August 19, 2008

Value Idea: NorthStar Realty- part 2- Risks

Part 1 can be found here.

Investing in what is called mortgage REIT is very risky and not for the faint of heart. Mortgage REITS market caps can be cut in half within few hours, and some actually have evaporated into bankruptcy heaven, hell is more like it. So it is important to list my risks and look down rather than up on this one. Actually if you read their quarterly or annual SEC filings you will be reading 3-4 times the number of pages of any other company. So here goes:
  • Liquidity: NRF has a good liquidity profile with some $296 million in cash and liquid securities.
  • Exposure to retail: Retail commercial real estate might be a sour spot and in a weaker position compared to other CRE properties and run the risk to suffer more defaults and losses. NRF has 8% mundane exposure to this retail properties.
  • Leverage: conservative leverage running about 3:1 compared to others with leverage that reaches up to 30:1.
  • origination discipline: management is very conservative in its risk management program. They avoided all of the residential fiasco by not buying intosubprime . They also originate their own loans rather than buying on the market so their have fist hand due diligence on borrowers and most importantly in most cases they have recourse on borrowers to recover their investment, if the loans go south.
  • no delinquencies in their portfolio so far and do not expect significant delinquencies in their CRE asset backed securities (CMBS) as most of their portfolio in CMBS have been accumulated prior to 2004 avoiding aggressive lending practices in the peak of the credit bubble from 2005 to mid 2007, see distribution of theirCMBS portfolio by vintage year.
  • with respect to risks associated with their CMBS portfolio: A 15% drop in property values will do relatively little to adversely impact the credit ratings of older vintage U.S.CMBS , even those tranches that are deemed impaired, according to Fitch Ratings in a new report titled '98% of Seasoned Deals Pass Stress Tests'. Other findings from the report:
    • Fitch stress tested its rated U.S. CMBS portfolio with significant exposure to near term maturities in order to address concerns about the stability of ratings. Tests were performed on loans maturing through 2012 and the results were evaluated on each transaction tested. Fitch concluded that these older vintages inCMBS were well-insulated in the event of a sizable drop (15%) in property value. Of the 1,381 total classes stress tested, only 138 were considered 'impaired', with only 20 of those tranches at the investment grade level. By class balance, 97.8% were considered not impaired, or $74.1 billion of the $75.8 billion tested. Classes that were determined to be impaired either incurred a hypothetical loss in the stress scenario, or the resulting credit enhancement deemed too low to support the current rating.
    • How bad can it get for commercial mortgage-backed securities in the event of a recession in the U.S.? A stress test on commercial mortgage-backed securities (CMBS) in 675 CMBS bonds, finds that CMBS securities rated BB have as high as a 63% chance of downgrade in a recession scenario, according to a recent Fitch study commissioned by industry trade group, Commercial Mortgage Securities Association, so you may want take that conclusion carefully. Moving up the investment spectrum, the odds against downgrading improve. Bonds rated BBB- have only a 47% chance of downgrade, while those rated BBB face a 31% chance of downgrade. AA-rated bonds face a low 2% chance of downgrade and A-rated bonds face a 6% risk. AAA-rated bonds in the stress test showed a 2% risk of being downgraded.
    • Expected losses could reach as high as 46% in the case of BB-rated bonds and as low as 1% for A-rated bonds. In the case of BBB- bonds, expected loss is more than 17%, and investors in BBB bonds could see more than a 9% loss. HoweverNRF portfolio is investment grade only and do not have any of BBB- assets.
  • Match funding: 91% of NRF capitalization comes from long term debt the balance is from short-term credit facilities provided by JP Morgan
  • CRE market still have good fundamentals as no overbuilding occurred in this cycle, but distress in CRE will come from lack of financing. Owners have refused to sell in the last 2 quarters due to low prices but they have to sell some time if they can't refinance. My thesis is condos and single home developers will be the one doing most of the selling but income producing properties like offices and retail are in a better situation completely. Banks have been reducing commercial loans and taking reserves against commercial loans because they lump single home and condo development loans with all commercial real estate loans. Financing for this type of assets have dried up but for an owner of an office building that have a viable property will be able to get refinancing.
  • No exposure to residential or sub prime and thus they are in better shape and their portfolio did not take a big hit.
  • Retail properties exposure: Retail CRE is one of the most problematic segments in CRE with many retailers under pressure due to consumer cut back on spending. NRF exposure to this sector is a mundane 8%
  • interest rate risk: NRF earns a spread between borrowing and lending rates so if borrowing and lending rates converge earnings will vanish and the company will be under pressure.

continued credit market instability, poor visibility on commercial real estate valuations, and a continued lack of liquidity in the CRE market are all uncertainties surrounding this type of business but I will buy those risk in the face of these uncertainties.
The book value is $12.5 which give me a 43% discount from its recent trading price.

This is a position to capitalize on irrational fear of all thing real estate. According to my thesis CRE have been thrown out with the bath water.

NorthStar realty presentations and SEC filings
CB Richard Ellis various research
Fitch research

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