Wednesday, November 16, 2016

Resource Capital Corp: Dividend Cut, New Management Simplifying Portfolio

C-III Capital Partners, led by Andrew Farkas, in September closed on the purchase of Resource America (REXI) which was the external manager of Resource Capital Corp (RSO), a troubled commercial mortgage REIT that has struggled since the financial crisis.  Prior to the financial crisis, as was popular, Resource Capital financed most of their commercial real estate loans through the CDO market, unlike the other mortgage REITs of that era, the company has pretty much stuck to that strategy creating a confusing portfolio with a eclectic mix of assets financed through securitization structures.  These assets include syndicated bank loans, middle market bank loans, life settlements, etc., more fit for a BDC but all squeezed into the 25% taxable REIT subsidiary carve out along with another side pocket of residential mortgages and mortgage servicing rights.  To be cynical, it appears that prior management would see an opportunity to earn a fee managing a new pool of assets, and simply used Resource Capital as a seed investor whenever needed, how else do you end up with that mix of assets in a commercial mortgage REIT?

The company reported third quarter earnings on Monday, first under C-III, and new management basically hit the reset button on the balance sheet, strategy, and the dividend policy all in one swoop.  Book value went from $17.63 to $14.71 per share as they took several impairment charges, and the dividend was cut from $0.42 to $0.05 per quarter.  The result was as you'd expect with many yield investors selling sending the stock down ~30% as they reacted to the dividend cut irrespective of the underlying value.  While certainly tough for previous RSO shareholders, the changes C-III Capital is making should result in the company trading closer to book value over time compared to a 40% discount today.

Capital Structure: $275MM market cap ($450MM book value), $270MM in preferred stock (3 tranches), and $1.4B in debt (both recourse and non-recourse).  Resource Capital reports leverage just under 2x which includes the preferred stock in denominator, putting the preferred in numerator would result in the common shares being levered 3.7x equity.

New Business Plan
The old plan in the 10-K.  It's odd that they use "commercial finance assets" for bank loans and CLOs, never heard that before but maybe because it sounds closer to "commercial real estate"?
C-III Capital's plan:
"Our plan, candidly, is simplify the Company and make it more understandable for investors and improve the transparency of RSO's performance.  We're going to do this by disposing of underperforming assets, divesting non-core businesses, and investing solely in CRE assets that produce consistent recurring cash flows and pay dividends out of earnings and not just out of cash that's on the balance sheet." - Bob Lieber, RSO CEO
The fact that this is a new plan says a lot about previous management.  I've talked about how public investors, especially in REITs like clean and simple portfolios, and that investors could get ahead of this when management is prepared to execute on that plan.  We saw that with Gramercy Property Trust (GPT) twice, first when they were transitioning from a mREIT not unlike Resource Capital to a triple net REIT and second when they absorbed the mix and match portfolio that Chambers Street Properties had created as a private REIT.  A good example of that today would be iStar (STAR) as they clean up their foreclosed operating and land assets, eventually returning to a hybrid mortgage and net lease REIT.  I think Resource Capital could do something similar as Gramercy and iStar, but in a quicker 12-15 month timeline.

The good news is that roughly 70% of Resource's portfolio is already CRE whole loans with a subset of that being legacy pre-2007 loans.  But most of these are senior mortgages on stabilized properties, 80% LTV, 3-5 year maturities and financed with cheap non-recourse (to RSO) funding via securitization structures.  They're currently passing all their OC/IC tests in these structures, if these were to fail cash flow would be diverted to pay down the senior notes.  This portfolio can earn mid-teen ROEs before expenses.
Outside of the CMBS piece, the rest of the assets (C-III's pegs it at 22% of the portfolio) are now considered non-core and will either be sold or allowed to runoff (much of it in the next year).  Included in ABS and other is more syndicated and middle market bank loans that are held via CLOs, these can either be sold into the secondary market or possibly Resource could utilize call features as the equity holder and liquidate the CLOs as pricing on bank loans has bounced back significantly from earlier in the year.  To quote the CEO again:
"To summarize, our strategy is to prudently divest non-core and underperforming assets, which account for nearly $0.5 billion, or 22% of our book value and as we realize the proceeds from the maturities and sales, we will deploy incremental capital into our CRE lending business and CMBS acquisition business" - Bob Lieber, RSO CEO
In setting the stage for the updated business plan, new management took the opportunity to take $55.3MM worth of impairment charges and reset book value lower.  Much of the impairments were related to their middle market and syndicated bank loan operation that they're exiting, along with write-downs of pre-financial crisis CRE loans in legacy securitizations.  While each of these were likely prudent, it has the effect of lowering the bar for future incentive fees RSO will be paying to C-III Capital if the new plan materializes as expected.

Management Agreement
Andrew Farkas, the new Chairman of Resource Capital, is a veteran real estate investor who founded Insignia Financial Group in 1990, took it public in 1991 and eventually sold the business to CBRE in 2003.  More recently he started C-III in 2010, and has since acquired special servicers, real estate brokers, and asset management groups to create a diversified real estate company.  Farkas is savy and RSO is their new fund to extract management fees, important to never really forget that management and shareholders aren't on the same side.

The external management agreement is typical-to-bad:
  • 1.5% of equity base management fee (better than if it was of assets, but REXI called this 70% margin revenue in their own presentation materials)
  • 25% incentive fee over 8% return (25% of which is taken in shares, 75% cash)
  • Expense reimbursement for CFO's salary and partial reimbursement on investor relations team (not covered in the base management fee apparently)
  • Termination fee equal to 4x the average base management fee and the average incentive compensation earned by the manager during the two 12-month periods prior (this would be at least 20% of the market cap, and that's low because no incentive has been earned in recent years)
C-III Capital is inheriting 714,000 shares of RSO from Resource America, or 2.3% of the company, rather insignificant compared to the fees they'll be earning annually.  But from C-III's perspective, their goal is to get RSO in a place where they could raise capital and grow the platform, that will only happen at a share price closer to book value and by playing nice in the sandbox with investors going forward.

Valuation
The larger, best of breed, commercial mortgage REITs like Starwood Property Trust (STWD) trade well above book value, other smaller externally managed ones like Ares Commercial Real Estate (ACRE) trade for about 95% of book value.  At even 85% of current book value, Resource Capital's upside is 35+% and over time as the new plan is executed even that discount should close to peers.  New management has guided that 2017 will be a transition year, and that dividends will likely stay in the $0.05 a quarter range, once the dividend policy is updated about this time next year, I'd expect RSO to be trading at least 85% of a simpler to understand book value.

New management plans to have an investor day soon where they will disclose more details on their future plans which could be an additional catalyst for the shares.

Risks
  • External Management - There's always going to be inheritent conflicts of interest with external management agreements.  With C-III Capital and RSO it seems to be initially surfacing with the buyback, the old management repurchased 8-9% of the shares at prices above $12 over the last year.  C-III plans to shelve the plan and instead deploy capital in CRE whole loans, with the stock trading at a 40% discount, there's no CRE investment I'm aware of that would equate to the same return as buying back shares.  But buying back shares would reduce equity and thus reduce management fees.
  • Leverage - Mortgage REITs are leveraged bets on the underlying portfolio.  CRE whole loans are typically floating rate so the portfolio shouldn't have much interest rate sensitivity but will be concavely exposed to any defaults.  I don't believe we're on the edge of another blowup in CRE/CMBS, but that's certainly always a risk.  
  • More Non-Core Impairments - C-III Capital took $55MM worth of impairments in their Q-3 earnings, about half of that was on the non-core, non-CRE assets and business lines that they're looking to sell.  Logic would say that they'd take the opportunity to get those marks correct, but they could need to come down more as they market these assets and determine what they're really worth.  The good news is CLO/bank loan market is open for business, but as we saw in the first quarter of 2016, these markets can close very quickly.
Summary
I bought some shares on Tuesday for $8.70, and expect the share price to be a little volatile over the next few weeks.  I'm not a long term holder of externally managed companies as eventually the conflicts of interest usually settle with management being the beneficiary.  But my plan is to hold RSO until it finishes management's capital recycling plan and the dividend normalizes which should bring back in the typical yield investors and push the price back up near book value.

Disclosure: I own shares of RSO

5 comments:

  1. Interesting idea... sounds vaguely similar to Altisource Residential (RESI) thesis... asset conversion while trading well below book value...

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    1. Thanks, RESI has always been on my list to get too, I will one day.

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  2. Good write up Clark Street Value. I will be paying more attention to your blog in the future.

    However, I'm going to try to poke one hole in it. I'm not sure you can assume management is going to "play nice" with investors and raise the dividend this time next year. Since their incentive is based on net common + retained, paying out a low % of CAD grows their compensation (90% of taxable income has historically been much lower than 90% of CAD so they can still keep mREIT status at a low payout for a while). Thus, I'm not sure the dividend gets raised when you assume. Sure the ability to issue more common also grows their compensation, but I didn't see anywhere where that common needs to be raised above book value.

    I like the preferred better than the common for now. The lower dividend and new portfolio clearly reduce risk on the preferred, and given their incentive, buying back preferred is a least possible. Their is no such reasonable possibility of the company buying back common. Like you said, it would lower their compensation. So for now I'll hold the preferred and see how NII and book shake out once they restructure the portfolio; if management starts buying common for their personal accounts, my focus would likely change.

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    1. Thanks for reading and commenting.

      You're correct, their base management fee will grow along with book value so there is some incentive to retain earnings (100% fine with me), eventually they'll want to pay a significant dividend to attract the typical mREIT investor back in the pond to bring the share price closer or above book value. There's no restriction against them issuing shares below book value like there is with a BDC, but the market would punish them in the same way and they'd never be able to raise equity again, which would also hurt any potential future incentive fees too. C-III is a much larger organization than Resource America, if RSO is to move the needle for them, it's going to have to be significantly bigger, there are plenty of mREITs out there that don't trade at huge discounts, easy playbook to follow.

      I don't have an opinion on the preferred shares, don't like to cap my upside like that, but if I like the common, I can't fault anyone for buying the preferred shares.

      I might highlight this in another post, but the assets they're either letting run off or are currently marketing (bank loans, CLOs) have seen a huge rally in recent weeks. Floating rate strategies have seen large inflows as rates rise, so they shouldn't have any problem liquidating those assets.

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