REITs are Overvalued

It seems like the Federal Reserve's zero interest rate policy (ZIRP) is having its intended effects all across the market with investors being forced to replace traditional income producing assets, such as treasuries and investment grade bonds, with riskier substitutes like REITs, BDCs, and junk bonds.  Risk averse investors sure have short memories as all three asset classes were hit particularly hard during the 2008-2009 credit crisis, however, as Howard Marks has been saying recently, they may not have any other alternative and are becoming essentially forced buyers.  Whereas forced sellers tend to create the best buying opportunities (see AIG), forced buyers are just the opposite, they distort the market and end up overpaying for certain assets, REITs in particular being one.

REITs (real estate investment trusts) are corporations that specialize in real estate based activities, and by electing to be a REIT, can avoid federal income tax as long as they pay out 90% of their taxable income to investors.  REITs are a popular way for retail investors to gain exposure to commercial real estate investments they would otherwise be restricted from due to vast funds needed to build a diversified portfolio of assets.  Publicly traded REITs also give the added benefit of liquidity that owning a strip mall outright wouldn't allow the average investor.

REITs definitely have positive qualities, but there's been many articles written recently on sites like Seeking Alpha that essentially ignore the price investors are currently paying.  Brad Thomas is a particularly ever present voice pushing REITs as a safe investment for those seeking income, focusing primarily on the dividend yields and the fact that some have never been cut (how'd the workout for GE?) or comparing REITs dividend yield to other income producing assets (aka reaching for yield). 

Total return should be the focus of every investor (capital gains and dividends), and at a price-to-adjusted funds from operations (P/AFFO - the REIT equivalent of P/E), investors are paying an over 21 times multiple, quite rich.  A 21 P/E might be appropriate for a growth stock that requires little in the way of capital investment, but REITs inheritantly require a lot of upkeep and generally have to fund growth through stock issuance and not retained earnings.

The inverse of the P/AAFO ratio is the AFFO yield, which can be thought of as the capitalization rate that the market is assigning to each REITs underlying assets.  Institutional buyers should be able to compare the cap rates they're getting the in private market with those available in the publicly traded sector and act accordingly.  If they're getting a better deal in the private market, simply purchase a portfolio of office buildings, malls, or apartment buildings outright.  At this time, it appears individual investors are acting irrationally and bidding up the prices of REITs compared to the underlying value of their assets.

Below are the 20 largest holdings of the Vanguard REIT Index Fund, one of the largest REIT focused mutual funds or ETFs.  The 2013 AFFO estimates are the average analyst estimates per Bloomberg.

During "normal times" cap rates are usually in the 7-10% range in the commercial real estate market in the private market, for instance, our friend Gramercy Capital  is targeting acquisitions in this range.  At today's prices, investors are willing to pay for publicly traded REITs at 4.6% cap rates, almost double, something is off here

As an investor in Gramercy Capital, this inefficiency is great, management can pick up real estate using cash on hand at 7.5%-9.0% cap rates and then have the public markets eventually value those same assets much higher (assuming of course Gramercy gets out of the penalty box and starts paying a dividend).  Other REITs are of course doing the same thing in order to maintain their AFFO growth and raise the dividend, however the available inventory and disconnect will eventually come to an end (possibly with the rise in interest rates). 

For the typical investor, I would be very careful adding additional REIT exposure at this time.  Many investors already have the market weight in REITs through a total stock market type index fund, so there's no reason at this point to overweight with an additional REIT sector fund.  I do feel for investors requiring income right now, but I don't think REITs are the magic answer, drawing a balance of capital gains (principal) and interest/dividends from a well balanced portfolio is a better solution than simply stretching for yield so you "don't touch the principal".

Disclosure: I own shares in GKK, recently sold GKK-A

My Take on Ultra Petroleum's 4th Quarter

To be a successful value investor sometimes you need to endure short term pain while "Mr. Market" goes through one of his mood swings.  While the broad stock market has been continually making new highs over the past two months, one industry that continues to be shunned is natural gas producers.

I run a fairly concentrated portfolio, natural gas producer Ultra Petroleum is one of my larger positions, and so far has been a disappointment.  After reporting 4th quarter results last week, Ultra hit fresh 52 week lows as gas prices remain stubbornly low and Ultra was forced to take another reserve write-down per SEC guidelines.

What is Ultra doing in response to the current environment?

Ultra is aggressively withdrawing capital as it doesn't make sense to monetize their assets at current natural gas prices if they can help it.  Despite cutting capital expenditures from $1.5 billion in 2011 to $835 million ($607 net after the LGS midstream asset sale), Ultra Petroleum still had record natural gas and oil production in 2013 of 257 Bcfe, illustrating the lag between cutting expenditures and the eventual decrease in production.  Ultra will be cutting capital expenditures even further in 2013 to $415 million and as a result will show their first reduction in year over year production, projecting 228 to 238 Bcfe for 2013.  Other natural gas producers are following suit in cutting production, including their joint venture partners in the Marcellus, Shell and Anadarko.

Natural gas supplies are sticky and still slightly elevated at 16% above the five year average, but if you compare that to where we were last spring/summer, supplies have closed the gap considerably and should continue to do so.

Despite low natural gas prices Ultra's margins continue to remain healthy, 64% operating cash flow margin and a 29% net income margin (after backing out the non-cash impairment charge).  Going forward Ultra is targeting $100 million free cash flow annually as they peg capital expenditures to operating cash flow for the next several years.  Management also stressed on the conference call that they are not in danger of breaching debt covenants, so the balance sheet looks safe with the debt having an average maturity over 7 years.

Ultra also provided the below reserve sensitivity, management has repeatedly targeted the $5 price to start deploying additional capital again, so what might their reserves look like at the $5 price?

UPL Reserve Fact Sheet

At the current market capitalization of $2.51billion in equity, and $1.8 billion in debt, that brings a total enterprise value of $4.35 billion.  Taking the $5 sensitivity with all the PUDs, its about a $7.182 billion valuation, subtracting out the $1.837 billion in debt, and you get an equity valuation of $5.345 billion, or over double the current valuation (~$35 per share).

I still believe that as natural gas producers reduce supply and new sources of demand come online, natural prices will eventual rise to where there's a reasonable balance.  That balance sounds like its in the $5-6 range over the next year or two which would still be half what it is in Europe or Asia.  I've taken advantage of this dip in Ultra's shares and continue to add to my position.

Disclosure: I own shares in UPL

Checking in on Asta Funding

Asta Funding announced their fiscal first quarter earnings today.  No big surprises as the company continues to accumulate cash, repurchase shares, receive cash flow from their zero-basis portfolio, and invest in their personal injury financing business over their traditional credit card receivable business.

The most interesting part of the conference call was the surprisingly robust Q&A session, a few takeaways:

• The divorce business (BP Case Management) is slow, Asta has put very little money into it, doesn't sound like they're committed to the business or just can't find the necessary scale to move the needle
• Asta still hasn't made a lot of progress on their share repurchase plan outside of the one off-market block trade with Peters MacGregor Capital Management
• The zero-basis portfolios total over $1 billion in face value which represents a large asset portfolio that is not on the balance sheet, Asta collected $8.1 million last quarter, and $35.9 million over the trailing twelve months
• The Great Seneca portfolio's loan matures in April 2014, Gary Stern anticipates an extension, but has had no direct discussions yet with BMO
• Asta is working on lowering overhead costs, but couldn't provide any further details
• One caller asked about Asta's purchasing criteria and how other publicly traded debt collectors have been actively purchasing credit card receivables, why hasn't Asta been able to?  But Asta is holding firm on not changing their purchasing criteria standards, they would like to purchase additional credit card paper, just haven't seen attractive pricing, specifically, earning 2.7x purchase amount over 84 months would not clear Asta's required return hurdle

Asta is still just treading water, waiting out the current pricing cycle, and that doesn't bother me as I don't want to see them stretch for a large portfolio again.  Where I would like to see more progress is on the share repurchasing front, any additional repurchases would be highly accretive to current shareholders, especially if management doesn't see credit card paper pricing improve in the near term (why earn 1% in CDs when you can buy the stock back?).  Even so, I peg the adjusted book value of the company at $15.25 after deducting the carrying values of the Great Seneca portfolio's assets and non-recourse debt, then adding back an estimate of the zero-basis portfolio's NPV.  Based on the current quote of $9.47, a nice wide margin of safety here.

Disclosure: I own shares of ASFI

Gramercy Sells CDO Management Business

Gramercy Capital has been on quite a run lately (22% YTD) as it continues its transformation into a net-lease equity REIT.  After the close today, Gramercy announced they sold the CDO management business to CWCapital for $9.9 million plus freeing capital that was tied up in the CDOs:

Gramercy will continue to hold the equity tranche of each CDO, which are probably worthless but potentially have some optionality value if the commercial real estate continues to improve.  While retaining the equity tranches is likely the right thing to do long term (free option), it means the CDOs will still be consolidated on the balance sheet creating negative shareholder's equity.  I'd probably trade the CDO equity for a clean balance sheet that more investors are able to understand.

Even with an additional $56 million in liquidity, Gramercy will still need to raise additional equity to fully becoming a performing REIT again and reinstate the dividend, but at least with the recent runup, they won't be issuing equity quite as cheap.

Disclosure: I own shares of GKK and GKK-A

UPDATE (2/6/13): I heard back from Investor Relations that "at settlement, we expect to deconsolidate."  Great news, Gramercy will have a clean balance sheet making the company easier to understand for investors and get to retain the potential upside of the CDO equity, however small that might be.

FRMO Corp

After years of being shunned, suddenly stocks are a hot asset class again with the Wilshire 5000 index (broad total market index) hitting a new all time on January 24, 2013.  Will retail investors finally return to the market?  What companies may profit from a broad shift from bonds back into stocks?

One such company is FRMO Corp, an "intellectual capital" firm headed by Steven Bregman and Murray Stahl of Horizon Kinetics fame.  FRMO can be thought of has having two sleeves, one sleeve includes various investment product revenue streams and a 0.87% interest in Horizon Kinetics, which is an investment boutique formed in 2011 through a combination of Horizon Asset Management and Kinetics Asset Management.  The second sleeve is cash and securities managed by Bregman and Stahl, including investments in several of the hedge funds managed by Horizon Kinetics.  FRMO's book value per share has grown at an incredible pace, starting at just under $50k in 2001 and as of 11/30/12 it stands at $58.3 million.

2011 Shareholder Letter

Horizon Kinetics
Back in February 2002, FRMO acquired a 8.4% interest in Kinetics Advisers for 315 shares of FRMO stock, then valued at $204.75, clearly an incredible investment for FRMO.  Today, Horizon Kinetics is a private investment company that manages roughly $7 billion in a variety of separately managed accounts, mutual funds, and alternative investments.  It manages primarily equity based portfolios that have faced constant redemption pressure across the entire industry for the past several years as investors have fled equities (and in particular active managers) for bonds and alternative investments.  While its nearly impossible to know when the bond "bubble" will end, at some point interest rates will rise causing bond prices to fall.  Pension funds who have return targets are unlikely to meet their objectives given the low return potential of bonds, while bonds prices might not crash, they won't earn what they have in the recent past likely pushing investors into riskier asset classes.

Several of the "Bond Kings" have recognized the potential shift into equities broadly and have begun opening up equity strategies: U.S. Bond Stars Bet Big on Equities Revival.  One change Kinetics Funds (Horizon Kinetics' mutual fund arm) recently made was to adjust the strategy of their Water Infrastructure Portfolio into an alternative fund strategy that tries to create bond like returns and volatility with stocks and stock options, the new fund is called Alternative Income Fund.  Horizon Kinetics hopes the fund will become popular with current bond investors as they realize past returns are no longer achievable in the current bond market.

Below is a breakdown of the firm's current AUM.  However, not all AUM is created equal, for instance alternative investments while a small piece of AUM contribute a disproportionate amount of the revenue in Horizon Kinetics compared to rather vanilla separately managed accounts that charge lower fees.

FRMO Q1 '13 Earnings Transcript

Many of FRMO's intellectual capital consultancy and revenue sharing agreements are based on the assets under management.  Below is what FRMO provided in their Q1 '13 earnings call transcript to provide a little more color on the portfolios:

FRMO Q1 '13 Earnings Transcript

For example, one of FRMO's revenue streams is a 20% interest in all the management and performance fees of Horizon Multi-Disciplinary Fund.  The Multi-Disciplinary Fund's strategy involves selling six month at-the-money put options on equities that they would otherwise be comfortable holding.  It only takes a little success and investor recognition for assets to multiple rapidly off of a small base generating revenue for FRMO.

Another one of their revenue streams could be on the verge of improving.  As mentioned on the latest conference call,  the Horizon Global Advisers Multi-Strategy Fund which founded in 2007, right before the credit crisis and at one point dropped 70% from peak to trough.  However instead of closing the fund, the managers stuck with it despite needing to return 400% in order to earn performance management fees above the high water mark.  Well as of this past weekend, the Multi-Strategy Fund finally crossed that high water mark and FRMO could potentially start earning a incentive performance management fee going forward in addition to the percent of assets management fee.  FRMO also has $5.2 million invested in the Multi-Strategy Fund, so they continue to benefit from the turnaround from an investor perspective too.  Management also noted similar circumstance at Polestar where it has recently cross the high water mark and will start earning performance fees.

Unique Business Structure
The beauty of FRMO's structure is the revenue streams are like royalties in there are no associated operating costs.  By nature, the intellectual capital business doesn't have operational costs as the costs are borne by the entity that FRMO is advising.  The level of business activity can thus be increased without the creation of expenses.  Bregman and Stahl have been successful in purchasing these interests before they are proven successful, and thus are generally inexpensive to the point where failures should not meaningfully harm the company.  Should such an investment prove successful, as the initial Kinetics Advisors interest was, the returns could be many multiples of the original investment.

FRMO also has no paid employees (the entry on the income statement is non-cash for audit reasons) and from the sounds of it, they don't intend to as long as they maintain the current structure, pretty shareholder friendly considering how much value management has created.

FRMO has $21.7 million in cash and below are their disclosed investments in limited partnerships, and their bond and equity securities.  It's difficult to find information on the hedge fund strategies, but both Bergman and Stahl are related to the two main holdings, Horizon Multi-Strategy Fund and Polestar Fund.  I tend to be skeptical of hedge funds and their ability to generate alpha due to high costs, but since FRMO is entitled to a portion of the management fees, the costs of FRMO's investments are essentially slightly subsidized as a result.

FRMO Q2 '13 10-Q

Shareholders equity is at an all time high of $58.3 million as of November 30, 2012 and virtually no real debt, the liabilities on the balance sheet mostly represent deferred taxes due to their investment holdings and their portfolio of securities they've sold short.  

The question of valuation for FRMO comes down to how you value the intellectual capital side of the business.  Backing out the book value of the cash, securities, and other investments, the market is valuing the intellectual capital side at $23.87 million.  Seems reasonable, but hard to really judge with the limited information and reporting that FRMO currently provides.

Potential Catalysts

FRMO has recently made efforts to increase its visibility with investors by holding very candid quarterly investor calls where they specifically make an effort not just to read the quarterly earnings report.  FRMO will also soon be eligible to start filing with the SEC again following two years after their reverse-forward split and the switch to the cost method of accounting of Horizon Kinetics after the merger.  Filing with the SEC will allow FRMO to leave the OTC Markets and once again list on a national exchange, opening FRMO up to a new investor base.

Additionally, FRMO is also exploring transactions that would add an operating business within the context of FRMO to provide cash flow for investments.  Management has stated that they are actively exploring such transactions, so something could be on the horizon in the near future.

FRMO is a unique company that is difficult to peg an intrinsic value, but you can't argue with the record of Bregman and Stahl as capital allocators.  I believe we could be on the cusp of a big shift into equities, and FRMO is well positioned to capture that trend.  I'm in the midst of selling a few legacy positions as their stories are playing out, so I'll likely allocate some of that raised cash to FRMO shortly.

Disclosure: No Position

Silver Bay Realty Trust

The Great Recession created many interesting investment opportunities in the financial and real estate sectors.  One market that's been off limits to public REIT investors until recently has been the single family home rental sector.  Historically this market has been limited to local landlords as its questionable if economies of scale exist or are translatable to a national REIT.

Silver Bay Realty Trust is a REIT recently formed to acquire, renovate and lease out single family homes with an eye towards dividends first and capital appreciation second.  It was formed in December 2012 as a partial spin-off of single family homes from Two Harbors Investment Corp (TWO), a mortgage REIT managed by Pine River, and a portfolio of single family homes from Provident, a private equity real estate fund.  The new portfolio will be managed by PRCM Real Estate Advisors, a joint venture between the two management companies.  Below is the new corporate structure:

The company at the time of formation has 2,548 single family homes (1,660 contributed by Two Harbors and 880 by Provident) located in the target markets of Phoenix, Tampa, Atlanta, Las Vegas, Tucson, Orlando, Northern and Southern California, Charlotte, and Dallas.  Each of these markets has a positive long-term trend of being located in desirable and growing locations away from the midwest and rust belt.  The company's portfolio is pretty new, with only 881 (or 34.5%) of their homes being owned for over 6 months, their general timetable to renovate and stabilize a rental asset.  Of the homes that have been owned for more than 6 months, 91% of them are occupied for an average rent of $1,126.  Costs at this point are pretty difficult to forecast, but the company estimates all property related expenses (vacancy, bad debt, property taxes, insurance, HOA, repairs and maintenance, and capital expenditures) will average 40-50% of rental revenues.  Silver Bay also has plenty of liquidity as it has $229.1 million in cash and no debt (all the homes are owned free and clear).

Its clear based on the current cost structure and pro-forma income statement laid out in the prospectus that Silver Bay will need to ramp up pretty quickly due to overhead costs at the corporate level.  The company is doing just that by completing most of their asset purchases through bank foreclosure auctions, many of these properties are likely very distressed and require a lot of work before becoming a performing rental, the company is current pegging those renovation costs at 10-15% of the acquisition costs.

From SBY's S-11

But the opportunity to acquire foreclosures is probably worth the renovation costs as these are exactly the kind of distressed properties that have the chance to achieve capital appreciation as the housing market continues to recover, housing inventories normalize, and family formations return to normal.

As for the potential rental revenues and potential dividend estimates, here's my extremely rough back of the envelope calculation:

• 2, 548 homes at $1,126 per month with 91% occupancy = $31.3 million
• $231 million in excess cash could purchase an additional 1,900 homes (at the current average of $121k per home), assuming rents remain constant, rental income = $23.4 million, for a total of $54.7 million
• Estimated property expenses are 40-50% of rents, so at 50%, rental income = $27.35 million, or $0.74 per share (37MM shares), that doesn't include the management fee or any first year extraordinary costs.

Assuming a normalized distribution of about $0.60 per share, and an 5% required yield, that would put the price at $12.00 per share, well below the current market price of $21.22.  This is a rough number and doesn't account for any added leverage Silver Bay might apply or any secondary offerings they might do to spread the costs over a larger asset base, but I think it's clear that shares aren't cheap at the current price.

I have a few other concerns besides the valuation, the one clear negative is the management cost structure, PRCM is due 1.5% annually of the total market capitalization.  Basing the fee off of market capitalization will encourage the firm to engage in secondary offerings, and as the stock price increases the profitability will decrease, an odd combination.  Also, if I were purchasing distressed properties for my own portfolio, part of my strategy would be to renovate and rent out the home until prices recovered, then harvest the gains and sell.  However, as part of the management and compensation structure, it appears Silver Bay would likely hold on to the rentals for the long term and realize those gains through rent increases.  I would prefer to see it structured more as a liquidating trust, over time working the portfolio down to zero, but that structure is more suited for a private fund.  I also have a bias against IPOs, the company is still too new and untested, the asset class seems like a difficult one to achieve national economies of scale, especially if operating the properties over the long-term.

While I don't think I'll get the opportunity to invest in Silver Bay at what I believe to be a reasonable price, its still an interesting company to monitor in case they have a temporary slip-up and the market overreacts.  I do believe there are substantial opportunities in single family homes, but its probably better suited to a different structure.

Disclosure:  No position

AIG: "Bring on Tomorrow"

I was initially attracted to AIG because of the presence of a forced seller, the U.S. Treasury.  However, now most of AIG’s short-term catalysts have come to fruition in the last month and a half, including selling 80% of their airplane leasing business (ILFC) to a Chinese consortium, the Treasury selling their remaining equity stake for $7.6 billion, and selling the remaining stake in AIA for $6.45 billion.  They’ve also rebranded their Life Insurance & Retirement and Property & Casualty Insurance businesses back to AIG (from SunAmerica and Chartis respectively) and launched a prolific advertising campaign thanking America for the bailout.  Going forward AIG represents more of a post-reorganization that needs to execute the new business model for a period of time before investors will trust it again and revalue it alongside peers.

So the investment thesis for AIG is fairly simple, it trades at roughly half of book value and expects to earn 10% ROE by 2015.  If AIG is able to grow book value at 10% over the next 5 years and the valuation gap between market value and book value converges during that time, it implies a ~26% annualized return (or over 3 times the current price).  AIG has been accelerating the book value growth through buybacks recently, however these are likely to slow in the near term as the company is switching its focus to improving the company’s interest coverage ratio, by repurchasing or retiring outstanding debt.  A simpler capital structure should reduce interest expense, improve credit ratings, and reduce the overall cost of capital, all positives.  AIG has also mentioned its intention of paying a dividend in 2013, opening it to more income based managers.

There are two large risks in my mind, the first is the overheated bond market which is the primary asset class owned by AIG.  Interest rates are low, and insurance companies are leveraged due to their float, rising interest rates could be a double edged sword.  Rising interest rates will increase earnings on the float in the long term, but also put pressure on bond prices in the short term, so AIG will have to manage its duration and continue to diversify into other assets.

Secondly there is the regulatory overhang.  AIG is expected to receive designation as a non-bank systemically important financial institution (SIFI) in 2013.  If AIG is designated as a SIFI, it will be required to carry additional capital above other insurers, hampering their profitability and balance sheet flexibility to return cash to shareholders.

Robert Benmosche, CEO of AIG, should be congratulated for the job management’s done restructuring the company since the bailout.  As the business plan is executed and AIG repairs its image with the public, the shares should overtime move closer to book value resulting in a tremendous opportunity for the patient long term investor.

Disclosure: I own shares in AIG, another way to play this story is through the warrants