Colony Credit On Death Row

Note: Seeking Alpha declined to publish this article in this form because the editor thought it was too provocative.

Explicit Content

 

  • Colony Credit delivered a disappointing 2Q19 GAAP loss of -$111mm and non-GAAP “Core Earnings” of $36mm ($0.28/share)
  • Share price is at a wide 38% discount to book value while peers trade at an average premium of 23%
  • Management commentary has been consistently over-optimistic
  • CEO Kevin Traenkle and manager Colony Capital have lost the confidence of investors.   The company should be sold.
  • Management has never disclosed what NYC property backs a $258mm loan pool responsible for $158mm of impairments.  I believe it is The Row NYC Hotel.

Colony Credit Real Estate (CLNC) could have provided an extremely attractive shareholder return if the impact of previously identified credit issues had been fairly reflected in its financial statements.  Unfortunately another large write-down of a NYC hospitality loan that was non-accruing over a year ago and then impaired in 3Q18, 4Q18, and 2Q19 has undermined any remaining basis for investor confidence in CEO Kevin Traenkle and manager Colony Capital (CLNY).  Having failed to deliver reliable book value and earnings, Colony Credit should launch a review of strategic initiatives and Colony Capital’s ongoing review of strategic initiatives should explore the sale of its shares in CLNC and the management contract.

CLNC remains significantly cheaper than peers based on book value.

CM REITs 081519

However, those peer premiums have been earned through steady performance. CLNC failed to meet the expectations it provided for rising core earnings and failed to quickly address the known valuation issues in its portfolio. The share price is likely to remain depressed and the company is likely to attract the attention of activist investors, as happened at its sister company NorthStar Realty Europe (NRE) and its manager Colony Capital (CLNY).

Topics

  • 2Q19 Operating Results
  • Asset Quality
  • Tha Row
  • Corporate Issues (Share Buyback, Colony Capital, and Potential Sale)
  • Investment Considerations

2Q19 Operating Results

Colony Credit’s 2Q operating results (press releasefinancial supplementconference call transcript, and 10-Q) were disappointing due to $129mm of impairments and loss provisions. Aside from the limited number of troubled assets, CLNC’s returns have been held back by slower-than-expected deployment of capital into new assets and rising interest expense.  Net Lease real estate has performed relatively well due to the stability of long-term lease revenues matched with long-term mortgage financing.

CLNC 2Q19 IS

Excluding a $14.5mm realized loss on sale of private equity interests, loan loss provisions, and impairments, “Core Earnings” would have been $0.39/share for 2Q.  Management suggested this benefited from about $0.01 of favorable seasonality and that run-rate core earnings are $0.38/quarter.  That’s a relatively weak 7.3% rate of return on $20.72 of undepreciated book value per share.

Asset Quality

CLNC reported several impairments during 2Q19:

  • $104.3mm New York Hospitality Loan.  CLNC placed this loan on non-accrual in March 2018 and recorded two provisions totalling $54mm in 2018.  The latest impairment reduces the carrying value to $100.0mm.  The company has never identified the asset backing this loan package, but I present evidence below that it is the Row NYC hotel.
  • $3.9mm Northeast Regional Mall loan.  Malls suck.  CLNC recorded a $23.8mm provision related to the same loan in 2018.
  • $2.0mm West Regional Mall loan.  Malls suck.
  • $8.8mm Southeast Regional Mall (reported under “equity earnings”).  Malls suck.
  • $10.0mm Impairment of “Other” operating real estate
During the 4Q18 conference call in February CEO Kevin Traenkle was asked about the possibility there could be further write-downs and he replied:
“…the risks are very low. We’ve gone through the portfolio pretty extensively kind of asset by asset, loan by loan.”  Source: 4Q18 conference call
The 2Q19 impairments were about $1/share so the subsequent $3 drop in CLNC shares  suggests that investors have given up on the company and CEO Kevin Traenkle.

A bright spot was that no loans were past due at 6/30/19 except for the $258mm New York hospitality loan:

2Q19 Past Due

It is disappointing that CLNC has repeatedly taken charges related to the same assets.  Prior company comments about the NYC hotel loan were:

1Q18 – No loss provision:

“In March 2018, the borrower on the Company’s $260.2 million NY hospitality loan failed to make its interest payment. The Company has placed the loan on non-accrual status and has commenced discussions with the borrower to resolve the matter. No provision for loan loss was recorded during the three months ended March 31, 2018 as the Company believes sufficient collateral value exists to cover the outstanding loan balances.” – Source: 1Q18 10-Q

2Q18 – No loss provision:

Source: 2Q18 conference call

3Q18 – $35mm loss provision:

Source: 3Q18 Conference Call

4Q18 – Additional $18.8mm loss provision:

“During the fourth quarter of 2018, the borrower entered into a listing agreement with a real estate brokerage firm and as a result, the Company believes sale of the underlying collateral and repayment of the four loans from the sales proceeds is the most likely outcome. As such, the Company recorded an additional $18.8 million of provision for loan loss on the four NY hospitality loans in 2018 to reflect the estimated proceeds to be received from the borrower following the sale.” – Source: CLNC 2018 10-K

As New York City hotel room additions are being absorbed, we continue to be optimistic on the New York City lodging market recovery and the ability to exit this recent credit impaired asset. – Source: 4Q18 Conference Call

2Q19 – Additional $104.3mm provision

“So let me provide some specifics about the $129 million in right down taken during the second quarter. One of the impairments is related to the ongoing resolution efforts of New York City Hospitality loans. This is a key part of our overall portfolio rationalization strategy, as the full loans secured by this asset remain on non-accrual status and therefore are not currently contributing core earnings.

We initially impaired this asset in the third quarter of last year, based on market pricing estimates provided to the borrower by its broker. The borrower launched the sales process for the property earlier this year, which is adversely impacted by deteriorating hotel market conditions throughout New York City in the second quarter.

This resulted in lower bids from potential buyers than originally anticipated. And therefore, during the second quarter, we impaired the asset to a revised estimate of current value. The borrower is monitoring market conditions, and we will share a progress with you in the near future.” Source: 2Q19 Conference Call

Shareholders have a right to ask whether Colony Capital has fulfilled its obligations as manager with regard to assets that led to repeated impairments (the NYC hotel loan and the private equity interests which have been largely liquidated):

Our Manager’s asset management team engages in a proactive and comprehensive on-going review of the credit quality of each asset it manages. In particular for debt investments, on at least an annual basis, the asset management team will evaluate the financial wherewithal of individual borrowers to meet contractual obligations as well as review the financial stability of the assets securing such debt investments. Further, there is ongoing review of borrower covenant compliance including the ability of borrowers to meet certain negotiated debt service coverage ratios and debt yield tests. For equity investments, the asset management team, with the assistance of third party property managers, monitors and reviews key metrics such as occupancy, same store sales, tenant payment rates, property budgets and capital expenditures. If through this analysis of credit quality, the asset management team encounters declines in credit not in accord with the original business plan, the team evaluates the risks and determine what changes, if any, are required to the business plan to ensure that the attendant risks of continuing to hold the investment do not outweigh the associated rewards.  Source: 2Q19 10Q
Shareholders have a right to ask whether the fair value of troubled assets was correctly represented in past CLNC financial statements.  How did a senior loan on a New York City property decline in value from $258mm at 6/30/18 to only $100mm at 6/30/19?  Isn’t it likely that the deterioration in value should have been evident earlier and possibly prior to the January 2018 formation of CLNC?  Was CEO Kevin Traenkle aware of the likely decline in value of this asset when he certified the accuracy of each quarter’s financial statements?  Source: 2Q18 10-Q Exhibit 31.1
Sarbox Certification 2Q18
The next section presents evidence that the asset backing the troubled hotel loan is the Row NYC.  If this analysis is incorrect and the loan is for a different hotel then the same questions would still apply.  Did the manager properly monitor this asset and was its value properly represented in past financial statements?

Tha Row

Colony has never identified the New York City hospitality asset backing $258.1mm of loans on which the company has recorded $158.1mm of impairments.  I believe it is “The Row” hotel for these reasons:

  • Northstar Real Estate Income Trust and Northstar Real Estate Finance extended a 10-year $255mm senior loan to the owners (a joint venture between Highgate Hotels and Rockpoint Group) in 2013 (link to Northstar disclosure).
  • Disappointing operating performance is suggested by use of a small portion of the hotel for housing homeless people in 2017 (LINK) and a supply glut (number of NYC hotel rooms rose about 50% from 2008-2017)
  • The Row’s owners put the hotel up for sale earlier this year (LINK) which fits Colony’s description in the 2Q19 conference call:

“The borrower launched the sales process for the property earlier this year, which is adversely impacted by deteriorating hotel market conditions throughout New York City in the second quarter.  This resulted in lower bids from potential buyers than originally anticipated. And therefore, during the second quarter, we impaired the asset to a revised estimate of current value. The borrower is monitoring market conditions, and we will share a progress with you in the near future.”

As the successor to Northstar Real Estate Income, Colony Credit owns the loan to The Row (the renamed Milford Plaza).   The only question is whether this loan is responsible for the impairments recorded in the past year.  The $258.1mm balance is very close to the original Milford/Row loan and the difference could be explained by a small subsequent restructuring of the loan package. 

The Row NYC hotel has a prime location on 8th Avenue between 44th and 45th Street.  It opened in 1928 as the Hotel Lincoln (The House of Hospitality):

Hotel Lincoln

The hotel was remodelled in 1958 and operated as The Manhattan and then from 1980-2011 as The Milford Plaza (“the lullaby of all Broadway“).  David Letterman filmed a 1987 show in the hotel’s Helen Hayes suite (LINK).  Highgate/Rockpoint spent $140mm on a renovation with a minimalist look and rebranded it as “Row NYC”.

(Koneko interpretation of the rebranding)NO MORE LULLABIES

Row NYC gets satisfactory customer reviews on Tripadvisor and Expedia.  Visitors frequently mention the great location, small room size, and bargain price (rates currently advertised from $98/night).  It’s probably easy to fill the hotel with budget tourists, but profitability must be weak due to the low pricing.  The minimalist redesign may have been a poor choice which is out of place with the Theatre District and Times Square mass market tourist clientele.  Guests can walk out the door and in one minute be at Frozen the Musical or in three minutes take a selfie with a Times Square Elmo.   The Milford Plaza image highlighted the Broadway environment while Row NYC hides it.  It’s hard to believe there is not a way to be successful at this location, but it might require a significant investment to expand and invigorate the lobby and common areas. 

Row lobby bar has few customers at 7:30 PM – Koneko photoRow Lobby Bar

Row lobby is boring but busy – Koneko photosRow Lobby Stairs

Lobby Check-in

CLNC has never confirmed that Row NYC is the asset backing it’s impaired NYC hospitality loans.  If my assumption is correct then the best way for CLNC to realize value might be through a restructured loan package for a strong operator that can contribute new equity and a fun new vision for this asset.  Planning to reconfigure and improve the space may be complicated by the existence of a ground lease and separate ownership of the retail podium.

Corporate Issues (Share Buyback, Colony Capital, and Potential Sale)

Buyback:  Colony Credit has not used any of its $300mm share repurchase authorization. Many investors see share repurchase as a litmus test of corporate governance and arithmetic competence.  CEO Kevin Traenkle has tried to explain that he sees more value from investment in new assets than from repurchasing shares at the discounted levels where they have traded over the past year.  After the impairments recorded over the past year one wonders whether CEO Kevin Traenkle’s reluctance to repurchase shares could have been due in part to lack in confidence in the company’s book value despite his quarterly certification of the financial statements.

Colony Capital:  Colony Credit is tainted by the poor shareholder return of its manager Colony Capital. The retirement of CLNY’s CEO and his replacement by Chairman Tom Barrack seems to have been accompanied by a more realistic and aggressive approach to addressing the problems resulting from the NorthStar mergers (described in more detail on the CLNY 3Q18 conference call). In February 2019, CLNY signed a standstill agreement with activist investor Blackwells Capital requiring the formation of a Strategic Asset Review Committee of the Board of Directors:

“… the responsibilities of the Strategic Asset Review Committee include: (I) conducting a comprehensive review and evaluation of all of the Company’s assets, businesses and business configuration; (II) assisting and advising on a long-term plan to optimize the Company’s assets, businesses, and business configuration; (III) providing the Board with periodic updates summarizing its progress to date; and (IV) from time to time as it determines appropriate, making recommendations to the Board regarding actions to be considered in furtherance of the Strategic Asset Review Committee’s purpose. The Strategic Asset Review Committee will be empowered to hire additional advisors, as necessary, to assist in its review.”

Significant developments have already occured with the acquisition of Digital Bridge , CEO transition plan, and marketing of Colony’s Industrial segment for sale.  The Committee is very likely to evaluate strategies for maximizing the value of CLNY’s interest in CLNC through sale of CLNY’s 48mm shares and the management contract.  CorpGov.com reports that Blackwells is likely to maintain pressure for change by nominating four new independent Directors at the next shareholder meeting (LINK).

Potential Sale of CLNC:   CLNC’s poor 2018 results did not fully capture the impairment of poorly performing assets and disappointments have continued in 2019.  It appears that the company and CEO Kevin Traenkle have lost the opportunity to build a reputation as a reliable vehicle for investment in commercial real estate credit.  It would be best for all parties if the company were sold.  A peer company such as ARI or BXMT could accretively acquire CLNC by paying 90-100% of CLNC’s book value using its own shares currently valued at a premium to book. The external manager of the peer company could acquire the CLNC management contract from CLNY. Benefits:

  • CLNC shareholders would receive fair value for their shares, a significant premium to the current depressed market price, and the opportunity to continue as shareholders of a company with a long-term record of value creation.
  • Colony Capital would receive publicly traded shares worth approximately $1Bn that could be sold over time to repurchase its own shares which are currently trading a deep discount to their fair value of $10-$12. Colony Capital could sell the CLNC management contract for approximately $270-400mm (based on 10-15% of equity).

Other potential buyers of CLNC could include international financial firms seeking a stronger US presence and private funds that could come public through a merger with CLNC.  Bloomberg reported that Colony Capital was in negotiation with Oaktree at the end of last year regarding a potential sale of its interest in Colony Credit (presumably the shares + management contract).  Those talks did not result in a transaction and Oaktree sold itself instead, however the talks illustrate that CLNY has already been considering a CLNC transaction.

Colony Credit’s low valuation is likely to attract pressure from activist investors just as Colony Capital and NorthStar Realty Europe did.  Rather than waiting for activists to attack, CLNC’s Board of Directors should initiate a review of strategic alternatives that would deliver fair value to company shareholders.

Investment Considerations

Dividends: Colony Credit pays an above-average dividend yield, but dividends transfer value rather than create value, so it is unwise for investors to use yield as a basis for security valuation. A fully invested CLNC portfolio should generate Core EPS of at least $1.86/year (a 9% return on book value) which would provide scope for a dividend increase.  However the run-rate of “core earnings” does not cover the current dividend and in the 2Q19 conference call CEO Kevin Traenkle said that dividend coverage “is our number one priority“, but he did not repeat prior guidance of covering the payout by year-end.

Earnings: Colony Credit is earning a below-average return on book value. If earnings rise to peer levels, then shares should appreciate to a valuation in line with peers. If Colony’s management is uniquely incompetent, then earnings and valuation will remain low.  However, even if profitability does not improve, CLNC’s current earnings yield is now slightly above the sector average and should provide some support to the share price.

Asset Value:  CLNC could report further impairments, but the current gap of over $900mm between market cap and book value provides a large margin of safety.

Activism: Colony Credit has not provided steady performance for shareholders. Investors in CLNC should understand that disappointments and blunders may continue, but that internal and potential external pressures should force the elimination of the discount to book value.  Colony Capital needs to realize value from CLNC due to pressure from Blackwells.  CLNC needs to deliver value to avert pressure from activists who will inevitably be attracted by its distressed price.

Disclosures and Notes: 

The author is a shareholder of CLNC, CLNY, and NRE. The author does not make any recommendation regarding any investment in any company mentioned in this article. Investors are encouraged to check all of the key facts cited here from SEC filings and other sources prior to making their own investment decisions.

The author does not wish to spread misinformation.  A link to this article was sent to CLNC’s investor relations representative, Lasse Glassen of ADDO Investor Relations.  If  the company can point to factual errors in the text using information public as of 8/16/19 then corrections will be made as promptly as possible.

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