- Average book value return of +1% in 9M20
- Avoided disorderly portfolio liquidation. Flexibility with borrowers and lenders preserved value
- Some bargains remain with 5 CM REITs at discounts of over 20% to 9/30 book value
- A longer recession would be a greater challenge to these business models
Commercial mortgage REITs have passed through the COVID crisis without large impairments to their asset values and future earning potential. The fair market value of their portfolios undoubtedly dropped sharply in the spring, but the nature of their business models enabled the REITs to work through the crisis without value-destroying forced sales.
- Stable Portfolios
- Dividend Reductions
- High Volatility
- Investment Considerations
Most commercial real estate segments have been weak with the Green Street Commercial Property Price index falling 8% over 12 months to 12/4/20. Industrial and Manufactured Housing gained while Malls and Hotels fell sharply.
Amid weakness in commercial real estate, commercial mortgage REITs were able to maintain relatively stable portfolios, a sharp contrast with residential mortgage REITs whose portfolios shrank by an average 43%.
Most financing for the Commercial Mortgage REITs is provided through non-recourse CMBS and CLOs and bank lines that have collateral-dependent margin requirements rather than market-dependent. Descriptions from several REITs:
- Starwood 10-K “We seek to mitigate risks associated with our repurchase agreements by managing risk related to the credit quality of our assets, interest rates, liquidity, prepayment speeds and market value. The margin call provisions under the majority of our repurchase facilities, consisting of 78% of these agreements, do not permit valuation adjustments based on capital markets activity. Instead, margin calls on these facilities are limited to collateral-specific credit marks. To monitor credit risk associated with the performance and value of our loans and investments, our asset management team regularly reviews our investment portfolios and is in regular contact with our borrowers, monitoring performance of the collateral and enforcing our rights as necessary. For repurchase agreements containing margin call provisions for general capital markets activity, approximately 22% of these pertain to our loans held-for-sale, for which we manage credit risk through the purchase of credit index instruments. We further seek to manage risks associated with our repurchase agreements by matching the maturities and interest rate characteristics of our loans with the related repurchase agreement.”
- Blackstone 10-K “Margin call provisions under our credit facilities do not permit valuation adjustments based on capital markets events, and are limited to collateral-specific credit marks.”
- Apollo 1Q20 Conference Call: “[Our lending facilities] don’t have spread marks, they’re credit-based discussions. To be fair, most of the agreements or all of the agreements are fairly opaque with respect to what constitutes a credit event or credit discussions. To give you a flavor of sort of how those discussions work, whether it be a hotel or any other asset, I would say the discussions are far more than just a static backwards-looking analysis. And the situation like that we’re faced with today, I would say the conversations encompass forward-looking views of what an asset may or may not be worth given various assumptions on how people think the economy might recover. I would say, ultimately, borrow behavior factors into it as well and what is the equity sponsor doing or not doing in a particular situation. So it would be disingenuous of me to tell you that there is a specific metric that is focused on. They are really — and not to dodge the question, but to be very candid, depending on the bank, depending on the asset, they are very much sort of individual customized discussions on every situation. ”
Many REITs agreed with their bank lenders to reduce bank balances over several months. The key contrast with residential mortgage REITs is that the commercial REITs were permitted much more time and flexibility. Examples:
- Apollo 1Q20 conference Call: “Over the past 8 weeks, in discussions with lenders, ARI has agreed to delever certain of its secured borrowings by a total of $144 million or less than 5% of secured credit facility borrowings as of March 31“
- Blackstone 1Q20 conference call: “we engaged our largest bank lenders with plans to reduce the leverage in their facilities, particularly as it relates to hotels and other more exposed properties in order to reduce the possibility of margin calls and create even greater stability within our capital structure. As of today, we have modifications closed or agreed in principle with our 7 largest lenders“
- Starwood 1Q20 conference call: “We worked with [our bank lenders] proactively to restructure our hotel loans, which we’re, obviously, going to have interrupted cash flow, and it’s been a very good conversation. The banks have been super supportive.“
Commercial mortgage REITs directly originated most of their loans and maintain ongoing relationships with borrowers. This provided the opportunity to modify loans backed by stressed properties to preserve value. For example, concessions could be granted in exchange for a borrower putting more equity into a property.
The accounting treatment of loans held by commercial mortgage REITs is largely driven by creditworthiness of the borrower rather than the market value that could be realized from sale of a loan at a particular point in time. Explanation from Ladder 10Q:
- “Provision for Loan Losses The Company evaluates each loan for impairment at least quarterly. Impairment occurs when it is deemed probable that the Company will not be able to collect all amounts due according to the contractual terms of the loan. If the loan is considered to be impaired, an allowance is recorded to reduce the carrying value of the loan to the present value of the expected future cash flows discounted at the loan’s effective rate or the fair value of the collateral, less the estimated costs to sell, if recovery of the Company’s investment is expected solely from the collateral. The Company generally will use the direct capitalization rate valuation methodology or the sales comparison approach to estimate the fair value of the collateral for such loans and in certain cases will obtain external appraisals. Determining fair value of the collateral may take into account a number of assumptions including, but not limited to, cash flow projections, market capitalization rates, discount rates and data regarding recent comparable sales of similar properties. Such assumptions are generally based on current market conditions and are subject to economic and market uncertainties.“
A multi-year economic downturn would carry the risk that the subjective valuation process employed by commercial mortgage REITs could be slow to recognize impairments. An extreme example would be the Manhattan hotel loan that Colony Credit marked at $258mm when it went public in 2018, then $223mm, then $204mm, then $100mm, then $50mm, and then finally realized proceeds of $13mm in 2020.
Commercial mortgage REITs were not forced to make distressed asset sales, but some chose to reduce dividends in order to accumulate capital for deleveraging.
Commercial Mortgage REIT’s leverage and complexity led to volatile share prices despite the resilience demonstrated by their financial performance this year. This chart compares total returns of 7 commercial mortgage REITs with 5+ year records against an ETF which holds a portfolio of investment grade commercial mortgage backed securities
The REITs each delivered a higher total return than CMBS with the exception of LADR which began 2015 at a valuation of 130% of book value and is currently trading at 69% of book value. The chart shows two broad opportunities for investors who were willing to make the volatility work in their favor by buying at discounted prices in early 2016 and early 2020.
Arbor Realty delivered by far the best return from its portfolio of multifamily assets. A recession such as 2008-2009 that had a greater impact on the housing market would be less favorable for Arbor.
Share prices of commercial mortgage REITs have risen sharply since March, but five still trade at substantial discounts to book value. Observations:
- ARI wisely transitioned in recent years away from a portfolio of higher risk junior loans to 84% senior loans. The company does have significant exposure to development assets (21%), hotels, and retail (10%). The company repurchased $92mm of shares in 9M20 at an average price of $8.47.
- LADR has a diversified portfolio of loans (96% senior), real estate (majority is net-leased essential retail, but the company also opportunistically invests in other sectors such as multifamily), and investment grade CMBS. The company suffered in 2020 from a conservative approach, holding excess cash and raising more long-term financing in case market conditions deteriorated and better investment opportunities arose later. Asset performance has been good and the share price is likely to recover once excess capital is invested and earnings return to normal.
- TRTX has a low-risk portfolio of senior loans (14% hotel and 1% retail), but had substantial leverage on its own balance sheet which was reduced through a dilutive financing with Starwood Capital in May (11% coupon + warrants). The company’s accounting for the warrants hides their impact on book value which would drop to $15.80/share if the warrants were exercised today.
- CLNC has demonstrated improved stability and vision under new CEO Mike Mazzei who joined in April. The company was fortunate in 4Q19 to complete a large CLO that reduced its dependence on bank lines. Investors should be concerned that the company’s average internal “risk rating” of its loan portfolio is 3.8 on a scale of 1 to 5 with “3” defined as “Average Risk – The loan is performing as agreed” and “4” defined as “High Risk/Delinquent/Potential for Loss-The loan is in excess of 30 days delinquent and/or has a risk of a principal loss“. It’s not surprising that the share price discounts the potential for additional impairments.
- GPMT has a low risk portfolio of senior loans (16% hotel and 8% retail) but had substantial leverage on its own balance sheet which was reduced through a dilutive financing with PIMCO in September (8% coupon + warrants). Similar to TRTX, the company’s accounting for the warrants hides their impact on book value which would drop to $16.13/share if the warrants were exercised today. The company rates the risk of its loans on a 1 to 5 scale similar to CLNC and at 9/30/20 the weighted average rating was 2.6. Shortly after drawing on the dilutive financing the company paid $44.5mm to internalize its management. I estimate this will further reduce book value to $15.39/share.
Overall, the commercial mortgage REITs showed they are less vulnerable in a market panic to catastrophic losses and margin calls than the residential mortgage REITs.
At the time of publication the author held a long position in LADR. This disclosure is not a recommendation and the holding could change at any time. Investors should check all facts cited here before making any investment decision.