from issuers for services including, but not limited to, acting as an underwriter in an offering or financial advisor in a merger or acquisition, or serving as a placement agent in private transactions. Moreover, Stifel Nicolaus and its affiliates and their respective shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options or other derivative instruments based thereon. These materials have been approved by Stifel Nicolaus Limited, authorized and regulated by the Financial Services Authority (UK), in connection with its distribution to professional clients and eligible counterparties in the European Economic Area. (Stifel Nicolaus Limited home office: London ) No investments or services mentioned are available in the European Economic Area to retail clients or to anyone in Canada other than a Designated Institution. This investment research report is classified as objective for the purposes of the FSA rules. Please contact a Stifel Nicolaus entity in your jurisdiction if you require additional information. The use of information or data in this research report provided by or derived from Standard & Poor s Financial Services, LLC is Copyright 2012, Standard & Poor s Financial Services, LLC ( S&P ). Reproduction of Compustat data and/or information in any form is prohibited except with the prior written permission of S&P. Because of the possibility of human or mechanical error by S&P s sources, S&P or others, S&P does not guarantee the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. S&P GIVES NO EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE. In no event shall S&P be liable for any indirect, special or consequential damages in connection with subscriber s or others use of Compustat data and/or information. For recipient s internal use only. Additional information is available upon request 2012 Stifel, Nicolaus & Company, Incorporated, One South Street, Baltimore, MD All rights reserved