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.

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)

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. 

Book Value

*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.