If Frank Quattrone could start over, he would be a REIT banker. REITs staged a huge rally this quarter, almost $15 billion in new equity has been raised through 45 public offerings this year, and even the Italians are descending upon New York to list new deals. With REIT stocks now being served up like Cannolis on Columbus Day, and consumed almost as fast by shell-shocked but somehow still hungry investors, you may have one question: What is Going On?

One reason is that REITs cram down desperately need the money, and while not all are teetering on the brink insolvency, most will do almost anything for fresh cash. This includes diluting their long-suffering shareholders bang zoom! to the moon, and cutting dividends prego! to the newly annointed.

How is this happening? Some intellectual honesty is called for here: REITs were simply oversold. Furthermore, no portfolio manager that I know of was willing to scale the ramparts for General Growth, no matter how many bankers GGP put to work pounding the phones, or how much they were being paid. Still, when there's an abundance of supply, demand needs to be stoked, and that's exactly what's being done. Almost all of these REIT equity offerings are being sold in "over-the-wall deals", much like tech stocks were in the late 1990s.

"Over-the-wall" deals are pre-arranged sales with leading investors at discounted prices, executed overnight. The news hits the tape the following morning, and the stock jumps. Basically, if you're not "over-the-wall" you're trapped beneath it, especially if you're short. Indeed, one goal of the strategy - to scare the pants off of short sellers - is surely working. Nobody wants to be short a company whose balance sheet can be de-levered overnight, and that (re-equitization) is the other goal.

Unlike GGP, investors are flocking to these deals like moths to a porchlight. At a securities conference several weeks ago it's just not true, there is a free lunch Mortgage REIT management presentations were standing room only. One of them, Chimera (CIM), had just used an $850 million offering to transform itself from a smoking heap of 2007 trade confirmations into a potential Microsoft of Mortgage REITs. Another, Redwood Trust (RWT) executed not one but two new issues, the latter just days after the conference, raising almost $500 million in equity.

REIT new issues have included such varied names as Alexandria Real Estate Equities (ARE), AMB Property (AMB), Pro-Logis (PLD), SL Green (SLG), Ventas (VTR) and Vornado (VNO). The AMB deal is a good example of how the REIT equity syndicate pot is being stirred. AMB's $575 deal combined pre-launch "over-the-wall" meetings with the chosen ones, followed by overnight execution. The deal was 80% sold before it was even offered to the public - and then upsized 24% for good measure. It was sold at a discount of 8% to previous close, which isn't bad considering that it represented almost 50% of the current shares outstanding, and that the stock traded up 16.5% the next day, resulting in an instant 25% gain for the new shareholders.

Who's next? Everybody wants to know. Significantly, IPOs in registration are dominated by Mortgage REITs. These include Cypress Sharpridge (agency RMBS), Invesco (agency & non agency RMBS; CMBS; TALF loans) Penny Mac (non-agency RMBS), Sutherland (agency & non-agency RMBS) and Starwood Property Trust (CMBS/RMBS). These initial public offerings will list under the symbols CYS, IVR, PMT, SPT and SLD, respectively.

Others in registration are Brookdale Senior Living (BKD) and Investors Real Estate Trust (Nasdaq: IRET). Recent shelf offerings include Northstar Realty Finance (NRF), with JMP Securities (a large investor in New York Mortgage Trust (NYMT) and manager of its mortgage assets) as sole manager.

Even crippled Anthracite (AHR) may be getting into the act. Miraculously, the company was able to restructure its secured and unsecured debt last month, and a round of fresh equity is undoubtedly next on the list. Anthracite's cozy relationship with Blackrock, which backstopped AHR with a line of credit in its darkest days, gives it an almost unparalleled window on the Fed's growing portfolio of "toxic" mortgage assets. In this latest game of "if you're not inside, you're outside" being played with REIT equity, that may be all AHR needs to push it over the finish line.



Disclosures: Long NRF at the time of this writing.

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Just two weeks ago, I speculated about REIT capital shortages and the ability of non-traded REIT equity to fill the gap in the post Averting Massive Sector Wide REIT Defaults: Non-Traded Equity May Be Part of the Answer.

Pacific Office Properties Trust (PCE) had just disclosed their intention to raise $350 million through this market, and now NorthStar Realty Finance Corp. (NRF) is following suit with intentions to raise up to $1.1 billion in non-traded REIT equity. Whether NRF actually intends to raise this much in this market is uncertain. Offering $1.1 billion in non-traded REIT equity would be an absolutely huge undertaking, as it represents more than 10% of the market's entire 2008 initial offering volume.

NRF remains one of my favorite Mortgage REITs, but the market has been just as unkind to NRF as it has to most other REIT stocks. The stock is down almost 70% since NRF's chairman David Hammamoto bought a bunch of stock on the open market at $8.26/share only months ago. Management owns a significant amount of stock, so it's no wonder they are pursuing cost-effective ways to recapitalize their balance sheet.

NRF and PCE are two of the only publicly traded Real Estate Investment Trusts to tap this market, but they are only the latest in a growing list of entities accessing this market. But do yourself a favor and don't even think of buying a non-traded REIT. In just the first three months of the year, five companies have launched efforts to raise $7.2 billion of equity through non-traded REITs. By comparison, $9.6 billion of equity was raised in this market in all of 2008.

For Northstar, a non-traded REIT offering is an incredibly cheap source of equity capital. NRF intends to raise the equity through a new entity, so existing shareholders in NRF common will not be diluted. The new NRF non-traded REIT intends to pay its investors an annual REIT dividend of 8 percent, which would be higher than the 5-7 percent typically paid by non-traded REITs and far better terms on equity than what NRF could get elsewhere.

While the offering is undoubtedly very attractive to NRF with respect to the scant alternatives available, it remains to be seen how well shareholders in the new entity will fare. Investors will pay fees of as much as 7 percent to cover the cost of selling commissions; a 3 percent dealer-manager fee, and 3 percent to cover the costs of organizing the entity. Accordingly, only 87 percent of every dollar raised will actually go toward investing in mortgages.

NorthStar's aim is to execute what it termed a "liquidity transaction" within five years of raising the capital. That could be a sale of assets, merger or listing on a stock exchange. Historical non-traded REIT returns are hard to quantify, because so few have executed their so-called liquidity events. Given how cheap this capital is, it's no wonder.



Disclosures: Long NRF at the time of publication
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Believe it or not, there was some good news for the beleaguered Mortgage REIT sector last month. Fitch said that commercial real estate CDO loan delinquencies actually fell in November. Translation: commercial real estate loans backing the CDOs that many Mortgage REITs issued by the bucketful were actually performing better, on average, than they had in October. Whether this reflects a reduction in the number of CDO loans that are likely to completely blow up (Alesco, Crystal River, Deerfield, Taberna, etc.) or improving fundamentals remains to be seen, since much of the improvement was simply the result of loan extensions.

As far as the data, Fitch reported that the delinquency rate for commercial real estate collateralized debt obligations, or CDOs, fell to 2.8% last month. This was down from 3.13% in October and it marked the first decline since July. However, there were 45 new loan extensions in November, up from 35 in October. Fitch said expects an average of 40 extensions each month going forward. This is about 3.5% of the $23.8 billion in commercial real estate loans backing the 35 CDOs that Fitch rates.

Anecdotally, Northstar Realty Finance's third quarter earnings release supports this data. NRF reported an increasing number of loan extensions, all of which had been successfully refinanced, as well as a doubling of the loans on its watch list. This was the first time any signs of real trouble had surfaced at Northstar. Unfortunately, it also looks like Northstar's triple net lease portfolio may get WAMbushed by JP Morgan later this month.

Apparently, the FDIC's agreement with JPMorgan Chase allows Chase to pick and choose which WAMU real estate it will keep. Chase will then turn over the rejects to the FDIC. But here’s the kicker: the FDIC, as receiver, can then simply terminate the leases of those rejected properties, all contractual obligations void. Done.

Typically, in a bankruptcy case involving real estate leases, the landlord's remedies are the greater of one year’s rent, or 15 percent of the rent on the remaining lease term (not to exceed three years). In normal times, this is meant to give landlords at least some breathing room while they line up new tenants. But these are obviously not normal times.

The New York Times reported today that Los Angeles is just behind New York in the number of properties that are or are likely to become distressed. Unfortunately, NRF's WAMU leases happen to be located in the Los Angeles area. According to a Real Capital Analytics analysis cited in the story, the Los Angeles had an inventory of about $11 billion of potentially troubled properties, followed by Las Vegas ($6.6 billion) and southern Florida ($4.2 billion). So, if WAMU/FDIC do reject the leases, these NRF assets may lie fallow for longer than usual, with none of the "normal" bankruptcy relief available to Northstar.

Both Fitch and Real Capital Analytics separately said they believe the sectors most likely to be affected are the retail, apartment and hotel sectors. So, in addition to sticking to those commercial Mortgage REITs that avoided the hysteria at the height of the bubble (an almost impossible task), you can add another criterion to your list: diversity by geography and property type. Even "24 hour" superstar cities like New York and Los Angeles are unlikely to completely escape the ferocity of this downturn.

As always, it comes down to careful underwriting - not all commercial real estate loans will go sour. As I pointed out in Commercial Mortgage REITs: Reason to Believe?, the news is not universally bad. But Mortgage REITs that have asset concentrations in either of those two cities may get a bit more than they originally bargained for.

Click here for a Mortgage REIT list, including current yields

Disclosure: long NRF at the time of publication

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"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.

The $1.2 trillion market for collateralized debt obligations (CDOs) is draining money from investor's portfolios faster than the mighty Limpopo River flushes monsoon rains into the Indian Ocean. Consequently, investing in a CDO is now about as popular as halitosis, and CDO assets have been marked down as fast as overwhelmed accountants can sharpen their pencils.

While this is obviously very bad for investors, it's potentially very good for some CDO issuers who were on the other side of the trade. Why? Because these borrowers can now dress up as loan buyers trick or treat! and buy these securities back for a fraction of the price at which they were originally issued.

It's the rough equivalent of selling your Miami condo at the height of the market in 2005, and then using that cash to buy it back several years later for half the price.

Background

CDOs were beneficial because they efficiently sliced assets such as real estate loans into several different pieces, each with a different risk profile. In practice, one BBB-rated whole loan could be sliced and diced such that there were several different tranches with much higher ratings than the single loan could earn on its own. Each piece could then be sold to different classes of investors, which optimized the overall price of the resulting debt.

Many Mortgage REITs were voracious issuers of CDOs, and they used the proceeds to fund new real estate loans, which they packaged into still more CDOs. At the height of the market, Mortgage REITs could issue CDOs at a blended cost of about LIBOR plus 50 basis points, while lending the proceeds out at LIBOR plus 250.

If everything goes according to plan, the CDO investors would earn that spread, the CDO issuer (e.g., Northstar, Newcastle) would earn fees to manage the CDO, and the same issuer would earn a spread on the subordinated equity interest that they retained in each CDO issue. In ten years or so, depending on the CDO, the loans would all pay off, and that would be that.

The CDO debt was non-recourse in many cases, which meant that the REITs enjoyed all the benefits of that cheap leverage, but none of the risks. The only thing that could really happen, in the event that enough of the underlying loans defaulted, is that the income from the equity interest held in each deal would be diverted to more senior note holders. Because of this and the fact that the CDO debt was generally "matched" to the life of the underlying loans, the CDOs would, in theory, chug along, dependably paying interest and principle for years and years.

How CDOs Work

CDOs are really pretty simple at heart, and really not much different than getting a mortgage to buy that Miami condo. Were you to buy that condo, chances are you would fund a small portion of the purchase price with equity, and then borrow the rest.

This is basically what Mortgage REITs did when they made a loan. They capitalized a very small portion of the loan with equity, and borrowed most of rest of the money by issuing CDOs to institutional "lenders". Because the CDO debt was non-recourse, the REIT was never at risk for more than its original equity investment, which in most cases was relatively tiny. Unfortunately, and not surprisingly, this made many Mortgage REITs rather careless with their loan underwriting.

Now fast forward to 2008. The loans made by many Mortgage REITs (and others) have gone bad, so now many CDO investors are sitting on a pile of basically worthless CDO paper (it is not paying interest and principle as expected), and they are desperate for cash because of the market melt down. In fact, cash is in such short supply Bernie Madoff with it that the market cannot discriminate between good CDO debt and bad CDO debt.

Enter your friendly REIT, which offers to buy back that "worthless paper" for pennies on the dollar. Why would they do such a thing? Simple, because there are no other buyers with the same intimate knowledge of the CDO collateral.

REITs like Northstar and Newcastle have been paid all along to manage the CDO assets, so they know exactly which loans are good and which loans are bad, how many there are of each, and everything else in between. For a series of quick videos on how CDO's work, see The Encylopedia of CDOs

Now For the Hard Bit: The Accounting

Assuming the CDO is consolidated and accounted for as a financing for GAAP purposes, the repurchase of the CDO debt allows the issuer to exinguish the CDO liability. To date, no REIT that I know of has repurchased an entire CDO issuance, so that particular CDO structure would remain intact to the extent that any CDO debt remains outstanding. The immediate accounting results for the CDO issuer (i.e., a Mortgage REIT) are:

1. Leverage ratios are reduced

2. To the extent that the debt is repurchased below par, a taxable gain is generated, and this creates taxable income

3. The remaining CDO liabilities are "marked to market" in accordance with FAS 159 (see below)

CDO debt buybacks at Grammercy Capital, Newcastle and Northstar are generating pretty significant capital gains. However, there is one very important characteristic of these capital gains that could be very significant in the case of these loss-hobbled Mortgage REITs: since the gains can be paired with capital loss carryforwards in most cases, they may not actually produce any immediate taxable income.

Immediate taxable income would would be distributable, but since loss carryforwards can be paired with the capital gains, one of the main obstacles to buying back REIT CDO debt is eliminated (i.e., where to come up with the cash to pay required REIT dividends on "phantom" taxable income that is suddenly higher than actual operating cash flow? See REIT Definition for more information on REIT dividend requirements).

Accordingly, quality, solvent, senior CDO debt backed by loans that are generating very attractive cash yields can now be bought back at pennies on the dollar, without any immediate obligation to distribute the "phantom" taxable gains produced by the extinguishment of debt. For those REITs with cash, this could be a very effective way to stabilize cash fows, and by extension, dividends. See REIT Taxable Income Definition Unlocking Opportunities? for more scintillating detail on this topic.

More Accounting: FAS 159

These CDO repurchases have real world implications for FAS 159. For more background, read FAS 159 Demystified. The applicability of FAS 159, or any complex accounting provision, is case by case. Those who argue against the validity of FAS 159 accounting have a pretty simple argument. In theory, these people believe that distressed beached, sunburnt, shriveled whales Mortgage REITs will never, ever have enough cash to buy back the billions of dollars of CDO debt they issued, even at pennies on the dollar. So why mark it down as if they could?

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). Without the loss carryforwards discussed above, this presents cash-flow issues, as the required dividend would most likely exceed actual cash earnings. (In the interest of 100% accuracy, the tax code allows REITs to elect to retain earnings from capital gains, but they rarely make that election, and if they did the code would then require the REIT to pay income tax on those earnings at the full corporate rate.)

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. Back to that Miami condo: if you lost it to the bank, you would only include your equity in the loss. Since you borrowed the rest in the form of a loan, how could you "lose" it, especially if the lender had no personal recourse to you? The money was never yours in the first place, and now you can just walk away with no further obligation. Mortgage REIT equity investments in CDOs are very similar. Not only did they invest a very small amount of equity, but the debt was also completely non-recourse. So who cares??

Moreover, FAS 159 is not just goofy accounting theory, as evidenced by Grammercy Capital's (GKK) partial buyback of it's own CDO debt in the second quarter of 2008. Northstar (NRF), Newcastle (NCT) and Crystal River (CRZ) have also repurchased their own CDO debt. All of these deals 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.

GKK's deal was a little different in that they used normal, every day depreciation losses in the portfolio of recently acquired American Financial Realty Trust to shelter the gains on the debt. GKK can do this because the purchase of AFR turned them into a hybrid REIT. Other Mortgage REITs with portfolios of operating real estate include NFR, RSO and RAS, although the latter two have much smaller portfolios. Presumably, GKK could also have matched the gains against its enormous loss carry forwards. But were it not for those depreciation losses, or the loss carryforwards and the fees paid to the bankers who printed the AFR trade the buyback could most likely never have been done. Sadly, the purchase of AFR was horribly timed, and it will be difficult for GKK to survive.

Loss Rationalization

Forget about all the accounting however; CDO buybacks are just an incredibly good trade. The CDO market allowed Mortgage REITs to basically sell their liabilities (debt) short at LIBOR plus 50. That debt was used to make loans. Now, these same REITs can repurchase that same debt for .20 to .40 cents on the dollar, allowing them to earn LIBOR plus 750-1000, net, to the extent the underlying loans are still paying interest and principle.

In theory, REITs still have to pay themselves par to collapse the entire CDO structure, but in practice investors are accepting far less just to be rid of this bad memory. So "par" is just as much of a fiction now as it was then. Listen to one of Northstar's convertible bond holders attempt to publicly negotiate a buyback of NRF's convertible debt on the Q3 2008 earnings call. If and when you do, you'll realize it's really just a matter of who wants "out" more, and it's pretty clear that Hamamoto, the CEO, felt that he owned the play. He sold the debt at the top of the market, and now he is sitting on $250 million in very precious cash. The nice thing about being the CDO manager is that you know when to hold 'em (Northstar), and you know when to fold 'em (Alesco).

Click here for an updated Mortgage REIT list, including current yields

Disclosure: Long NRF at the time of this writing


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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.

Click here for an updated Mortgage REIT list, including current yields


Disclosure: At the time of this writing, long NRF

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 term 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. Click here for an updated list of Mortgage REITS", including current yields.

Disclosure: At the time of this writing, long NRF

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

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

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 (See "Is Commercial Real Estate Really Dead?"), 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

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 REIT investments) 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.

Click here for a Mortgage REIT list, including current yields



Disclosure: Long NRF at the time of publication

mortgage reits, reits, reit

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, much less risky Mortgage REITs in the REIT Wrecks 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 NLY and AGNC.

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.

Click here for an updated Mortgage REIT list, including current yields


Disclosure: REIT Wrecks owns NRF at the time of publication

Update: More detailed information on how the "Other Comprehensive Income" account works can be found in this post on REIT Accounting.