Monday, November 19, 2012

Gramercy 2.0

Summary/Background Information:
Gramercy Capital ( is a commercial mortgage REIT that is undergoing a transformation to become a net lease equity REIT focused on office and industrial properties.  Formed in 2004, Gramercy previously originated and acquired commercial real estate whole loans, mezzanine loans, and commercial mortgage backed securities by utilizing financing through collateralized debt obligations (CDO).  Gramercy issued three CDOs, one each in 2005, 2006, and 2007. Gramercy managed and retained the equity interest in the CDO, thus exposing themselves to the first loss in the collateral pool.  CDOs have an overcollateralization ratio test which measures the assets owned divided by the liabilities issued by the CDO, if the test is breached, excess interest cash flows are diverted from the equity and junior notes to pay down the most senior notes in the structure until the test is cured.  As of 9/30/12, all three of Gramercy’s CDOs are failing their overcollateralization tests and the cash flows are now limited to the senior management fee.

Outside of the CDO management business, Gramercy also has a property management division, named Gramercy Realty, which oversees its small and low-quality owned portfolio of 21 bank branches and 13 office buildings with an occupancy rate of 40.9% as of 9/30/12.  Additionally, Gramercy Realty manages $1.9 billion in real estate assets for KBS Real Estate Investment, Inc. (KBS), as part of a collateral transfer and settlement agreement executed in September 2011 where Gramercy Realty’s prior assets were transferred to KBS for the forgiveness of debt.  The portfolio includes 514 bank branches, 273 office buildings and one land parcel, totaling approximately 20.1 million rentable square feet.  After the settlement agreement, Gramercy Realty was retained to manage the portfolio for a fee of $12 million annually with some additional incentive bonuses.  Going forward, Gramercy is going to use the Realty platform as a launching pad for the net lease business model.

The company's past as a commercial mortgage REIT has been well documented, so I’d like to focus on what the company could be worth going forward with the new net lease equity REIT business model.

Balance Sheet
Gramercy has a strong liquidity position, which is being masked by the GAAP accounting treatment of the equity ownership in the CDOs.  Accounting rules require Gramercy to consolidate the CDOs assets and liabilities on its balance sheet, creating a negative book value due to the assets in the CDOs being marked at less than the CDO debt outstanding.   It also creates the illusion of a highly leveraged company; however all the CDO liabilities are non-recourse to Gramercy, meaning any losses beyond Gramercy’s initial equity investment in the CDOs will be borne by CDO debt holders.  If you remove the CDO consolidation the balance sheet would breakout as below:

Gramercy’s capital structure also includes 3,525,822 Class A preferred shares with a redemption value of $25.00 per share, which earn $0.50781 in dividends quarterly (8.125% annually).  Beginning in the 4th quarter of 2008, Gramercy elected to suspend the preferred dividend payment to maintain liquidity in order to survive the financial crisis, as of the end of Q3 12, the amount due to preferred holders totaled $28.65 million.  Due to the non-payment of preferred dividends for six consecutive quarters, the preferred stockholders exercised their right to elect a board member, William Lenehan, and will continue to have representation on the board until the accrued dividends are current.

New Management & Strategy:
After considering strategic alternatives, including an outright sale of the company, Gramercy decided to stay an independent company and in July 2012, the Board of Directors hired a new management team to transform the existing public entity into a net lease equity REIT. In a triple-net lease, the tenant is typically responsible for all improvements and is contractually obligated to pay all property operating expenses, such as real estate taxes, insurance premiums and repair and maintenance costs.  Gordon DuGan was brought in as CEO, he spent over 20 years at real estate firm W.P. Carey & Co (NYSE: WPC) where as CEO he oversaw the growth of the company’s assets from $2.5 to $10 billion.  One concern is how he abruptly resigned from W.P. Carey in 2010 because of a disagreement with the founder and chairman (  But on the plus side, under his leadership Gramercy is resuming quarterly conference calls which were absent the last couple of years.

Gramercy’s new stated strategy is to focus on industrial and office properties in top 50 markets with an average lease term of more than 10 years.  Gramercy plans to use leverage of approximately 50%, utilizing primarily fixed-rate non-recourse debt with an expected borrowing rate between 3.0% and 4.75%.  By targeting cap rates of 7.5% to 9.0% and 1:1 leverage, Gramercy expects to earn an ROE in the 12%-15% range.

Insider Purchases
As a show of commitment to the new business strategy, Mr. DuGan purchased 1,000,000 shares of common stock at $2.52 per share directly from the company (not in the secondary market) before taking his post as CEO.  He’s not the only insider showing confidence with their wallet, new president Benjamin Harris also made an open market purchase of 40,000 shares at $2.64 a share on 8/27 and preferred share director William Lenehan purchased 20,000 common shares at $2.62 a share on 8/24.  With his interests aligned with the preferred shareholders it’s interesting to see Mr. Lenehan purchasing the common shares, it makes the investment case even stronger that the accrued preferred dividend will be paid before too long.

MG&A Costs
One of the new management’s goals is to reduce the cost structure of Gramercy; the net-leased business by nature should be a low overhead operating model.  A lot of the cost baked into Gramercy lies in the CDO management business, Gramercy Finance, which employs 25 people and experiences a lot of the professional fees associated with managing distressed assets.  Gramercy communicated in their September investor call that the goal SG&A run rate is below $20 million, which still seems high in comparison to their size.  Hopefully as the asset base grows, the expenses come more in line with peers.

Bank of America Portfolio Transaction
Management has gotten off to a quick start in deploying Gramercy’s free cash into the new investment strategy.  They started off on 8/21 by entering into a joint venture with Garrison Investment Group to purchase a portfolio of office buildings and bank branches which had previously been apart of Gramercy Realty and are currently in the KBS Portfolio that Gramercy already manages.  The portfolio consists of 5.6 million square feet of which approximately 81% is leased to Bank of America, N.A. for a term ending in June 2023.  The projected 2012 net operating income for the portfolio is approximately $41.5 million.  Gramercy will also manage the portfolio and earn a management fee of about $1 million from the joint venture, although that’s less than the agreed decrease in the management fee of the KBS portfolio from $12 million annually to $9 million on the remaining KBS portfolio.

At the deal closing, the joint venture will sell two large office buildings in Chicago and Charlotte for $135 million, bringing down the total purchase price to $350 million.  Additionally, management has a plan to sell 45 non-core and primarily multi-tenant properties to “more active investors” in the next twelve months for an estimated $350 million, leaving the joint venture with a portfolio of core properties primarily leased to Bank of America, N.A.

To fund the purchase, Gramercy will use $60 million of its cash position and issue $15 million worth of common stock to KBS (6 million shares at $2.50 per share, no transaction fees).  The common stock issuance is a little puzzling as management is issuing cheap shares (expensive funding) when it has plenty of available cash on the balance sheet.  Potentially KBS knows the Bank of America Portfolio is an attractive asset and negotiated receiving equity in exchange for slightly more favorable terms.  Garrison will also kick in $75 million in equity, and then the joint venture has secured a $200 million loan from a major bank.

Industrial Property Acquisitions
Gramercy also recently announced it has entered into a contract to purchase two Class A industrial buildings in Indianapolis leased to three tenants for an average weighted lease term of 10+ years.  Details provided so far have been light but management provided the below in a recent investor presentation:

Another transaction that appears more preliminary was announced in the third quarter results press release.  Gramercy entered into a letter of intent to buy an industrial building portfolio totaling 1 million square feet with a cap rate in excess of 8.5%.

After the closing of the three transactions, Gramercy provided the below data for what the asset composition will look like at year end:

After the closing of the three transactions, based on the approve purchase price and leverage, Gramercy will be left with available free cash of $73.95MM.  The company also has additional assets that are up for sale or can be sold and used to buy additional net lease portfolios.

CDO Management Sale
Gramercy has hired Wells Fargo as an advisor to sell the CDO management business and the CDO equity.  All three CDOs are failing their overcollateralization tests and it is likely that they will for the foreseeable future.  However, that doesn’t mean the equity pieces are worthless, with a long-term horizon and an active management approach a manager could eventually end up extracting value from the CDOs.  On the 3rd quarter conference call, Gordon DeGan commented, “Our hope is the transaction will be completed this year and I think that the investors will be pleased with the results of that transaction.”  While the CDO/CLO market is making a surprising comeback, it's still advisable to temper expectations and assume the sale will bring in a non-material amount.

The non-accounting reporting benefits to selling the CDO business includes reducing overhead costs and freeing up cash advances made to the CDOs.  The current servicing advances to the CDOs total $10.2 million as of the end of the 3rd quarter, which should be freed as a result of the CDO business sale and become available for investment in the new strategy.

KBS Mezzanine Loan
As part of the KBS/Bank of America Portfolio transaction, Gramercy invested $19 million in the origination of a mezzanine loan to KBS which KBS will pay off with the proceeds of the Bank of America Portfolio closing.  The loan included a 1% origination fee and accrues interest at 10% annually, creating a quick but compelling IRR profit if the Bank of America Portfolio closes as expected in the 4th quarter.  The repayment of the loan will also increase the available cash proceeds for investment.

CDO Senior Bonds
Gramercy holds some senior bonds that were previously issued by their CDOs but were repurchased by the company, these bonds are consolidated and cancelled on the balance sheet, but they have a face value of $45.4 million with a fair market value of $36.2 million.  Gramercy previously had purchased junior notes at a discount in order to cancel them to prevent the overcollateralization tests from failing and to keep the equity payment turned on.  However the CDO bonds currently held are high in the capital structure of each CDO (Class A-1, A-2, and B) and wouldn’t have a material impact on the overcollateralization tests if cancelled as you get more bang for your buck lower in the capital structure. 

Due to GAAP accounting rules, these holdings are consolidated on the balance sheet and are essentially cancelled out.  Once management has invested the available cash, they have indicated they would look to sell the CDO bonds in order to continue investing in net leased properties until fully ramped.

Available Liquidity
If you conservatively assume that Gramercy will get the $10.2 million in servicing advances out of the CDOs, receives full payment of the $19 million KBS loan, and is able to sell the CDO bonds for $36.2 million, that frees up an additional $65.2 million in cash for a total of $139.35 million in available funds to purchase more net-leased assets, with upside pending the CDO business sale.

At current prices the market is valuing the common shares at about investable cash (including the additional liquidity items mentioned above) subtracting out the preferred shares, almost like a blank check IPO.  Equity REITs typically are valued on a multiple of funds from operations (FFO), which is calculated by adding depreciation and amortization expenses to earnings, instead of earnings.  Management has declined to provide any FFO guidance, so in order to attempt to put a value on the new Gramercy model; I’ve attempted to project what the normalized FFO could be given the money available for investment.

Using the numbers provided by management of what the portfolio will look like on 12/31/12, and then assuming the remaining $139.35 million (including the CDO servicing advances, CDO bonds, and KBS loan) is invested in similar fashion I come up with the below via a back of the envelope income statement:

This doesn’t include the value of any of the legacy owned properties or any cash that comes out of the sale of the company’s CDOs and CDO management business.

Comparable NNN REITS

Realty Income (O) and National Retail Properties (NNN) are not great comparables since they are primarily focused on the retail market and trade at high valuations due to their long track record of dividends, dividend increases, perceived quality, and the rush into yield in the zero rate investment environment.  In terms of assets and quality, CapLease (LSE) and Lexington Realty Trust (LXP) are better comparables for Gramercy, averaging the two Price/FFO ratios equals an 8 multiple, leading to a value of ~$3.20 for Gramercy’s common shares, with the potential upside in time to trade closer to a 13.2 multiple of the average net lease REIT.  It should be noted that each of these comparables is much larger than the projected Gramercy and can spread their costs over a much larger asset base, so as Gramercy adds assets using equity issuances the increased scale should be accretive to future FFO.

Most net lease REITs are highly diversified across tenants and industries, Gramercy will start out with its largest pool of properties highly primarily leased to Bank of America, N.A.  Bank of America is still in the midst of their own turnaround and reorganization strategy to sell non-core assets, shrink the business, and cut costs in the aftermath of the financial crisis.  While Gramercy management stresses that these properties are critical to Bank of America’s operations, it’s still worth noting and monitoring.  As management deploys more cash into net lease assets, it will be important to increase the number of tenants in order to reduce credit risk to any one entity.

Management’s decision to issue shares as part of the Bank of America Portfolio purchase when it has plenty of available cash is concerning, one of the new goals is also to “expand the equity base” of the company which foreshadows additional equity raises in the near future.  Gramercy should wait until its shares are trading more in line with net-leased peers to avoid issuing additional undervalued shares.  However, even fully invested, Gramercy would be one of the smallest publicly traded net leased REIT and it will be necessary to issue additional equity in order to gain scale and spread the management costs over a wider asset basis.

Old Gramercy didn’t have a natural long-term buyer; it’s a non-dividend paying mortgage REIT with a negative book value.  So yield investors aren’t interested, and with a shareholder deficit it doesn’t show up on many screens utilized by value investors.  By reshaping the company as a net-leased REIT, Gramercy will have two main catalysts to unlock value: (1) the sale of the CDO business to allow for the balance sheet to be easier to understand and (2) the payment of a dividend after the investment of the free cash in income producing net leased assets.

Management has hinted that the CDO business could be sold as early as the end of the year.  Mr. DuGan said on the recent conference call that the fourth quarter would be a “watershed quarter in terms of transition” for Gramercy, presumably he means shedding this legacy business in order to fully focus efforts on the net-lease space.   If the CDOs and CDO management business bring in a material amount in the sale, that could provide more upside to the share price.

The timing of the dividend is a little more uncertain, while management has expressed that they intend to pay a dividend and remain a REIT, its difficult to project exactly when that will happen.   Management has stated their philosophy is to pay dividends out of “recurring cash flows”, so only once the available cash is invested in the new strategy and those investments start to cash flow the dividend payments will be turned back on to investors.  The preferred shares have accrued $28.6 million up to this point (still accruing $1.8 million per quarter), and based on my projections of FFO, it could still be another 18 months until the preferred dividend is paid in full.

The preferred shares still offer a compelling investment opportunity; currently trading at $30.00 the preferred shares offer a 10.8% discount to the fully accrued dividend and $25 redemption value ($33.63 as of the most recent missed dividend date).   The preferred shares are well covered by the assets and cash on the balance sheet, and management has signaled repeatedly that they intend to pay the dividend once the new strategy is up and running, it continues to accrue 6.8% in yield off of the current market price, creating an attractive risk/reward opportunity in a low return environment.

At current prices, the common shares sell for near cash, creating a margin of safety.  Once the business is simplified and the dividends are turned back on, the shares should trade up more inline with the net lease peers in time, but it will test the patience of current shareholders who have already been waiting quite some time for the turnaround to materialize.

Disclosure: I own both GKK and GKK-A.

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