FASB Amends Fair Market Value Accounting

Governments around the world have gone on a coordinated offensive of truculent press releases in an effort to combat the growing credit crisis. Mortgage REIT prices also popped again on Friday, NCT was up over 60%, RAS and RSO were both up over 30% and NRF was up almost 40%. But this is not the first time this has happened in REIT land, which has basically been short heaven for 18 months. Three weeks ago, NCT was the largest percentage gainer on the NYSE, almost doubling as shorts rushed to cover. Last week however, NCT was pushed back below $3 in a renewed and relentless selling assault. But this week should signal the beginning of the end of the easy short pickings in Mortgage REITs.

The price floor will be put in with the worldwide, coordinated focus on the problem, including the U.S. Treasury's new focus on direct recapitalization of U.S. banks with a voluntary program of government-sponsored equity investments and world-wide guarantees of interbank lending. The U.S Treasury's direct equity approach not only avoids the politically awkward "socialization" of private bank losses by allowing potential government equity participation in a recovery, but it also allows the banks to exercise some discretion in terms of selling assets into a fire sale market. However, the treasury is also moving forward on its program of purchasing both mortgage backed securities and whole mortgage loans.

There were numerous other news items this morning, but few as relevant to beleaguered REIT investors as the staff position rushed out by FASB entitled "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active". The guidance was rushed because regulators and policy makers wanted it out in time for companies to use in computing third quarter earnings, which should make this earnings season incredibly interesting - yet AGAIN!

The FASB staff position clarifies the application of FAS 157 where there are limited or no observable inputs for marking certain assets to market. The guidance does not eliminate Fair Market Value Accounting, but it does provide management with much more discretion with respect applying the convention when pricing illiquid assets. This discretion includes ability to use internal assumptions with respect to future cashflows, which would mean employing generally more benign estimates than what the "market" is currently imposing (see Is Commercial Real Estate Really Dead?).

The guidance specifically allows management to use internal cash flow models and assumptions to estimate fair value when there is limited market data available, or market data that is characterized by extremely wide "bid-ask" spreads.

"When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable," according to the FASB.

Determining whether a market is or isn't active requires judgment based on factors such as the spread between buyers and sellers. It provides that transactions in inactive markets "may be inputs when measuring fair value, but would likely not be determinative."

Another issue addressed by the guidance is how much weight to give to distressed sales when estimating the fair value of holdings. The guidance specifies that distressed sales or forced liquidations "are not orderly transactions" and "are not determinative when measuring fair value."

The guidance emphasizes transaction-level analysis, allowing performing transactions to be marked according to the value of that particular asset. Accordingly, these performing deals will no longer be considered "stressed" simply because the entire market is stressed. For commercial mortgage assets, including whole loans and CMBS, this allows management to consider overall default rates (still at historical lows), collateral characteristics and the underlying obligors on each underlying mortgage. Applying this discretion to portfolios that have few, if any, defaults and high quality collateral will obviously result in meaningful increases in GAAP earnings this quarter compared to previous quarters as previous distressed marks are reversed.

This amendment is huge for financials and for REITs in particular. The wholesale elimination of Fair Market Accounting would have removed a critical component of transparency from our markets, which obviously would have been detrimental. But amending it in such a way as to prevent portfolio valuations from being held hostage by a "market" that refuses to function is a constructive step. Now more than ever, management quality will be key in evaluating REIT investments. But for those REITs that make the grade, we could very well see a Mortgage REIT melt-up that could rival the melt down that has been in progress for so long.

Northstar/Landcap Loan Acquisition: High Reward, Low Risk

"Jeff [Gault] is a very smart guy with two very smart partners," [Goldman Sachs and Northstar Realty Finance] Matkins said. "They formed LandCap 18 months ago. They did two deals in 18 months. Now Jeff will get 10 calls a day."

Just a couple of weeks after the Northstar Realty Finance (NRF) reported strong earnings, the Mortgage REIT turned its shareholders' attention toward the economics of its high yield and potentially high risk Landcap joint venture. Landcap is a 50/50 joint venture between Goldman Sachs and Northstar, with each partner contributing $175 million in fully discretionary equity. In its most recent of only two transactions in 18 months, Landcap announced late in August that it had agreed to purchase (Northstar JV Buys Distressed High Yield Distressed Residential Assets) 2900 partially completed developer lots in high distress states like California, Arizona, Florida and Illinois.

For Northstar, one of the many risks of contributing equity to these transactions is the cash flow profile money pit related to purchasing defaulted loans secured by raw land and partially completed lots. Unlike the rest of NRF's portfolio, not only is there very little current income, but cats on a hot tin roof property taxes must be paid, insurance coverage must be maintained, lawyers must be hired to commence foreclosure proceedings in multiple jurisdictions and 2900 weed-strewn lots must be matched with 2900 lawnmowers. anyone for whack-a-mole across four time zones? When coupled with the demands of NRF's expensive capital structure, which must be fed at least quarterly with interest payments and dividends, and the relatively long-term nature of non-cash flowing land investments, it creates a spooky looking mismatch.

However, the Landcap purchase of the defaulted Wachovia loans appears to have been structured to mitigate these risks. The East Bay Business Times is reporting that the Landcap purchase used a creative joint venture structure with Wachovia as a partner. The article gives no detail on the exact capital contibutions to the joint venture, but joint venture structures typically confer a number of advantages to the purchaser of assets like these.

First, the purchaser in a jv typically acquires 100% dominion and control over the assets but contributes much less than 100% of the total acquisition cost. Many traditional real estate jont ventures use a "90/10" structure in which the one partner puts up the majority of the equity (90%), and the operating partner puts up much less (10%). In some cases, this could translate into a minority capital contribution of as little as 2%-3% of the entire transaction cost, depending on how much debt is used to fund the acquisition.

Without having seen the documents but salivating at the thought of a 25 cent peep it's hard to know how much debt, if any, was involved in the acquisition and what the terms may be. However, if other recent transactions are any guide, it's probably safe to assume that, in addition to contributing an equity interest to the joint venture, Wachovia also financed a portion of the acquistion cost, possibly on a non-recourse basis. One need look no further than Merrill's CDO sale to Lonestar, in which they financed 75% of Lonestar's purchase price with non-recourse debt, or Lehman's contemplative fits and starts toward spinning off its rancid from day one soured real estate assets into another publicly-held entity. That proposed spin off would also involve seller financing, consisting of both debt and equity.

There is a price to be paid for using a joint venture structure however, but if the economics work out as planned, the rewards can also be very rich for the sponsor (Landcap). In return for contributing less, the minority partner agrees to subordinate its equity interest to that of the majority partner. This means that the junior partner not only sees no return on its investment until after the senior partner is paid out, but also that the junior partner assumes the risk of first loss.

But here is the juicy part: the majority partner also typically agrees to cap its share of the profits, which means that Landcap would receive 100% of any profits over the cap. This can be very lucrative, and many joint ventures are structured to produce a residual junior yield that has the potential to quadruple or even quintuple the minority partner's equity in two to three years. Furthermore, because of the equity contribution required from Wachovia (which could be significant), and the likely possibility of non-recourse seller debt financing, the sale price of $40 million dollars probably overstates Landcap's actual exposure to the deal.

Wachovia would be interested in a transaction like this because the advantages for them are also very attractive. They get to move these assets off their books and into a ready made "bad bank", yet still retain some of the upside. It also shifts the assets into the hands of highly motivated partners with much more experience in dealing with land workouts, freeing Wachovia to concentrate on what they are supposed to be good at, wanted: puts namely lending. Most importantly, it also minimizes (and in some cases could eliminate) Wachovia's obligation to immediately book a loss on the "sale" of the assets. Indeed, the JV was set up so that it could fund more purchases from Wachovia in the future. If this first small deal works out for the joint venture partners, expect more like it.

Now for the most distinct risk, namely: why is Northstar trying to catch this falling knife in the first place? The reason, obviously, is that the market will eventually turn; it's only a question of when. With the Treasury finally having pulled the trigger on the Fannie Mae/Freddie Mac bailout yesterday, that turnaround is much closer. Indeed, before the news of the bailout began to circulate late on Friday, Bloomberg reported earlier in the week that when may be now. Bloomberg says that bulk sales of distressed Miami properties have begun, which is signaling a bottom for south Florida's real estate market. The Bloomberg report said that it is also the start of a wave of investment from some $30 billion in vulture funds that have been waiting for almost three years to buy.

According to the report, the sale of 120 condominiums last month to a Philadelphia private equity firm and Related Group of Florida, a development company led by Jorge Perez, "broke the logjam" for investors targeting the oversupply of condos in downtown Miami.

Perez and the real estate private equity firm Lupert-Adler paid about $235 a square foot for the 120 units in Key Biscayne, which is about half the $454 a square foot paid for three individual sales of the building's units late in 2007, and comparable to the $175 to $240 a square foot it now costs to build a new condo in downtown Miami.

If they and other vultures are right, the housing price picture has already started to change, even without the Treasury's actions on Sunday. However, using a joint venture structure to purchase the Wachovia loans would still minimize Landcap's exposure to any further price erosion, while maximizing the profit potentital from a nascent turn around. All of which may help explain why David Hammamoto (NRF's Chairman), decided to write a check for $183,916 and buy 25,000 more shares of Northstar Realty early last week.

Disclosures: Long NRF at the time of this writing.

Northstar JV Buys High Yield Distressed Residential Assets

LandCap Partners, a fully discretionary, 50/50 joint venture between Northstar (NRF) and Goldman Sach's (GS) Whitehall Real Estate Funds, is buying $40 million of troubled land and construction loans from Wachovia Corp (WB), according to The Wall Street Journal.

This $40 million purchase will be the fund's second investment. Northstar committed $175 million to the venture, which is intended to capitalize on the high level of distress in the residential real estate markets. The fund has plans to invest in non-performing loans backed by residential land and equity interests in residential lots, and this purchase certainly fits within that scary scope.

According to the Journal, the loans are collateralized by 2,900 house lots, which are in varying stages of development, in states such as California, Arizona, Florida and Illinois. Wachovia sold the loans as a result of delinquent payments and the plunging values of the collateral. The $40 million purchase represents an almost 50% discount to the original face value of the loans, and by extension, an even higher discount on the original value of the collateral.

Northstar management expects these deals to generate unlevered IRRs of 20-30%, which is absolutely astronomical. There is a downside, however (aside from the obvious), and that is that these investments are not expected to generate meaningful returns until the assets are eventually re-sold, which may be several years from now.

Because NRF's capital has a current-pay requirement, including that for quarterly preferred and common equity dividends, this JV may start to create a near-term drag on earnings as more capital is invested without immediately generating significant cash returns. It's something to keep an eye on, but given NRF's performance thus far, I'm content to wait and see.

Disclosure: At the time of this writing, long NRF

Northstar Flexing Earnings Muscles; Window Closing on Others

I have already written extensively about Northstar here, here and here, among other places, so I will keep this somewhat short.

The biggest news to come out of the call from a "market" perspective is that Northstar is now starting to deploy cash. Forget about having to raise equity; they have $295 million available to invest. Also, in a further indication of credit quality (still no non-performers) they had $53 million in repayments during the quarter, and they estimate a possible $200 million in "optional" repayments for all of 2008. This means that their borrowers don't have to repay, but they are choosing to do so because they are finding profitable exits, even in this terrible market

By extension, this also means that Northstar's self-origination model is performing much better than the "whale" strategy employed by some other REITs: Raise a bunch of cash, and then cruise down Wall Street with your mouth open, collecting loans like so much plankton and krill.

Northstar was much more selective, and they did sacrifice short terms earnings as a consequence (all that low yielding cash did nothing for their dividend). However, as things begin to play out, and assuming they maintain their incredible credit discipline, the forward dividend will start looking stronger and stronger.

Why? Because they have cash to deploy now. There are 36 private equity mezzanine funds on the road now, attempting to raise $21.3 billion. 2008 will see a huge increase in the number of these funds and their buying power. We're only half way through the year, and already 14 mezzanine funds have raised $20.3 billion, vs. 29 funds that raised $15.7 billion for all of 2007. You can read the full story here, and a related story here.

These are not all real estate-focused funds, but the distress in this area is no secret, and plenty of them will be focusing on deals like the one that landed in my inbox just this morning: a discounted $231 million commercial and mezzanine loan portfolio with office and multifamily collateral located in New York and Chicago.

This is Northstar's bread and butter, and they are clearly trying to get out ahead of the crowd (the article above notes that prices are already starting to increase). Accordingly, they expect to reduce available liquidity to between $50 and $100 million by the fourth quarter. Based on their available cash and estimated loan repayments, that may mean $400-$500 million of equity invested by year end. They think these investments will generate levered returns in excess of 20%.

With the new players rushing into this market, Northstar is betting that opportunities will start to decline in quantity and quality in 2009 and 2010. It's too early to tell, but unless they can raise cash, this may mean that many of the more broken REITs will simply be left to manage run-off on legacy portfolios (or be wound up, acquired, etc).

There was some interesting "Itolja so" as well. Northstar did in fact buy back some of it's own highly rated CDO debt at a 40% discount to face. As the CEO said, this validates the FAS 159 accounting model, and they booked a $7 million gain on the repurchase. It will be interesting to see how many other REITs choose to take advantage of the same dislocation.

It will be even more interesting to see NRF earnings when they report again next quarter.

Disclosure: At the time of this writing, long NRF

Stifel Takes a Stab at Northstar

FAS 159: More Red Flags Than a Military Base in China, or Just a Little Frost on the Windshield?

Stifel Nicholas analyst David Fick downgraded Northstar from hold to sell on Friday. Maintaining coverage at a hold is hardly table-pounding, so downgrading to sell what ev's, dude seems like a minor administrative point, especially in this market. The stock was trading ex-dividend on Friday anyway, so it was difficult to know whether the downgrade had any real effect on the price.

I have only seen excerpts of the report *because I am child-like and not to be trusted* but the main point of the report appeared to be a debunking of FAS 159's applicability to the calculation of NRF's book value. Because NRF does not apply any FAS 159 gains to taxable earnings, the only real issue here is NRF's true duh! we OWN this pos! book value. Using FAS 159, NRF calculates its book value at just over $12 per share, Fick writes that it is even less, about $5 per share, and Mr. Market simply says "Do I have to??"

The applicability of FAS 159 is definitely a case by case play. For some background on how it works, see "Muddled Mortgage REIT Book Values Create Opportunity". The argument against applying FAS 159 accounting to REITs is pretty simple. In theory, many people believe that distressed beached, sunburnt, shriveled whales Mortgage REITs will never, ever have enough cash to buy back their own debt. Furthermore, people argue, even if they did manage to come up with the cash they would have to account for the discount as an immediate taxable gain (i.e., the gain on the debt repurchase must be distributed as dividends). This presents cash-flow issues, as the required dividend would most likely exceed actual cash earnings.

But neither can FAS 159 be dismissed completely out of hand. It just doesn't make sense to penalize REITs for an amount that exceeds (in the case of a CDO) their net economic investment in a specific transaction. Moreover, FAS 159 is not just accounting theory, as evidenced by Grammercy Capital's (GKK) partial buyback of it's own CDO debt last quarter (check out "The New Mortgage REIT Magic" in The Mortgage REIT Journal for great detail on the accounting behind that deal). The GKK deal proved that FAS 159 can actually be converted to economic reality, and that even distressed beached, sunburnt, shriveled whales REITs can find a way around the frozen capital markets.

The key to GKK's deal is that they were able to shelter the gains on the debt repurchase with normal, every day depreciation losses in the portfolio of recently acquired American Financial Realty Trust. Were it not for those depreciation losses, and the fees paid to the bankers who printed the AFR trade the buyback could most likely never have been done.

A quick aside: the value of depreciation losses in relation to buying back your own highly discounted debt potentially creates a fascinating conflict: To what extent, if any, should REITS overpay for physical assets, and thus "step up" the depreciable basis of those assets, so that they can shelter even more taxable gains on repurchasing their own dodgy debt??

In NRF's case, it's a double edged sword: their CDOs are performing well so it's doubtful that FAS 159 is correcting any great accounting wrongs on NRF CDO equity valuations vis a vis the correspoding debt. It would also be difficult for NRF to take adavantage of any opportunity offered by FAS 159. They do have their net lease portfolio (which generates depreciation losses), but these are already matched against income in that portfolio, so that portfolio would not be of much use when it comes to offseting gains on the repurchase of debt. Opportunistic distressed portfolio acquisitions could incrementally create additional shelter for them, but that's unlikely to be of any great significance.

For now, I think Fick is in a dying business right to question the value of FAS 159 to NRF. For long-term investors though, this shouldn't be disappointing as the fundamental question has always been this:

how good are the assets and can management generate earnings growth?

The answer to the first question is that they are clearly very good, while the answer to the second question is a weak maybe. In this environment, NRF just can't raise accretive capital easily, but they do have some very inexpensive retained earnings/debt repayments to deploy which should help. I'm long very here, but money is fuel in this sector and right now most Mortgage REITS are simply out of gas.

But none of this FAS 159 stuff is incredibly insightful how much is Stifel paying that guy, anyway and if your investment thesis is to buy high-quality, 100% match-funded assets and ride it all out (see "High Yield Mortgage REITs, the Perfect Storm?"), that thesis is still intact with NRF. Indeed, the stock is still trading above the lows sir, your card has been declined seen in November '07 and January '08. So for now, I think it's still safe to ignore all the noise and quietly bank the 18% yield. REITwrecks is on your toes!

Disclosure: Long NRF at the time of this writing

High Yield Northstar To Set Dividend

Here is the dividend history (below). The announcement should be out after the market closes tomorrow, 7/22 or perhaps 7/23. What will it be, .36/share, or maybe something else?

The recapitalization of Wakefield should provide some downside protection, but there has been virtually no new investment activity at Northstar since Q1 '07. Consequently, Northstar is sitting on a lot of low yielding cash that would normally have been invested, and that will definitely cause a drag on taxable earnings.

I much prefer a drag on earnings than imprudent portfolio bets, but a decrease in the dividend will put short term pressure on the stock. In this market there is almost no way to win, except for staying in bed during opening hours....

Declaration Date Record Date Pay Date Amount Type
04/22/08 05/05/08 05/15/08 $.36 Regular Cash
01/22/08 02/05/08 02/15/08 $.36 Regular Cash
10/23/07 11/07/07 11/15/07 $.36 Regular Cash
07/24/07 08/07/07 08/15/07 $.36 Regular Cash
04/25/07 05/07/07 05/15/07 $.36 Regular Cash
01/23/07 02/05/07 02/15/07 $.35 Regular Cash
10/24/06 11/06/06 11/15/06 $.34 Regular Cash
07/25/06 08/04/06 08/11/06 $.30 Regular Cash
04/12/06 04/19/06 04/26/06 $.30 Regular Cash
01/30/06 01/31/06 02/10/06 $.27 Regular Cash
10/06/05 10/14/05 10/21/05 $.23 Regular Cash
07/28/05 08/08/05 08/15/05 $.15 Regular Cash
04/21/05 05/02/05 05/16/05 $.15 Regular Cash

Disclosure: Long NRF

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

$4 Billion of Sweet CDOs: Northstar REIT Ready to Shine With 19% Dividend Yield

As the British comedian Douglas Adams once wryly noted, “Nothing travels faster than light, with the possible exception of bad news, which follows its own rules”. Indeed, the bad news careening through the financial services industry has now permeated every corner of the market, forcing even the once impermeable Bear Stearns (BSC) into a government-sponsored survival suit.

The well-publicized crisis in the mortgage market has by now forced write downs and write offs of anything that is mortgage related, never mind the near bankruptcy of Bear Stearns. Even once sacrosanct “agency mortgage securities”, those mortgages guaranteed by quasi-governmental Fannie Mae (FNM) and Freddie Mac (FRE) are trading at a discount.

For those prescient few who saw this coming, 2007 was a year to position for a correction. There are two primary ways to position for a downturn, and Northstar Realty Finance (NRF), an internally managed Mortgage REIT that invests only in prime commercial mortgages, took them both.

The first is to maintain deal flow but slow asset growth by underwriting only to the highest standards with the best sponsors and at appropriate and rational risk/reward levels. Thus, through deliberately prudent underwriting, Northstar intentionally reduced direct originations of real estate debt in 2007 by almost 50%, down from 74 new loans in 2006 to just 41 in 2007.

The second is to strengthen the balance sheet and raise cash. Northstar, in essence, went long on cheap liabilities. The Company entered into a new $600 million term loan facility, mitigating the mark to market risk that has been hammering Mortgage REIT valuations) based on credit spread movements and interest rate fluctuations, and sold $135 million in loan exposure, at par, which returned equity and reduced future funding commitments.

While not directly impacting the Company’s liquidity except through increased management fees, in February of 2007, NRF also launched N Star IX, an $800 million CDO, which is the ninth in its “N Star” series of managed CDOs. The N Star managed CDOs are absolutely beautiful things to behold from a credit perspective: the aggregate upgrade/downgrade ratio is a stunning 25:1

In addition to Northstar’s managed CDO’s, the Company has directly issued approximately $4 billion of term financing via its own CDOs. If Northstar’s managed CDOs are absolutely beautiful to behold, Northstar’s issued CDOs are pure gold, and Northstar is about to take it all to the bank.

Not only have these issued CDOs never experienced a downgrade and continue to perform as expected, but 15 classes of notes have actually been upgraded. Most importantly for shareholders, these CDOs are in their reinvestment period. This means that as the loans inside the CDOs mature and pay off, Northstar can reinvest the proceeds at vastly improved spreads over their average cost of funds, which have been locked in at about a 50 basis point spread over swaps. Northstar has almost complete discretion in determining how and when to reinvest these funds.

While the company says it is difficult to determine exactly how much capital may be recycled due to performance-related extension options, approximately $427 million of NRF’s funded loan commitments have their initial maturity date in 2008. This is an enormous advantage in an environment where the capital markets have virtually shut down, cutting off capital intensive REITs from the fuel they must have to grow earnings.

Because the current lending environment is so constrained, the terms on which NRF can invest these recycled proceeds have also improved dramatically. The market for floating rate loans, which make up almost 90% NRF’s portfolio, has increased from LIBOR plus 250-350 bps in 2006 to LIBOR plus approximately 400-550 bps today (depending on term, structure and LTV). These vastly improved spreads will flow directly to earnings as the capital is reinvested.

NRF also indicated its intention to monetize the above-book value of its healthcare and net lease portfolios in 2008. This will allow NRF another opportunity to recycle cash into higher yielding investments and boost its historically strong ROE of over 20% (net).

As of year-end, the Company’s careful underwriting has resulted in strong credit performance with no credit losses and no non-performing assets not only in the "N Star" CDO series, but also across the entire $7.4 billion managed asset base. Northstar has consistently grown its Adjusted Funds From Operations and dividend, which increased 19% and 12%, respectively, over 2006 results. Northstar, which has no direct exposure to the single family housing market and subprime mortgages, pursues a match funding strategy and finances its assets in long term, non-recourse financing vehicles that eliminate mark to market risk.

With a .36/share dividend declared in the fourth quarter, Mr. Market has priced the stock to yield in excess of 19%. While 2008 will undoubtedly bring more challenges and there is considerable uncertainty generally, NRF’s historically strong performance and 19% yield would seem to compensate even the most adventurous investor pretty well.

Disclosure: Long NRF

Mr Market trips on Mark to Market, Gives REITs Away

In this bountiful era of REIT wreckage, with liquidity having virtually disappeared from the mortgage market, the auction rate securities market, and last week, even the municipal bond market, it is helpful to be reminded of the irrationality that can sometimes rule daily trading gyrations.

According to Warren Buffett, Ben Graham said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market. Without fail, Mr. Market appears daily and names a price at which he will either buy your stock or sell you his.

At times he feels euphoric. When in that mood, he sets a very high price for your stock 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 stock, since he is terrified that you will try to unload your stocks 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.

In my opinion, Mr. Market - always fallible and never perfect - is now being blind-sided by mark to market accounting. The non-cash charges resulting from these “mark to market” write downs are causing our servant Mr. Market to see nothing but trouble ahead for business and the world. Thus, he is setting a very low price for REITs and many other financial stocks, and that is creating opportunities.

In a different post, I will add more fascinating detail on the rigors of the Other Comprehensive Income account found on the balance sheet of most Mortgage REITs. For now however, suffice it to say, this is the magic "now you see it now, you don't" account for charges not affecting the income statement, because these charges are non-cash and in many cases, NOT permanent.

Furthermore, in the absence of a market for the securities held by many Mortgage REITs, most portfolio managers must use the CMBX and ABX indices to mark their portfolios to the market. As Fitch Ratings pointed out last month, the CMBX is currently indicating a default rate that is four times anything ever seen in the history of the CMBS market. So, managers must mark their portfolios to values that do not correlate with anything even close to actual performance. Does that seem rational?

Unfortunately, for REITs that are highly leveraged, these marks can also lead to margin calls which cannot be ignored – hence the aerial somersaults being performed by the funding desk at Thornburg Mortgage this week (with a perfect triple twist).

While Thornburg may yet make it (Larry Goldstone is clearly very talented and well-regarded), there are a number of well run, slightly less risky Mortgage REITs in the REITwrecks universe that Mr. Market has put on sale.

Companies such as NRF have funded nearly all of their assets on a long-term, non-recourse basis and are not subject to margin calls. They have cash available to reinvest in a vastly improved (less competitive) lending environment. Mr. Market is literally giving these stocks away, offering yields in the high teens and low twenties. Other attractive REIT stocks include AHR, NCT and RAS.

The catch? You must be able to ignore Mr. Market while you push the button and buy from him. Let him serve you, not guide you.

Disclosure: REITwrecks owns AHR, NCT and NRF

Update: More detailed information on how the "Other Comprehensive Income" account works can be found here.