November 27, 2011 - 11:50pm EST by
2011 2012
Price: 13.20 EPS $1.55 $1.80
Shares Out. (in M): 33 P/E 8.5x 7.3x
Market Cap (in $M): 429 P/FCF NA NA
Net Debt (in $M): 40 EBIT 0 0

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Equity-like returns with bond-like risk can be found in the mortgage REIT sector at this time.  The equity market has created a dislocation where debt instruments trade at pennies on the dollar while paying double digit yields.  Colony Financial (CLNY) is a REIT that invests in commercial mortgage loans and is trading at 67% of book value and yields 10%.  A return to book value will generate a return over 50% including dividends.

Quick Summary

CLNY is a commercial mortgage REIT that was formed in late 2009 to acquire, originate, and manage commercial mortgage assets.  All assets on the balance sheet were originated or acquired after September 2009.  CLNY was created to opportunistically invest in commercial debt post credit crisis and has no legacy assets.  Currently CLNY is paying a $1.32/share annualized dividend which should go up during the next few quarters. 

What are Mortgage REITs?

VIC has occasionally had mortgage REIT ideas posted but it is not a frequent occurrence.  Past names posted have been Dynex Capital (NYSE-DX) and Annaly Capital (NYSE-NLY).  I have taken the liberty to briefly describe what mortgage REITs are below.

Mortgage REITs are a subset of the $500 billion Real Estate Investment Trust (REIT) sector.  Mortgage REITs are REITS that invest in real estate debt instruments.  So unlike equity REITs such as Equity Residential (EQR) or Simon Property Group (SPG) that own property and collect rents from tenants, mortgage REITs invest in the debt that secures the property.  One way to look at it is that mortgage REITs are higher in the capital structure in the REIT universe.  REITs do not pay federal or state income tax but must distribute 90% of their taxable income as dividends to their shareholders to maintain REIT status. 

Mortgage REITs have been a fast growing asset class this year (over 20%) which has companies with various different strategies.  Some mortgage REITs invest in Fannie Mae and Freddie Mac residential mortgage backed securities (MBS).  Others invest in non-agency MBS.  Mortgage REITs can invest in residential, multi-family, or commercial mortgage debt or securities.  Commercial mortgage debt can secure office, lodging, industrial, retail properties etc.  Mortgage REITs have can take various levels of credit risk:  agency MBS carry little or no credit risk, while a mezzanine loan on a low quality hotel carries higher credit risk.  Mortgage REITs also can have various levels of prepayment risk (having the loan payoff as interest rates decline):  agency MBS carry high prepayment risk while commercial and multi-family typically has low prepayment risk.  Finally mortgage REITs carry various degrees of leverage:  mortgage REITs that invest in securities typically carry higher leverage while mortgage REITs that invest in un-securitized loans typically carry little leverage.  Finally like any good company, a Mortgage REIT’s success depends largely on its management team and its abilities to make intelligent investments for its shareholders.

Why Mortgage REITs Now?

The purpose of this write-up is not to make a macro call but we believe this asset class will provide excellent risk-adjusted returns in the coming years.  We believe the U.S. is facing significant structural issues that will lead to subpar growth over the next several years.  Simply put, there is too much debt is as percentage of output, and the deleveraging of the United States will take years.  This will continue to keep a lid on interest rates and encourage investors to look for yielding securities. 

Mortgage REITs recently have been punished along with financial stocks even though the mortgage debt pricing levels have not declined nearly so much.  This has left a dislocation in the publically traded prices of mortgage REITs relative to their underlying assets which are bond-like in nature.

Why is Colony in the right place?

Over the next 3 years there will be about $2 TRILLION of commercial debt that is maturing that needs to be refinanced over the next 3 years.  Large financial institutions are burdened with greater regulatory pressures and have less capital leeway to finance debt.  The CMBS market is currently in turmoil and does not represent a viable source of capital in the near term.  FDIC continues to takeover financial institutions and liquidate loan portfolios.  Banks are expected to be selling more distressed assets to those like CLNY who are better at restructuring loans.  Currently Colony sees a large pipeline of opportunities.

Colony’s Business Model

Colony Financial (CLNY) is a mortgage REIT that is managed by a $16 billion real estate investment firm called Colony Capital.  Colony Capital has 250 employees in 12 offices across 9 countries with in-house asset servicing capabilities.  CLNY pays Colony Capital a base management fee of 1.5% of the stockholders equity at CLNY, plus an incentive fee equal to 20% of the earnings that exceed an 8% annual return on equity hurdle.  For these fees, CLNY has the benefit of a world class investment firm with exceptional resources and access to proprietary deal flow from Colony Capital’s extensive relationship network.  CLNY invests alongside with funds that are managed by Colony Capital.  The recent dislocation in CLNY’s stock price has created an opportunity to invest at a significant discount than the institutional money placed with Colony Capital directly.

Background on Colony Capital

One of differentiating features of CLNY is its sponsor in Colony Capital.  Colony Capital is not just a couple of ex-investment bankers in a few offices, but rather a successful real estate investment firm with a long track record of success since 1991.  Its management is led by Thomas Barrack.  Mr. Barrack formed Colony in 1991 after overseeing real estate investments for Robert M. Bass including Westin Hotels and American Savings.  Colony Capital was formed coincident with a multi-hundred dollar investment in Resolution Trust Corporation Loans.  Throughout the 90's and 00's Colony Capital set up successful funds to invest in distressed debt and distressed real estate assets.  Back in 2008, they raised almost 1 billion dollars to invest in distressed mortgage assets post credit crisis.  In 2009 through 2011, Colony has invested about 2 billion dollars in real estate loans and securities.  Mr. Barrack also served as Deputary Undersecretary of the Interior for the Reagan Administration.  Another noteworthy member of Colony is Richard Saltzman who was Vice Chairman of Merrill Lynch's Investment Banking Division.  Mr. Saltzman serves on the Board of Kimco Realty (NYSE-KIM).  The rest of senior managment also has very deep experience. 

Colony’s Loan Acquisition and Origination Strategy

CLNY seeks to acquire and originate commercial loans that offer an attractive risk adjusted return through both income generation and capital appreciation of the loans. 

Loan Acquisitions-  CLNY acquires mortgage loans, or portfolios of mortgage loans, secured by first or second liens on commercial properties, including office buildings, industrial or warehouse properties, hotels, retail properties, apartments and properties within other commercial real estate sectors, which may include performing, sub-performing and non-performing loans.  CLNY also acquires participation in a loan alongside Colony Capital.

Origination of Whole Mortgage Loans- CLNY originates whole mortgage loans that provide long-term mortgage financing to commercial property owners and developers.

Mezzanine Loans-  The origination or acquisition of loans made to property owners that are subordinate to mortgage debt and are secured by pledges of the borrower’s ownership interests in the property and/or the entity that owns the property.

Because CLNY invests alongside Colony Capital in loan originations, these are structured as joint ventures. 

Balance Sheet (in mms)

Cash         6           
Investment in Joint Ventures
Loans Receivable 229
Securities 32
Other 15
Total Assets 695
Line of Credit 32
Secured Financing 14
Accrued and Other 28
Dividends Payable 11
Total Liabilities 85
Total Equity 600





Colony gives pretty good detail about their investment portfolio.  The following tables will give you a sense of the types of investments they are in. There are some key points to be made:

1.  No investment is older than Q4 2009. 

2.  75% of the portfolio is performing and is currently yielding over 9% at cost. 

3.  The non-performing portfolio is valued at just 33% of the original principal balance.  Due to Colony's servicing and structuring capabilities, Colony has the ability to restructure or foreclose on delinquent loans to improve performance. 

Some details of the Investment in Joint Ventures and Loans Receivable are below.

(Dollars in thousands) Total Invested Date of Description
Our Investments     Initial  
Bulls Loan Portfolio $65,100   Jun-11 Approximately 650 performing and non-performing
          loans consisting of substantially all
          first mortgage recourse commercial real
          estate loans
Centro Mezzanine Loans   60,000   Jun-11 Participation in mezzanine loans secured
          by equity interests in 107 retail centers
          located in 27 states.
U.S. Life Insurance Loan Portfolio   49,700   Dec-09 25 fixed-rate first mortgages secured
          by commercial real estate
WLH Secured Loan (4)   48,000   Oct-09 Senior secured term loan secured by first
          mortgages on residential land and security
          interests in cash and other assets
Luxury Destination Club Recourse Loan   45,800   Sep-11 Performing first mortgage secured by 42
          properties located primarily in Manhattan
          and Maui
Extended Stay Loan   37,400   Oct-10 Performing mezzanine loan to Extended
          Stay Hotels, which includes 664 hotel portfolio
DB FDIC Portfolio   34,700   Jan-10 Approximately 1,200 performing and non-performing
          loans secured mostly by commercial real
CRE FDIC Portfolio   33,400   Aug-11 Approximately 760 performing and non-performing
          loans secured mostly by commercial real
German Loan Portfolio IV   30,000   Jul-11 5 non-performing commercial real estate
Manhattan Landmark Buildings Loan   29,100   Mar-11 Performing first mortgage secured by two
          landmark properties in Manhattan
Multifamily Tax-Exempt Bonds   27,900   Jun-11 Senior interest in tax-exempt bonds secured
          by a multifamily residential property
          located in Atlanta, GA
First Republic Bank (5)   24,000   Jun-10 Equity stake in financial institution
          with approximately $20 billion of assets
Hotel Portfolio Loans (6)   23,900   Apr-10 Two senior mezzanine loans indirectly
          secured by a portfolio of 103 limited service
Class A Manhattan Office Loan Participation   15,000   Mar-10 First mortgage pari-passu participation
          interest secured by Class A midtown Manhattan
          office building
Southern California Land Loan   13,400   May-11 First mortgage loan secured by a Southern
          California master planned development
          and equity participation rights
Spanish REOC/Colonial Loan   12,500   Nov-09 Syndicated senior secured loan to a Spanish
          commercial real estate company
Barclays FDIC Portfolio   10,300   Jul-10 Approximately 1,660 performing and non-performing
          loans consisting of substantially all
          first mortgage recourse commercial real
          estate loans
West Village Loan   9,900   Mar-10 Recourse loan secured by first liens on
          two West Village Manhattan townhomes and
          a photography catalogue
Cushman ADC FDIC Portfolio   9,100   Jan-11 Approximately 1,500 performing and non-performing
          loans secured mostly by commercial real
G&E Secured Loan   8,900   Apr-11 Senior secured multiple draw loan secured
          by assets of Grubb & Ellis Company and its
U.S. Commercial Bank Loan Portfolio   6,700   Dec-09 10 performing and one delinquent, fixed
          rate first mortgages secured by commercial
          real estate
2100 Grand B-Note   6,600   Dec-10 First mortgage B-note participation interest
          secured by an office building in El Segundo,
German Loan Portfolio   5,300   Dec-09 94 primarily first mortgage non-performing
          commercial real estate loans
German Loan Portfolio III   5,300   Jul-10 18 non-performing commercial real estate
Other Investments   22,800   various Investments with less than $5 million of
          originally invested or committed equity
Total Committed & Invested $634,800      



($ in thousands)  
Collateral Type Unpaid Amortized % of   Weighted   Current   Weighted
  Principal Cost Amortized   Average   Interest   Average
  Balance     Cost   Coupon   Yield   Maturity
                      on Cost   in Years
Originated performing loans                              
Retail $60,000 $60,000   9.30 %   9.80 %   9.80 %   4.80
Office   20,379   20,331   3.20 %   8.00 %   8.00 %   4.20
Hospitality   84,000   83,235   12.90 %   11.30 %   11.40 %   4.50
Other commercial   9,439   9,273   1.50 %   11.50 %   11.80 %   0.40
Residential   73,816   72,369   11.20 %   13.60 %   14.20 %   3.40
Total originated performing loans   247,634   245,208   38.10 %   11.40 %   11.50 %   4.10
Acquired loans and beneficial interests                              
in bonds                              
Retail   66,926   49,847   7.70 %   6.20 %   8.80 %   5.80
Office   62,078   45,678   7.10 %   5.00 %   7.10 %   5.60
Industrial   33,384   25,226   3.90 %   6.20 %   8.40 %   4.70
Hospitality   4,469   2,944   0.50 %   6.20 %   9.70 %   13.40
Multifamily   56,087   47,901   7.40 %   4.50 %   5.20 %   4.20
Other commercial   66,349   51,128   7.90 %   8.20 %   10.70 %   3.80
Residential   16,862   8,776   1.40 %   5.30 %   10.00 %   5.70
Land   15,662   6,266   1.00 %   5.90 %   13.90 %   2.80
Total performing   321,817   237,766   36.90 %   6.00 %   8.30 %   4.90
Retail   53,155   23,854   3.70 %                
Office   158,365   31,925   5.00 %                
Industrial   22,673   9,613   1.50 %                
Hospitality   39,613   32,099   5.00 %                
Multifamily   50,205   16,850   2.60 %                
Other commercial   39,269   14,929   2.30 %                
Residential   38,264   14,620   2.30 %                
Land   80,245   17,028   2.60 %                
Total non-performing   481,789   160,918   25.00 %                
Total acquired loans   803,606   398,684   61.90 %                
Total portfolio $1,051,240 $643,892   100.00 %                


Book Value

Book Value Per Share 18.47
Adjusted Book Value/Share* 19.55


*Adjusted Book Value per Share is based on adding the excess of the fair values of CLNY’s financial assets over the carrying values, which was $35.3M at 9/30/11, to total stockholders’ equity, as reported in accordance with GAAP, divided by total shares outstanding. The fair values of CLNY’s financial assets are based on CLNY’s prorata share of fair values for investment assets calculated for investment funds managed by affiliates of Colony Capital in accordance with FASB ASC 820 and disclosed in the footnotes to CLNY’s financial statements.


Valuation Rationale

Colony targets unlevered returns on investment of 10-15%.  Loan performance to date has been performing as expected.  If you take the adjusted current book value of $19.55, that means EPS or Dividends per share should eventually get to 1.95 to 2.93/share.  At the mid point of $2.44/share that would represent an 18% yield at the current price of $13.20/share.  My target for Colony is $20.33/share which represents a 12% yield on $2.44/share of earnings, or conversely a small 4% premium to adjusted book value of 19.55.

At $13.20/share, the market is saying that CLNY's portfolio is worth 32% less than what Colony says its worth.  Since the first investments took place in late 2009, I do not believe Colony got that stupid in such a short period of time.  Some might be concerned that the non-performing loans are a big concern.  But the non-performers are valued at just 33% of original loan amount and only amount to about $160mm at cost, and management believes it can improve loan performance. 

Stock Repurchase Program

Due to the dislocation seen in August CLNY’s board instituted a stock repurchase program of $50mm.  Through September they have purchased a small amount at $15.27/share.    At these levels, purchases are both highly accretive to book and EPS/share. 


Significant stock repurchases inlcuding tender offer
Dividend increases or special dividend
Eventual realization of value
Growth in earnings due to improved portfolio performance or growth in portfolio
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