What's The Rub With RAS?

Things are looking up... The Wall Street Journal reported Wednesday that investors and issuers of commercial mortgage-backed securities have something to cheer about for a change: The CMBX, a two-year-old credit-market index that has been heavily influencing CMBS prices, has been on a tear since late March.

As REITwrecks wrote earlier, the index had been under the influence of short sellers and trading at levels that would imply default rates of as much as 100% of the underlying commercial mortgages. As the WSJ reiterated, this is an all-but-impossible scenario, and with the index now oversold, investors are starting to pay more attention to the fundamentals of the commercial-property market.

REITwrecks has been emphatic about this disparity between price and value: for a long time, a myopic Mr. Market simply got it very, very wrong. Superficial similarities between residential and commercial real estate just did not and do not exist, and he has discounted the instrinsic values of the cash flows associated with commercial real estate far too heavily as a consequence.

Goldman Sachs' CFO David Viniar underlined the point in a conference call with investors last month. "Many assets are being priced by the market at levels which are significantly below the levels that would stem from a fundamental valuation approach," he said, while blaming depressed prices on "technical contagion" that eventually will abate.

As if on cue, over the past several weeks, spreads between Treasury's and the AAA CMBX have tightened dramatically, which in turn has driven up the prices on actual bonds. According to the Wall Street Journal, the spread on the triple-A series 4 index, which tracks certain 2007 CMBS deals, has shrunk to less than a hundred basis points after almost reaching a 3-handle in mid-March.

"I see the rally as something that should have been expected given how far out of whack CMBX spreads had gotten versus stable commercial real-estate fundamentals," said Darrell Wheeler, global head of securitized strategy at Citigroup Inc.

In another rare sign of stability returning to the market, last week Lehman Brothers and UBS lowered some yields on $1 billion of commercial mortgage-backed securities in what may mark the first CMBS of 2008 to price at yields lower than those first pitched.

According to Reuters, Lehman and UBS lowered yields on the "AAA" rated portions by 15 basis points to 25 basis points without losing orders. Previous issues had been sweetened with additional yield to draw investors shaken by the credit crunch and concerned that commercial real estate would falter in a U.S. recession.

Signs that sentiment has begun to improve have also been seen in the secondary market for CMBS. Spreads on outstanding 10-year "AAA" bonds have dropped by 100 basis points in the past month, according to JPMorgan Chase & Co.

After spending a considerable amount of time at the bottom of the lake, even the CLO/CDO market is starting to slowly heave its chest again. Traders report an increased appetite for European CLOs in the secondary market, but that the interest remains hampered by the lack of supply - caused primarily by sellers who see value in the paper and are thus unwilling to sell at such wide spreads. Previously there had been a steady trickle of assets from credit funds, SIVs and other forced sellers, which satisfied interested buyers, but this now appears to have ended.

The groundwork is being laid for a recovery in the second half of the year, suggest structured credit analysts at JPMorgan, who contend that higher relative value now compensates for the risk of mis-timing the bottom. CLOs could actually be part of the solution, given that banks are using the vehicles to move loans off their balance sheets.

However, demand is nothing what it used to be, with two thirds of the market for CLOs, CDOs and MBS having been wiped out, and those investors that do remain have become even more sensitive to underwriting and the managers behind each deal. Track record is everything. Demand has thus not even come close to recovering from pre-crisis levels, if it ever will at all.

And this is the main Rub with RAS: even with cash flowing assets match funded with long-term, non-recourse liabilities, RAS has been cut off from the oxygen it needs to grow FFO. Thus, in one of the best markets in 20 years, RAS has very little room to maneuver for new, choice assets at these premium spreads.

Combine this with lingering doubts about the Trust Preferred portfolio, much of which is covenant-lite and exposed to less solid credits and, indirectly, even shakier markets (think Accredited Home Lenders), and you still have a lot of uncertainty. Consequently, even with Thursday's 7% jump, RAS is still trading near its credit-crisis nadir.

REITwrecks is conducting research on the Indian Ocean and will be relatively unplugged when RAS reports on May 5th, but mark-to-market is now old news. The issues to pay attention to now are the ability to fund growth (true for all REITs), and the health of the TruPs portfolio (RAS in particular).

As Lehman Brother's CFO said, "we look at the mark-to-market adjustments as more temporary in nature," the steep decline of mortgages and loans has been "driven by many technical factors, which may not reflect intrinsic value," she said.

Unfortunately, the true intrinsic value of RAS's TruPs portfolio is yet to be determined, and future value creation in this bountiful market hinges heavily on the Cohen's funding creativity. Watch for both on May 5th.

Disclosure: Long RAS

Conservative Investors: Apartment REITs Offer Safety Amid Market Turmoil

Despite the industry wide turmoil in REITs and real estate, the Multifamily Executive News Service reports that Apartment REITs seem to be faring well, according to a recent study from Standard & Poor's Ratings Services.

Things might not look as good as 2006 and 2007, but they still aren't bad, according to George Skoufis, S&P's primary apartment REIT analyst. "In 2008, we expect continued moderation but positive rent growth," he says. "From a fundamentals standpoint, we've seen moderation in rent growth and NOI growth."

Green Street Advisors, based in Newport Beach, Calif., also studies the REIT market and sees positive growth potential. The firm projected that revenue growth would hit 3.8 percent coming into the year, but those projections have since fallen back to the 3.5 percent mark.

"Apartment REITs overall this year should still achieve positive revenue growth, even in the face of a mild recession," says Haendel St. Juste, an analyst with Green Street. "Despite a slowing economy and an increased supply of single-family and condo "shadow rentals" in certain markets, the supply/demand picture is still in pretty good balance."

Skoufis sees the for-sale market troubles as one of the biggest boosts to the supply/demand equation. "Homeownership is coming down," he says. "That will benefit the multifamily sector."

Even with a slight recession, St. Juste thinks multifamily will hold up. "Demand will still be driven from household formation, a declining homeownership rate, and Echo Boomer demand," he says. "Even in periods of very weak job growth, new household formations tend to bottom out at around 500,000 per year, a result of an ever-growing population."

All of these factors help the REITs, of course. S&P sees AvalonBay (BBB+/Positive), Equity Residential (A-/Stable), and Camden (BBB+/Stable) as setting the pace for the multifamily sector, though it recently downgraded both AvalonBay (for its large development pipeline) and Equity (for not having debt protection).

Although BRE Properties (BBB/Stable), Essex Property Trust (BBB/Stable), Post Properties (BBB/Credit Watch) and UDR (BBB/Stable) were at the bottom of the REITs list, Skoufis says they're still fairing well compared to other sectors.

"They're solidly investment grade," Skoufis adds.

Amplifying this point, the National Association of Real Estate Investment Trusts (NAREIT) reported that Residential REITS were the second best performing REIT sector in the first quarter of 2008.

Apartment REITS, which comprise most of the Residential REITS (the balance is composed of manufactured housing REITs), were up 12.29 percent year-to-date. Residential REIT returns increased 11.20 percent in the first quarter. These are impressive figures compared with the Dow Jones Industrials which was down 7.55 percent to start the year.

Apartment REITs' total returns compare favorably with the those of the U.S. REIT market, which was nearly flat for the first quarter of 2008. (The FTSE NAREIT All REIT Index was down 0.42 percent, while the FTSE NAREIT Equity REIT Index was up 1.40 percent.)
By contrast, other market benchmarks dove into negative territory to start the year.

Other than the Dow Jones Industrials, the S&P 500 was down by 9.44 percent, the Russell 2000 dropped by 9.90 percent and the NASDAQ Composite was lower by 14.07 percent.
REIT performance accelerated in March, as the FTSE NAREIT All REIT Index was up 3.88 percent in the month.

“The sub prime mortgage crises did not have a direct negative impact on apartments but did in fact have an indirect positive impact,” says Brad Case, VP of research and industry information at NAREIT. “All those people who could not afford to buy homes had to start renting apartments.”

This, Case believes is the reason Apartment REITS are a safe way to play the real estate meltdown.

“Fundamentals in the REIT industry are pretty strong and there is no real sign that they are likely to weaken anytime soon,” Case concludes.

For more, see "Even Ben Stein Likes REITs".

Bargain Hunters Circle European CMBS

LONDON (Reuters) - Banks and opportunity funds are hunting for bargains among cut-price European Commercial Mortgage-Backed Securities (CMBS), raising hopes the debt market deep-freeze may be about to thaw.

Growing appetite for European CMBS could provide a breakthrough for banks desperate to free up loan book capacity by issuing new CMBS, which many see as a vital first step back towards cheaper and more flexible lending.

"CMBS is fantastically cheap. We see this as a once in a lifetime buying opportunity to pick up AAA-rated paper at amazing spreads," said Caroline Philips, Eurohypo's managing director of securitization in Europe.

The once-thriving CMBS market has been comatose since last summer's credit crunch triggered a collapse in demand and enormous slack in spreads.

Credit Suisse data from March 27 showed European CMBS cash spreads were 240 basis points over the London Interbank Offer Rate (LIBOR) at AAA level and 750 basis points over at BBB, which Philips said was basically pre-credit crunch prices "with a zero on the end".

Philips said Eurohypo, which is better known for its CMBS issuance activities, was in the middle of an acquisition spree motivated by "no-brainer" AAA CMBS pricing.

"We have bought around 100 million pounds worth of CMBS in recent months but we want to do more," she said, adding that the bonds were bought with a view to holding to maturity because potential returns on equity were "enormous".

Spreads at their current magnitude could indicate huge problems with the underlying credit but some investors say the CMBS sector has been hit too harshly by fallout from the U.S. subprime residential mortgage crisis and the long-anticipated end of a European property market boom.

"...Even with pressure on property values, there is currently no great pressure on security of rental income, so unless a loan is due for imminent refinancing, the loan will still be kept current...the bonds will still pay," said Philips.

The young market for European CMBS saw the biggest output of issuance between 2005 and H1 2007, with around 135 billion euros of bonds issued, European Securitisation Forum data showed. Issuance dived to 10.7 billion euros in the second half of last year.

The bulk of these were structured on five and seven year loans and are not due for refinance until 2010 at the earliest, the same year the property derivatives market is banking on a recovery in UK property values.

"If you look at the real estate fundamentals -- expected vacancy rates, yield movement -- this downturn is not expected to be as bad as the last... The message we need to put across is this is not going to be the next U.S subprime sector. There will be no meltdown," said Philips.

OPPORTUNITY KNOCKS

Cash-rich opportunistic buyers are also tempted by CMBS, adding to downward pressure on spreads.

Many of these funds are drawn by the chance to make double-digit returns on equity -- returns that are now harder to grasp in bricks and mortar buys after a sharp slowdown in property capital value growth.

"We're looking closely at buying CMBS on behalf of investors," said one senior European real estate investment banker, on condition of anonymity.

"They may be traditional buyers of assets but debt looks so cheap at the moment. If you do not need to mark-to-market in your portfolio and you can buy AAA at 300 basis points and hold to maturity then that's a hell of a good buy," he said.

Marc Mogull, founder of opportunity fund manager Benson Elliot Capital Management, said he was confident European CMBS prices had "bottomed".

"Opportunity funds go where the opportunities are and I'd expect all are sniffing around the European CMBS space right now," Mogull said.

Mogull said he believed current AAA spreads "were not a fair reflection" of their repayment prospects and that a repricing of risk across BBB and sub-investment grade paper had been "indiscriminate", leading to pockets of real value.

Trading has been hamstrung by a standoff between buyers and sellers over price, but Mogull said the market was close to a clearing price that could jumpstart transaction volumes and help banks to cut burdensome property loan positions.

"My view is that BBB paper will clear at spreads of 800 to 1000 basis points ... From a default perspective, AAA's look outstanding value at close to 250 basis points, even ungeared. Once people see prices sticking at these levels, we'll see the backlog start to move," Mogull said.

Brenna O'Roarty, director of European Strategic Research at Deutsche Bank's property arm, RREEF, said she felt CMBS were blighted by "branding" but had potential to bounce back.

"If you look beyond the label of CMBS and focus on the coupon and the risk attached to that coupon, CMBS can look like good value," she said.

High Yield Mortgage REITs: The Perfect Storm?

Volume of Maturing Mortgages to be Low in 2008 and 2009, Reducing Refinance Risk Even Further, but Mark to Market is Discounting REITs to the Depths of Atlantis.

After a couple of alarming headlines in Seeking Alpha related to commercial real estate, the most recent of which was "Commercial Real Estate Collapsing", REITwrecks decided to do some digging. Sherlock Holmes may have had Watson, but who better than REITwrecks to sleuth the truth in real estate?

One of the first articles appeared last week and was prompted by a study issued by the Johns Hopkins Carey School of Business on the short term future of commercial real estate markets. Despite Seeking Alpha's clumsy attempt to connect the report to potential nation-wide troubles, the report actually focused almost entirely on the the Baltimore/Washington area, and then primarily on certain development projects within that area.

It was a comprehensive report, but with such a narrow focus it hardly qualified as meaningful commentary on the market as a whole. In addition, the John's Hopkins report itself was very positive overall.

However, the SA article focused on the negative comments of several experts, who worried that the Baltimore-oriented report was overly optimistic. One of those experts was David Fick, who covers REITs for Stifel Nicholas. For that reason, the story deserved further attention, and that attention exposed some very interesting market data.

According to the story, Fick said that $236 billion in equity investments have already been written off as a result of the subprime mortgage crisis, and that "most of that investment has been in the commercial, rather than the residential, market". By the end of the credit crunch, he said he expects to see at least $400 billion in write-offs.

“The oxygen, the mother’s milk of commercial real estate, is capital,” he said in the article. “Try to get a construction loan now — it’s virtually impossible.”

In one of the more confusing paragraphs, the article quoted Fick as saying that "more 10-year, commercial mortgage-backed securities were issued in 1998 and 1999 than ever before, and that most of them would not be financed". I'm not sure what that means, but Fick went on to predict that the result would be "the demise of many of the region’s existing real estate investment trusts within the year".

Unfortunately, the author didn't attempt to clarify whether Fick meant these deals wouldn't be financed in today's market, or whether these deals wouldn't be refinanced in today's market (as the loans mature). Asserting that a development deal would be more difficult to finance today's market is not particularly insightful, nor is it relevant to a question dear to the heart of REITwrecks: what is the health of Mortgage REIT portfolios, and is the market pricing the intrinsic value of these cash flows rationally?

So I continued an investigation into refinance risks that resulted in a previous article, which disclosed that 99% of all CMBS deals maturing since the credit crunch began in August had been successfully refinanced. Thus, the supply of credit for commercial real estate appears to be holding up even in this credit-stressed environment.

Alas dear readers, that good news on supply is naturally only one side of Adam Smith's beautiful yet invisible hand, and REITwrecks unintentionally left some astute readers clinging frantically to their mousepads for even more. What about the demand side for credit in this environment? More importantly, would a huge supply of maturing paper in need of refinancing put even more pressure on the commercial real estate debt market?

I found the exact opposite to be true. According to a report issued by the Mortgage Bankers Association, the volume of maturing mortgages will be low in the coming years, which would expose few commercial loans to these refinance risks.

"There's been a general impression that a large volume of commercial/multifamily mortgages are coming due this year and next," Jamie Woodwell, MBA's senior director of commercial/multifamily research, said. "The reality is that 2008 and 2009 will see a relatively small volume of maturing mortgages, with the majority of CMBS loans not maturing until 2015 or later."

Capturing data from JPMorgan and Wachovia Capital Markets, the report found that there is more than $600 billion of outstanding loans in fixed rate commercial mortgage-backed securities (CMBS). Of this, only $16 billion is scheduled to mature in 2008 and another $19 billion in 2009.

The surge in sales, financing and refinaning volume during 2005, 2006 and 2007, coupled with the fact that CMBS loans tend to have a 10-year term, mean that the majority of CMBS loans will not mature until 2015 or later -- $98 billion of loans are scheduled to mature in 2015, $128 billion in 2016 and $127 billion in 2017.

Of the loans due in the coming years, the majority is well seasoned and have been amortizing, meaning that they now have lower loan-to-value ratios and will be more attractive to lenders. JPMorgan reports that $14 billion of the $16 billion maturing in 2008 is fully amortizing, as is $14 billion of the $19 billion coming due in 2009. According to Wachovia Capital Markets, more than two-thirds of the volume of loans coming due prior to May 2009 was originated prior to 2000.

In addition to the fixed-rate conduit deals described above, the report noted that Wachovia Capital Markets has identified $30 billion of large-loan floating-rate deals that will be coming due prior to May 2009. The maturity dates of these loans are spread throughout the period, with relatively larger volumes -- $3.5 billion and $3.3 billion, respectively -- coming due in August and October 2008.

These numbers all appear to be manageable given Fitch's report that over $21 billion in CMBS fixed rate loans had been refinanced just since August of 2007, when the credit crunch began.

The MBA report focused on maturing mortgages in the same CMBS market. Banks and thrifts will be more likely to have shorter-term and adjustable-rate loans, while life companies will tend to have longer-term fixed-rate loans, but with much lower leverage and thus easier to refinance. Each group's maturity patterns will also be affected by the ups and downs of its originations experience, but each group's originations generally fell as the CMBS market grew.

So what we appear to have is the equivalent of a hurricane hitting during a spring tide. The storm's turbulence is no less intense, but the extremely low tide is preventing the storm waters from getting anywhere near the beach.

Nevertheless, the market is pricing a force 5 hurricane hitting during a full moon flood tide, and it is conspiring with mark to market accounting to discount prices by Poseidon-like proportions. The resulting price dislocation is almost unprecedented, and for long-term, opportunistic investors it really is the perfect storm.

Dividends Under The Bridge? Markit Responds to CMSA

In responding to the Commercial Mortgage Securities Association's ("CMSA") letter regarding increased transparency on CMBX trading, the Markit Group (the administrator of the CMBX indices) has apparently responded with a modern-day version of "Frankly my dear, I don't give a damn."

Evidently, Markit is contending that since the CMBX trades on the OTC derivatives market, Markit does not have access to trading data (either volumes and/or number of daily trades).

They also pointed out that trading volumes have never been published for other OTC derivative products (e.g. rates, FX, commodities), except for general surveys by ISDA, so it's unlikely that precise CMBX volume and trading data would ever be known. This would be good news for the speculators who make a living off of playing the index, and who now appear to be unloading their short positions.

I wrote about how all this is creating a the mother of all dislocations for REITs and financials in the recent article How Markit Turned Mr. Market into Mr. Magoo and much earlier in a March article entitled Mr. Market Trips on Mark to Market.

With respect to mark-to-market accounting, Reuters reported that Fed Chairman Ben Bernanke recently threw his policy-making heft behind the "if it ain't broke don't fix it" crowd in declining to recommend changes to mark-to-market.

According to Reuters, when asked about the issue in a question and answer session, Bernanke said that on balance mark-to-market has worked well, but "it's also true in the current context, that mark-to-market accounting has been sometimes destabilizing in that sales of assets into very illiquid markets had led to reductions in prices, which have caused writedowns which have sometimes caused firesales, and you get into an adverse dynamic which has caused problems in some of our markets,"

While he said mark-to-market accounting has been a positive influence for investors, he also said that valuations should be determined during normally functioning, stable markets, not times when assets are illiquid.

Dottie Cunningham, CEO of CMSA, expressed the same concern in the CMSA's original letter to the Markit Group. "In a volatile market, this mark-to-market process becomes a self-fulfilling prophecy, driving prices down based on index trading activity rather than asset fundamentals," she said. "Some market participants may be relying on what we believe is a distorted value that perpetuates the current cycle of no issuance, erroneous spread widening and additional mark-to-market write downs."

So what can Markit expect next from the CMSA? Perhaps it will be a modern-day version of "I'll get you my pretty". Fortunately, for far-sighted investors who can stomach the turmoil and almost daily drumbeat of bad news, it really doesn't matter. As Bernanke said, mark to market has been good for long-term investors.

In an act of self-healing triage, the market has put itself on sale, and this will almost certainly cause liquidity and prices to recover. It will take some time, but at this point and with these discounts, the recovery may shift into higher gear sooner rather than later. In the meantime, you get paid to sit and watch the show.

Bloomberg: PIMCO Big Buyer of Mortgages

Several days ago, I posted that Morgan Stanley CEO John Mack likes mortgages. However, Bill Gross and his PIMCO Total Return Fund are definitely putting their money where his mouth is.

According to Bloomberg, the $125 billion fund increased mortgage debt holdings to the highest level since 2000. Bloomberg says the fund had 59% of its assets in mortgages in March, which is up from 52% in February and just 23% in March of 2007. Simultaneously, he put on a very bearish bet on Treasuries.

Don't tell me the bottom bottomed and we missed it!

The full story is here

Risk Rising on Alesco's REIT Status

CDOs are back in the headlines - again. The old story is that they are defaulting in record numbers. Indeed, few now seem to be generating any income for anyone, except for the lawyers that are now starting to unwind them. And that is the new story: increasing numbers of defaulted CDOs are now being completely liquidated.

As of March 31st, S&P reported 141 CDO events of default with all but two coming from the 2006/2007 vintages. By volume, US$157bn or 44% of 2006/2007 CDO issuance is in technical default.

According to S&P, thirteen CDOs are reportedly now in liquidation, while fifteen deals have already been liquidated. A total of 8% of 2006/2007 issuance is in some form of liquidation (14% mezzanine, 4% high grade and 12% CDO-squared). Those in the acceleration phase tally 16% (27% mezzanine, 11% high grade and 6% CDO-squared). CDO squared deals are those CDO deals that invested in other CDOs. Just think Jurassic Park and you'll have it about right.

S&P said that liquidations would probably start to increase, and that structured finance CDOs and CDO-squareds from 2006 and 2007 are "the most vulnerable" to events of default (yet more reason to stick with the seasoned veterans in Mortgage REITs) and possible liquidation following an event of default. Liquidations would be the end of the line for these troubled CDOs.

S&P's report was prompted by a ratings action which lowered the ratings on 33 classes of notes - worth US$3.6bn - from across four ABS CDO transactions to single-D (far below CCC, the dreaded "triple hook" for investors), following news that the trustees had liquidated the portfolio collateral and have distributed or are in the final stages of distributing the proceeds to noteholders.

What is most interesting with respect to Alesco (AFN) is that S&P said the trustees for the four CDOs do not anticipate that the proceeds from the sale of the collateral (including the principal collection account, any proceeds in the super-senior reserve account, the CDS reserve account, etc.) will "be adequate to cover the required termination payments to the CDS counterparty, and that it is likely that proceeds will not be available for distribution to the notes junior to super-senior swap in the capital structure of the CDO transactions." Hence the downgrade to single D.

While this structure is a little different than the Alesco CDOs, "super senior" means just that, and the trustees are not only indicating that the sale proceeds will be insufficient to make distributions to anyone junior to them, the text of the trustee's notice also indicates that there may not even be enough value in the collateral to satisfy the capital structure's king of the hill!

The fact that Alesco's REIT status is at risk is really not news. Alesco has been relying on its Kleros CDOs to help satisfy its REIT qualification tests, and their default has put that qualification test in doubt. To say that the issue dominated the discussion during last quarter's conference call with management would not be an overstatement.

AFN management also indicated during that call that continuing to meet the REIT classification would not be an issue, and that they were working on ways to replace the Kleros income. However, increasing rates of liquidation would finally put these crippled CDOs out of their misery, and it puts Alesco in an increasingly hot foot race with the Kleros noteholders and their lawyers.

Maintaining REIT status is important to investors because it requires those entities that claim it to distribute a minimum of 90% of taxable gross income to shareholders. The REIT laws were developed by the Treasury to encourage capital formation around housing and commercial real estate, and it rewards this by not taxing REITs at the corporate level. Zero taxes.

In return, REITs must derive 95% of their gross income from "real estate related activities". Real estate related activities has recently meant a lot of different things to a lot of different people, but to AFN it included the income on the spread between the assets held in the Kleros CDOs and the cost of servicing the Kleros notes paired to them.

Well, as it turned out there would be very little income generated by the Kleros assets. What remains is now being diverted to the senior noteholders, away from AFN, so there is no spread to collect, and the note holders - through the Kleros trustee - have declared an event of default on the notes for failure to meet the over-collateralization tests. The note holders do not have any recourse to AFN, so AFN's exposure is limited to its own net investment, which it has already written off anyway.

The Alesco story is nothing if not intriguing, and I would say it is one of the more interesting shows going on in the REIT world right now. It is run by the Philadelphia-based Cohen family, who run a veritable MacDonald's Farm of CDOs through the family of REITs they control. They have an experienced, qualified, and capable team, and to varying degrees they have also put their money where their mouth is with significant insider purchases. However, an even more significant insider purchaser pattern persisted at Thornburg Mortgage (TMA), and not even that commitment could prevent management's stakes from being vaporized into their worst dilutive dreams.

Also, as I wrote in an earlier article, the mark to market write downs on AFNs assets alone have been so substantial that just by adopting FAS 159, which AFN plans to do, AFN would add approximately $2.7 billion in GAAP book value, or $45.03 per share, to stockholders equity. Much of that comes from writing down the liabilities paired with the already cratered Kleros CDO assets that are the subject of this post. Some of it also comes from investments in Trust Preferred's issued by regional banks and mortgage lenders, and that part of the portfolio may be the next shoe to drop.

Ignoring the Trust Preferred issue (some TruPs were bought from regional banks with heavy exposure to local home builders), there may be about $6-$7 dollars in GAAP book value left when all is said and done. Because AFN's assets are almost all match funded with long-term, non-recourse debt, what value remains continues to be safe from margin calls.

Nevertheless, because REIT status guarantees that investors receive the majority of taxable income generated by those assets, however meager they may be in AFN's case, most investors do not underestimate the claim on earnings that REIT status affords them, and nor should you.

If, as S&P postulates, the risk of CDO liquidations is rising and that the 2006/2007 vintage CDOs are the most vulnerable, this would put the Kleros family of CDOs in an increasingly tenuous position. Because the noteholders are taking the trouble to liquidate these CDOs regardless of the value of the collateral, it heightens the risk of AFN losing its REIT status by eliminating its last "practical" line of defense against a total Kleros liquidation, which is: why would anybody bother?

Disclosure: None

Morgan Stanley's CEO Likes Mortgages

The media sentiment on the credit crisis looks like it's starting to turn from a dour play by play to furtive attempts at calling a bottom. In an earlier article, I wrote that the "rescue" of Bear Stearns may have been the last shoe to drop, because it signaled the Fed's determination not to let the credit crisis worsen. Who knows. But after all this bad news a bottom would be nice to contemplate, wouldn't it?

Along those lines, Morgan Stanley's CEO John Mack was quoted by the Associated Press as saying he thinks the market may in fact be bottoming. According to the article, Mack said that Morgan Stanley is also seeing opportunities in the very same mortgage market that caused most of Wall Street's pain. "I don't know if this is the bottom or close to the bottom, but at some point it will be wise to invest there."

The AP's full story is here.

How Markit Turned Mr. Market Into Mr. Magoo

In order to understand the answer to this question, it helps to first ask another: How could a Commercial Mortgage REIT, with absolutely no credit losses and no non-performing assets across its entire $7.4 billion portfolio, be forced to take a $180 million loss?

Part of the answer lies in an earlier post I wrote about Mr. Market, an imaginary man who has helped created the buying opportunity of a lifetime in many REIT stocks. According to Ben Graham, the legendary value investor who imagined him, Mr. Market appears daily without fail to name a price at which he would either buy your assets or sell you his.

At times Mr. Market feels euphoric. When in that mood, he sets a very high price for your assets because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead. On these occasions he will set a very low price for your assets, since he is terrified that you will try to unload your interests on him, bringing him immediate losses.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. Consequently, Graham said you must heed one warning: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful.

While we are free to determine the merits of Mr. Market’s wisdom on a daily basis, the accounting profession is entrusted with no such discretion. They are collectively the Joe Friday’s of the investing world: “Sorry m’aam, just the market value.”

Believe it or not, accounting rules require most Mortgage REITs to value the vast majority of their investment portfolios at whatever value Mr. Market thinks they are worth, no matter what mood he’s in, as if they were going to sell 100% of their assets - all at once - at whatever price the market would bear on any given day. This is what “mark to market” accounting means, and that is essentially how it works.

But what if these were not normal times, and Mr. Market was almost completely out of action, frozen by fear? What if Mr. Market were so completely incapacitated that he could not even quote a price, never mind buy or sell?

This is exactly what has happened, and the accountants are left with nothing but the Markit Group’s CMBX index to value many tranches of CMBS. The CMBX is partly what scared Mr. Market half to death in the first place, and it has drawn scrutiny for its lack of transparency and limited disclosure.

If Mr. Market was near sighted before, the Markit Group has helped turn him into Mr. Magoo, the very caricature of myopia.

While the dust-up between the the Markit Group and its critics will be fun to watch, here is the important part for REIT investors: Mr Market’s Markit driven myopia results in accounting losses that are mostly temporary, non-permanent, and non-cash. Not only have these huge GAAP losses created frightening headlines, they have contributed to a great deal of confusion over the real valuation of financials. This confusion, and the fear related to it, has created a huge window of opportunity in certain REITs and financial stocks that simply will not last.

Here’s how it works: Because the securities being valued aren’t actually being sold, GAAP allows management some discretion in determining whether impairments can be considered temporary or permanent. If cash flows have actually declined and the asset is not performing as expected, management must classify the asset as permanently impaired. Permanent impairments flow through the income statement and drive taxable income lower. This is bad, because taxable income is what drives dividends. If taxable income declines, so do dividends.

However, if cash flow hasn’t declined and management determines that fair value will recover in a reasonable amount of time, they are given the discretion to classify those market value “losses” as temporary. Temporary impairments do not affect taxable income. They run through a balance sheet account known as Other Comprehensive Income, or Other Comprehensive Income (Loss), depending on who is doing the reporting, and they are reflected on the balance sheet as a reduction of stockholders' equity. This only affects GAAP book value, not taxable income.

Making the determination is a three step process, and it goes like this:

(Diagram courtesy of Redwood Trust 2007 10K)

Because temporary impairments adjust a balance sheet account (stockholder’s equity), not an income statement account, temporary impairments are non-cash. Consequently, they have no real effect on income. They do not impact cash flow, taxable income or dividends, and no money is lost until the securities are actually sold – if they are ever sold. As long as the assets continue to perform as expected, your dividends will not be cut. Furthermore, any increase in Mr. Market’s myopic view of market value will cause those write downs to be written right back up.

What about that REIT that took the $180 million GAAP loss, despite having no non-performing assets across its entire $7.4 billion portfolio? That REIT is Northstar Realty (NRF), and Northstar almost doubled net cash flow from operating activities in 2007. This increase in cash flow helped contribute to dividend growth of $.10/share during the same period. It is cash flow and taxable income that should matter to REIT investors these days, not the myopic noise coming from the shareholder’s equity account.

Given its strong operating performance and the almost pristine credit quality of its portfolio, NRF would qualify as a REIT that’s not so wrecked. Most people would consider it a good investment in almost any environment, never mind one in which a myopic Mr. Market has discounted its dividend into the high teens.

The catch? As I wrote earlier, you must be able to ignore Mr. Market while you push the button and buy from him. Unlike the accountants, you are free to let him serve you, not guide you.

For additional information on a related accounting topic (FAS 159), see Muddled Mortgage REIT Book Values Create Opportunity

Disclosure: Long NRF

OT: Time out for RSS

As the Dear Leader might say, investing in high yield mortgage REITs is tough enough never mind having to keep up to with all those internets out there. Thankfully, those crafty internets have come to the rescue with a handy tool called RSS (Really Simple Syndication). Best of all: it's free, and that's cheaper than a 17% dividend.

If you'd like to know more about it, check out this fun and informative three minute video by Lee LeFever describing RSS in PE (Plain English). It requires an Adobe Flash plug in (if the start page is visible, you already have it), but it could change the way you stay updated with online content.

Now, if that video cast its magical spell on you, and you think you might want to try it out, you can subscribe to REIT Wrecks via RSS, courtesy of Feedburner, by clicking on the below link. Your sign up details will depend on the browser you're using, but it seems to work exceptionally best on do-no-evil's igoogle.

Subscribe to REIT Wrecks

If you want to check out a tutorial on using RSS with the Safari browser, here's a quick link to that compliments of CreativeTechs.

If you just want to receive REITwrecks by email without any fuss at all, simply click here and sign up. Even I subscribe by email. Not because I'm narcissistic, but because I want to make sure that all you get is 100% REITwrecks. That's right: no sham, no glam - and NO SPAM.

If all you wanna do is go home, there's no need for ruby slippers. Just click on the REITwrecks logo below or one of the article links to the right:

Thanks for taking the time to visit REITwrecks. I hope you have enjoyed reading these posts as much as I have enjoyed writing them.

CMBX Shorts Start to Unwind, Yields Dropping

Gobs of Fed Grease Moving To Mortgages, Offering Lubricious Relief

Hedge funds that had been aggressively shorting the CMBX market on the basis of the superficial similarities with the ABX (subprime housing related index) unwound some of their short positions last week. Spreads on all the CMBX indices continued to come in, and analysts at Citi contend that as more market participants start to focus on how CMBS is actually performing (low delinquencies, low defaults), and the health of the commercial property sector generally, those CMBX shorts may continue to unwind.

The speed and volatility in this market continues to burn even professional mortgage traders, however. The head of the mortgage desk at a top five investment bank with large mortgage exposure said last week that “we got hammered on the way in and hammered on the way out” as they hedged and rehedged their portfolio against the volatile CBMX. When those shorts reversed unexpectedly and CMBX spreads dropped, they were unable to unload their hedges quickly enough.

That same trader said that last week was the first time in months that the cash market (trading in actual CMBS paper) started to show signs of returning to life, after being almost completely frozen since August of 2007. Still, he said that two thirds of the investor base had been wiped out (e.g., SIVs, CDOs), and it would be a long while before replacements were found.

There is also conspiratorial talk at the highest levels of these firms regarding the hedge funds that brought down Bear Stearns. They are determined not to let it happen again, and senior executives from several firms are now quietly discussing the trading activities of those funds with various regulators.

That debacle led the Fed to intervene in the market in historic proportions. I thought it would be important to review the magnitude of those actions in their totality, because together they are incredibly important for REITs and Mortgage REITs in particular.

If you haven't arleady seen them, it may also be helpful to review excerpts from Bernanke's 2002 speech on asset deflation to understand why his Fed won't let things get any worse, and why saving Bear Stearns was so important in the first place.

The Fed's actions started in earnest on the same weekend that Bear Stearns failed, when the Fed established a Primary Dealer Credit Facility (PDCF). This facility was meant to provide assistance directly to the major investment banks, and for the first time ever it offered direct overnight loans through the Fed’s discount window to that beleaguered group.

Until the PDCF was developed, the access for cash through the discount window was only open to depository institutions with reserve accounts at the Fed. The new Fed facility also allows a much wider range of collateral, including investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities. If a price quote is available, the Fed will take it.

Essentially, the PDCF provides investment banks with access to cash using formerly illiquid mortgage assets as collateral. The liquidity provided by that facility will obviously be very good for the many REITwrecks out there, and it should help reduce the odds of another liquidity crisis in the investment banking sector following the Bear Stearns problems.

Two days after that, the Fed cut the short term rate once again, which cumulatively brought Fed funds down by 300 basis points between last September and March of this year. The last time the Fed undertook such an aggressive action (from 5.25 percent to 2.25 percent or a 57.1 percent cut) was between April and November 2001 (from 4.5 percent to 2.0 percent -- a 56.5 percent cut), in the midst of the previous recession and the aftermath of September 11th.

Just one day later, the Bush administration reduced the amount of capital Fannie and Freddie are required to hold, allowing them to buy or guarantee more mortgages. Combined with OFHEO’s ealier lifting of the portfolio caps on February 29th, and an increase in the conforming loan limits, two major sources of both commercial and residential mortgage capital are now back in full operation. At the same time, Fannie and Freddie agreed to raise more capital (perhaps through stock offerings) providing assurances that capital levels will exceed requirements.

And just one day after that, the New York Fed announced a modification to the Term Securities Lending Facility (TSLF), which was already so new the ink hadn’t even dried yet. Until the modification, the TSLF allowed primary dealers to obtain Treasury securities (not cash) for 28 days in exchange for a broad range of assets, including agency debt, agency residential mortgage-backed securities (RMBS), and AAA private-label RMBS – but not commercial mortgages.

The new, new TSLF (the first auction was held on March 27) now allows agency collateralized mortgage obligations and top-rated commercial mortgage-backed securities (CMBS) as collateral as well.

As the trader at the big 5 firm indicated, these efforts are starting to get the markets for all mortgage-backed securities moving again. Even the incredible, unbelievable, unkillable Thornburg (TMA) announced last week that it would begin lending again “within weeks, if not days.”

While all this was going on, commercial banks, insurance companies and even more conservative pension funds were quietly stepping in to fill the capital markets void in commercial real estate.

Just last month, the San Francisco Employees' Retirement System disclosed that it had increased its investment in CMBS through a $25 million commitment to the Fidelity Real Estate Opportunistic Income Fund LP. The fund will invest primarily in high yield real estate debt securities and instruments backed (directly and indirectly) by commercial property. While this investment is a drop in the bucket individually, it is a great example of a market wide trend that Fitch took note of in its March 25 report on maturing CMBS loans.

Fitch Ratings found that 99% of all CMBS loans maturing since the credit crunch began in August had been successfully refinanced. In the report, Fitch Managing Director and head of U.S. CMBS Ratings wrote that "the diversity of property type and geographic distribution of recent refinancing activity shows that debt capital is still widely available for commercial real estate."

So the commercial real estate debt market continues to function, even in this stressed credit environment, and all that activity in the synthetic CMBX indices looks to be the result of pure speculation - or worse: pure manipulation.

As this massive dose of Fed dollars continues to sluice through the mortgage market, the CMBX shorts continue to come off, and the murky REIT accounting issues begin to clear, more investors will reverse course and begin to sift through these REITwrecks rationally, assessing the true value of their cash flows.

By then it will be too late, so stay the course. The headwinds in the financial services sector are turning to tail winds, and the eye of the storm has passed. I am looking forward to writing more about the micro accounting issues this week, but unfortunately I am so endlessly fascinated by this story and just can’t write fast enough! As I wrote once before, ignore “Mr. Market”. Be careful. But let him serve you, not guide you.

Even Ben Stein Loves REITs

TORONTO — The beaten-up REIT sector got a ringing endorsement last Wednesday from Ben Stein, the author, actor and economist best recognized for his role as the humourless high school teacher in Ferris Bueller's Day Off.

“I'm buying all [the REITs] I can get my little paws on. These are God's gift to retirees,” Mr. Stein said in a keynote speech at CIBC World Markets Inc.'s annual North American Real Estate Equities conference in Toronto.

Despite their depressed market values, many U.S. and Canadian REITs are generating good yields, something that is becoming more critical as the wave of baby boomers in North America nears retirement, said Mr. Stein, whose career also includes stints as an economist at the U.S. Department of Commerce, a lawyer at the U.S. Federal Trade Commission and teaching posts at various U.S. universities.

The bulk of Americans do not have pension plans or adequate retirement savings, and should be looking at this “best income producing, most-fabulous” asset class while the REITs are a bargain, he added.

The S&P/TSX Capped REIT Index has bounced back from a low hit in January, but is down 4.6 per cent year-to-date, and 18.3 per cent from a year ago.

While Wall Street has taken on the atmosphere of a “casino” as of late, long-term investors who are buying trusts for income rather than capital appreciation shouldn't be scared off the markets, Mr. Stein said in an interview following his speech.

During his presentation, Mr. Stein also lambasted U.S. politicians and regulators for the “nightmare” in the U.S. subprime mortgage and credit markets. Deregulation of the financial industry is the culprit behind the current credit crunch, and also the root of the tech bubble, the U.S. savings and loan crisis and the collapse of the junk bond industry, he said.

While the bail-out of Bear Stearns Cos. Inc. was necessary to protect investors, it should also spark greater regulation of industries, including investment banking and hedge funds, he said.

Sophisticated investors are now likely eyeing products such as structured investment vehicles (SIVs) and collateralized debt obligations (CDOs), Mr. Stein said.

“They are so oversold and there is so much money to be made from them,” he said.

Mr. Stein said he's guessing one investor eyeing these assets could be billionaire Warren Buffett. On one visit to the Oracle of Omaha's office Mr. Stein said he saw a collection of framed notes, which Mr. Buffett told him he had made during his failed attempt to purchase collapsed hedge fund Long Term Capital Management in the 1990s.

Mr. Buffett likely would have made billions on that portfolio, and a similar opportunity could now exist in the asset-backed securities sector, Mr. Stein said.

High Yield Mortgage REITs Still Look Safe, But Stick to “Seasoned” Veterans

This may be no country for old men, but it’s definitely no market for little boys.

The headlines on February’s mortgage delinquency numbers were either negligible or somewhat alarming, depending on who reported them and the comparisons they were using. The biggest surprise in all the data was the increase in multifamily delinquencies, which is traditionally the safer and less volatile of the four real estate “food groups”. Here is a look behind some of the data.

A majority of the increase in multifamily delinquencies are linked to just one borrower, New Orleans-based MBS Companies. MBS has a checkered past and was attempting a comeback in Texas. The Company aggressively overpaid for its assets and then severely under-managed them.

Market participants involved in the sale of some of these defaulted loans indicated that MBS was almost inept. Despite some well-located properties, they said that some on-site property managers were accepting cash rent payments and under-reporting occupancies to MBS management (so they could line their pockets with said cash) and maintenance was not even an afterthought.

As of the end of 2007, MBS had over $900 million in multifamily loans that were either delinquent or in foreclosure. The Company raises equity from individual investors (OPM) and generates earnings through fees and carried interests. Thus, their earnings are decoupled from asset cash flows and not aligned well with either investors or lenders.

Most of the loans were originated by PNC Bank’s Midland Loan Services unit, and then securitized. Midland remains the “special servicer” on many of these loans. Because Anthracite Capital (AHR) reports a close relationship with Midland in its SEC filings, this could be something to watch for with respect to AHR.

Given the size and diversity of AHR’s portfolio however, MBS is likely not much more than a fly on its elephantine behind. Other investors that own the below investment grade tranches on these loans are JER Investors Trust (JER) and Centerline (CHC) – though Centerline is not a REIT, and neither is as exposed as Midland.

Meanwhile, the first three months of 2008 ended with only $6 billion of domestic CMBS issuance, the lowest first-quarter volume in a decade. Given current lending volumes, it is unlikely CMBS issuance will even reach half of 2007 volume and some are predicting less than $60 billion for the year.

A liquidity vacuum still exists in this market, despite current BBB CMBX spreads of 1100 of 1200 basis points. Believe it or not, these spreads are actually in from about 1500 basis points before the Fed bought Bear Stearns and dropped rates yet again, all in the same day and on a weekend, no less.

It’s only a matter of time before these incredibly high, unprecedented spreads combine with the Fed's largesse and the fundamentals of the commercial real estate market to over take short-term speculators in the CMBX.

With respect to delinquencies, according to the research firm Real Point, the delinquent unpaid balance for CMBS rose to a trailing 12-month high of $3.48 billion through February 2008, up from $3.16 billion a month prior. On its own, this is an alarming number, but doesn't fully represent the breadth of what is a really a fairly placid and benign market, at least in terms of delinquencies

While it’s true that delinquent balances jumped 57%, from $2.21 billion to $3.48 billion, there is almost $815 billion in CMBS debt outstanding. Thus, even with a 57% rise in delinquencies, troubled loans still represent less than half of 1% of the total market, and CMBS delinquencies overall remain at historic lows.

The real story in the Real Point report is that the increased delinquency rate came primarily from two of the most recent, less seasoned vintages of CMBS. According to their research, over 40% of delinquent unpaid balances through February 2008 came from transactions issued in 2005 and 2006. Nearly 22% of all delinquencies came from the 2006 vintage alone. Almost seven percent of all delinquencies came from the 2007 vintage.

What is the significance of all this for Mortgage REIT investors? Stick to the seasoned veterans. Those who came late to the game have been hit the hardest and will take the longest to recover (if some of them ever do) because they bought at a time when underwriting standards suffered badly, and they stuffed their portfolios full of weak, demand-driven paper.

Chris Milner, Anthracite’s CEO, punctuated the point in his Q4 earnings release: “The dislocation in the capital markets continued to worsen in the fourth quarter, causing CMBS spreads to reach unprecedented levels. While this development clearly has resulted in negative price changes in our portfolio, the relatively better performance of our non-U.S. and seasoned vintage U.S. CMBS assets muted the overall impact.”

In Wall Street's latest game of grown-up musical chairs, it would be wise not entrust your investment dollars to those little boys who sat down last.

Disclosure: Long AHR

Lack of CMBX Transparency Draws Industry Scrutiny

International Trade Association Requests Release of Daily Trade Volume; Calls for Greater Transparency in Trading Data.

Last week, in move that may be at least partially responsible for the nearly 150 basis point drop in the AAA CMBX Index, the Commercial Mortgage Securities Association (CMSA), requested that trading data on the CMBX Index, including total volume and number of daily trades, be made publicly available in order to increase market transparency.

The CMSA made the request in a formal letter to Markit, the administrator of the CMBX Index, a synthetic credit default swap derivatives index introduced in March 2006.

“Public disclosure of derivatives trading data in the CMBX Index would provide an invaluable service to investors in the commercial real estate capital market finance arena,” said Leonard W. Cotton, Vice Chairman of Centerline Capital Group and President of CMSA.

“We believe the volatility in the CMBX index caused by momentum traders, rather than fundamental traders, distorts the true picture of the value of CMBS bonds, which are backed by the cash flows from loans on income-producing commercial real estate.”

“Given the role the Index has come to play in determining the ‘mark-to-market’ value of securities held by financial institutions in the current market environment, greater transparency on CMBX trading volumes and the number of daily trades would aid investors in assessing the merit of values as indicated by the Index,” Cotton added.

Dottie Cunningham, CEO of CMSA, expressed concern that the Index is not indicative of the underlying fundamentals of the investment product. “In a volatile market, this mark-to-market process becomes a self-fulfilling prophecy, driving prices down based on index trading activity rather than asset fundamentals,” she said.

“Some market participants may be relying on what we believe is a distorted value that perpetuates the current cycle of no issuance, erroneous spread widening and additional mark-to-market write downs.”

“The commercial real estate securities marketplace is a responsible, healthy and vital contributor to the overall economy,” said Cotton. “What we’re asking for are additional transparent practices that will allow the market to better evaluate the significance of the spread levels resulting from CMBX index trading.”

For general background on the accounting impacts, see earlier post Mr. Market Trips on Mark to Market, and for background on hedge fund speculation in the CMBX index see Is Commercial Real Estate Really Dead?

Anthracite: High Yield REIT Spins Cash; Raises Capital

Attempting to mix a fouler sounding alphabet stew than that being served up by Mortgage REITs these days is pretty hard work. They invest in CMBS and MBS, mostly by issuing CDOs, sprinkled generously with swaps, derivatives and repos. Add it all up, and you’ve got the ingredients that helped cook up what the New York Times has called “the worst financial calamity in decades”.

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 overblown 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) and Redwood Trust (RWT). RAIT (RAS) is also interesting as is Newcastle (NCT), though the latter has reduced its dividend. 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.

Disclosure: Long AHR, NRF and RAS

Is Commercial Real Estate Really Dead?

In September 2007, hedge fund manager Andrew Lahde of eponymous Lahde Capital, which had previously earned huge returns by heavily shorting the ABX, launched a new fund to short commercial real estate via the CMBX. The ABX was becoming too expensive to short, and tying up all that capital reaching for the final 10% of the trade wasn’t worth it.

At the time, he predicted a “100% likelihood” of a US recession that would cause commercial property to also tumble and that his “commercial fund [would] act as a hedge for all of the carnage still to come”.

His thesis relies heavily on exploiting the leverage often used to finance real estate. Using an analogy he says is from Peter Schiff, he explains that one should picture the commercial real estate market as a beach ball, with an arm holding the ball. If the arm is taken away, that ball will fall to the ground. He says many foolishly believe that somehow if you take cheap financing (the arm) away, the ball will remain afloat.

Despite a relatively placid commercial real estate market thus far, Lahde still fervently believes that the “losses will materialize”. Though he admits he doesn’t have any idea how severe the losses will be, nor does he have a model that can correctly predict all the variables (who does?).

He says he is sure of one thing though: “It is safe to assume a market is dead when deal volume falls to zero, as was the case with CMBS issuance during January 2008.” He goes on to say that “risk premiums for this type of debt have skyrocketed as exhibited by the CMBX. If you dramatically increase the risk premium for an asset class, especially one that is so heavily financed, the value of that asset class must fall. End of story”.

But is the CMBX really an accurate gauge of risk premia these days, or just plain paranoia? Worse, has it become an easy way to create a self-serving and self-fulfilling short prophecy on a popular trade? Particularly if it is one of the few vehicles available to speculate on that strategy?

Interestingly enough, the Markit Group, which runs the index, will not provide daily trading information, despite requests from the CMSA to do so. Obviously, low volume could make it subject to manipulation and price swings that do not actually reflect the current healthy fundamentals of commercial real estate.

Lahde knows this (he is clearly a smart guy), and what he also purposely fails to mention - his shareholder letters are all over the internet - is that although the CMBS market is truly quite dead, that doesn’t also mean the commercial real estate market has died along with it. Before the CMBS came market along, real estate financing was the almost exclusive domain of pension funds, insurance companies and regional banks, the very financiers that are now stepping in to refinance that “dead” CMBS market.

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.

Lenders continue to finance assets like these because they produce reliable monthly income, not consume it. The arm analogy was a handy way to promote a niche short strategy, but far to simplistic for the real world.

Indeed, the beach ball is still there, and so are all the old lender’s arms, clamoring for a piece of it.

Update: "Lack of CMBX Transparency Draws Industry Scrutiny"