Capstead Mortgage Corporation (CMO) is one of the oldest publicly traded mortgage REITs dating back to 1985. Capstead has a fairly simple business model, they own adjustable rate residential mortgage securities issued by a government sponsored entity like Fannie or Freddie, then lever it up 7-8x and pay out substantially all the resulting net interest spread in the form of a dividend. Capstead is historically well managed, they were one of the few mortgage REITs to maintain their dividend throughout the pandemic and didn't get portions of their portfolio liquidated due to margin calls like so many others.
But times change, the returns available doing this "arbitrage" aren't what they used to be, forcing higher and higher leverage to the point where it doesn't make a lot of sense. In July, Capstead agreed to a reverse merger transaction with a public but non-traded traded REIT, Benefit Street Partners Realty Trust ("BSPRT"), with the proforma entity moving forward with BSPRT's management team and current middle market CRE loan strategy. Capstead is currently an internally managed REIT, the market likes those better as the incentives are more directly aligned, but as part of this reverse merger, the new combined entity will switch to an externally managed structure. To compensate Capstead shareholders and entice them to vote for the transaction, BSPRT and their management entity are paying a 15.75% premium over Capstead's book value in cash plus CMO shareholders will receive shares in the new entity on a book-for-book basis. The new entity will be called "Franklin BSP Realty Trust" and trade under the ticker FBRT, the external manager Benefit Street Partners is a subsidiary of Franklin Resources (BEN).
The 6/30 book value of CMO was $6.35/share, 15.75% of that is approximately $1/share in cash. The stock is trading for $6.77/share, if the proforma trades for book value, that's 8.5% upside for a deal that likely closes in the next month or two. This is a fairly simple investment thesis, really two questions you need to have some confidence in answering:
- How much, if any, has the book value moved in CMO since 6/30?
- What premium or discount to book value should FBRT trade at?
For the first one, agency ARMs have little to no credit risk and less interest rate risk compared to other fixed income securities. Just taking a glance through agency bond ETFs, they seem pretty stable since the middle of the summer, might be some slight fluctuation but I don't think its a stretch to think that the book value has been relatively stable.
The second is a little trickier, most of the larger (FBRT will be ~4th on this list in size) externally managed commercial mortgage REITs are trading near or above book value. You can probably toss out the top and the bottom on this list, Starwood Property Trust is the original and best run of the bunch and STWD bailed out TPG RE Finance Trust during the pandemic as TRTX had a CMBS securities portfolio that was margin called and liquidated.
Most of these are household names, Benefit Street Partners is not what I would call a household name but they are a large CLO manager and have been utilizing the structure within BSPRT for some time now with success. They launched the non-public REIT about 5 years ago, have had no losses in the portfolio in that time and the portfolio looks reasonably healthy today with only one potentially problem loan (rated 4 below, its a self storage loan, guessing its not materially underwater). Despite being non-traded, BSPRT is public and does file with the SEC, you can find their filings here
This is effectively a big capital raise for FBRT/BSPRT, they'll let the old CMO portfolio run off or sell opportunistically to fund their pipeline of new CRE loans, I like that they have a fairly clean portfolio free of legacy issues and dry powder to put to work in the post-covid world, there should be plenty of low risk opportunities as we know which sectors/markets are the most impacted by the pandemic, what developer business plans make sense, etc. If you're a growing mREIT, problem assets if they pop up naturally become smaller and smaller.
Additionally, the reverse merger has two structural features as part of the deal that should help support the stock once the proforma company is listed:
- $100MM repurchase program, with $35MM being funded by an affiliate of management, the repurchase program would kick in post close if FBRT is trading below book value.
- Approximately 94% of BSPRT shareholders will be locked up for 6 months post merger, so there shouldn't be the fear that this is an immediate liquidity event and all BSPRT shareholders will sell at the first chance they get.
On top of those, they are also going to pay a significant dividend, they cite they've done over 10% ROEs and are going to pay it all out in a dividend, meaning if this trades even moderately below book value it would have a double digit dividend yield which should attract retail investors. Overall, a pretty simple and hopefully short duration idea, I'll flip the shares if they trade for book immediately, otherwise I'll be content to wait a quarter or two, collect some dividends and wait for the discount to narrow.
Disclosure: I own shares of CMO
Thanks ! Always enjoy your research.ReplyDelete
I bought CMO on the morning of announcement then sold a month later for small gain as I got out of a bunch of positions thinking the fall market pullback would hurt some (of course market pulled back but barely hurt most things I've been following anyway). Has anyone looked at the GNE spin-off (Oriel Energy)? I was pretty excited because it's another Howard Jonas spin but looking at the registration statement I cringe. That thing is garbage (just wait for most recent #s now that they have to deal with the crazy energy pricing this quarter in UK!) - I'm thinking remainco - GNE - could possibly be a buy after the spin but not sureReplyDelete
As I dug into it I noted that CMO's book value has declined almost every quarter since forever, which made me wonder if they will experience a similar decline in 3Q and 4Q. If so, there isn't much to be made here. So I drilled down into this aspect further. Most of the decline appears to be the result of the dividend exceeding EPS. i.e. the quarterly decline in BV roughly equals the dividend. The good news is the merger agreement states that CMO's 3Q and subsequent dividends cannot exceed core EPS (thus ensuring BV should not change much). However, I think you need to adjust the 2Q BV of $6.35 by $.15 for the 2Q divie that was paid in July. So BV per share is probably around $6.20 +/- any fundamental changes since the end of 2Q. For deal price I get $6.35 less the $.15 2Q divie plus the $.99 cash payment = $7.19 for a 6% gross return, and a 25% IRR using a 12/31/21 close. Make sense?ReplyDelete
Yeah that's probably roughly right, I would expect a quicker close than 12/31. Good catch on the July dividend, should adjust a bit for that.Delete
Targeting a 10/19 close
It seems like I completely got "question 1" wrong, the book value used for the conversion ratio is estimated to be $5.974 versus $6.35 ($6.20 proforma for the Q2 dividend) at 6/30, which takes away much if not all of the upside. Hopefully should be a pretty inexpensive mistake.
What is your estimate of pro-forma book value?ReplyDelete
They give it to you in that press release, its $5.974 for CMO, with the exchange ratio of 0.3288, that implies $18.17 for the pro-forma FBRT.Delete
To be clear, I don't think its a great idea at this point, I was wrong.Delete
Anyone know if the merger proposal was approved this morning?Delete
It was approved. I bought some near the close today, seems like someone was dumping it pretty hard.Delete
Market at close trade was 1,147,008 shares @ $6.34. Looked like a fund or etf liquidation.Delete
Using $6.34 backing out the $0.94 estimated cash dividend, that's $5.40, using the exchange ratio you're creating FBRT at $16.42 or ~88% of book value. I'm comfortable with that valuation given the buyback, lockup, etc.Delete