Risk/Reward of Owning REITs, Raymond James in this Boom Bust Cycle

We know the conventional method of security analysis is to try and predict the future course of earnings and then to estimate the price that investors may be willing to pay for those earnings. This method is inappropriate to the analysis of mortgage trusts because the price that investors are willing to pay for the shares is an important factor in determining the future course of earnings (the same can be said for a conglomerate boom, where companies make acquisition using shares rather then cash/debt).

There are three factors that reinforce each other and will help in determining the price of REITs.

1. Effective rate of return on the REITs capital
2. Rate of growth of the REITs size
3. Investor recognition

The attraction of REITs as noted by investors in the 70s lies in their ability to generate capital gains for their shareholders by selling additional shares at a premium over book value. If a trust with a book value of $10 and a 12% ROE doubles its equity by selling additional shares at $20, the book value jumps to $13.33 and per share earnings go from $1.20 to $1.60.

Investors in the past were willing to pay a premium because of the high yield and the expectation of per-share earnings growth. The higher the premium, the easier it is for the trust to fulfill this expectation. The process is a case of reflexivity in the stock market.

Once underway, trusts show a steady growth in per-share earnings, concurrently distributing the earnings as dividends. Investors who participate early enough enjoy the compound benefits of a high return on equity, a rising book value and a rising premium over book value.

Presently the effective yield on construction loans is the worst it has been in years. Not only are interest rates low; but losses are beginning to pick up. There is no longer pent-up demand for housing and new houses are having difficulty finding buyers. While we know the American housing market is in a mess, it isn’t clear that it has spilled into commercial property. We are very clearly at a tail end of a boom. Moreover liquidity in the after market for packaged loans has dried up and there is no clear sign that we will see the sales/purchases that were seen during the height of the boom.

As a result, the ability to promote equity prices and sell shares at a higher valuation has declined.

In the past, lower interest rates have brought the ability to increase leverage, thus increasing the rate of return on equity despite the lower effective yield. With investor sentiment growing increasingly bearish on the loan market, the credit cycle and real estate valuations the premium over book should decrease.

REITs have been forced to take increasing greater risk to maintain the perspective of historical returns on equity. As the housing boom wanes, accompanied by rising unemployment, decreased GDP growth I believe the commercial real estate market will see a temporary decline in real estate prices.

As we’ve seen in the residential market banks have begun to panic and demand lines of credit be paid off. Some banks have begun to take advantage of forced selling at depressed prices to drastically increase their book value.

As investor disappointment with the overall market continues and the perception that the loan/credit market continues to drive the sell off, the valuation of REITs as a group will continue to decline. A lower premium coupled with a slower growth will in turn reduce the per-share earnings progression and the overall market multiple will decline.

Evaluation

As the process is underway, REITs are still trading at a premium to book value, as a group they are 20% off their highs. As banks are deleveraging REITs bust cycle may cause investors to reevaluate their long term expectations of REITs return on equity. A lower ROE combined with negative investor sentiment towards leveraged loans and real estate may further depress the book value (or current premium we see with the sector). As a result I recommend shorting the Vanguard REIT ETF (VNQ).

Some banks like Raymond James Financial’s (RJF) RJBank, who have aggressively expanded their loan portfolios to include non-agency CMOs, residential and commercial real estate and construction loans, are going to face further pressure as the cycle shakes it self out.

RJBank’s CFO said on a recent conference call:

They expect problems, particularly in the residential and homebuilders space to be relatively modest in number and size. Further these problems are being overshadowed by the Bank’s record level of interest earnings.

Interest earnings should not be as big of a concern to this CFO as the effect a double in home delinquency payments will have. RJBank, in their 2007 annual report, noted that they’ve expanded their non-agency collaterized mortgage obligations to $382,980 million (almost three times that of 2006). Below is a more comprehensive breakdown of their loan portfolio from their 2007 annual report.

click to enlarge image

As 3 million new mortgages reset, it will be interesting to see how the ARMs on RJBank’s book respond, given that they’ve tripled the loans under management.

RJBank is just one example of the market stepping in to purchase loans perceived to be selling at a discount to fair value. As this has occurred since the beginning of the crisis, it has helped to limit losses of REITs and increase interest earnings of brokerages like RJBank. If the crisis continues, defaults increase then investor sentiment should turn increasingly sour towards outstanding loans, acting to further depress the book value of REITs and groups that have purchased loans. (Important to note that companies like Raymond James Financial have to report as a brokerage firm, thus marking-to-market their investments). As a result, these asset prices with dip further and bring further pressure on REITs and our financial system.

If the self-reinforcing process is coming to a close, then the downside risk to a short of the REITs and companies containing banks such as RJBank may be low enough to attract investors, as sentiment towards these as equity products will be tainted until the next boom cycle. Follow up comments from companies in the sector should prove essential in seeing how this boom/bust progresses.

Disclosure: Author holds short positions in the above-mentioned securities

Comments

[A Concerned Investor]

Your analysis of RJF makes very good points. As I assume your research indicated, there may be more issues than you had space to detail. Our analysis has turned up some questions as well.

Raymond James Financial is viewed by most analysts as a brokerage firm but it is actually a thrift holding company, with its savings bank subsidiary now holding 45% of its assets, over which RJF has more leeway in mark to market reporting. The RJF management takes the position that the discounted Commercial Real Estate, Alt A I/O hybrids, and the other loans that are held in the RJBank subsidiary do not have to be marked to market. They seem to know the position is a bit shaky. As you probably saw in looking at the RJF press releases and SEC filings, RJBank announced in late March that it had increased the write-downs in the CMO portfolio you referred to from $3 million to $62 million, finally recognizing deterioration in market value of real estate assets. This was an admission that the real estate assets in the Securities portfolio had to be written down. The CEO went on to say, in so many words, that although logically this real estate mark down process should also extend to the bank loan portfolio, there are bank accounting rules that allowed them to not report the loans on a ‘marked-to-market’ basis. This forbearance of the accounting rules on mark to market and write-downs might make sense if RJBank actually were run as a normal bank, but in the RJF holding structure the bank is just a “holding pond” (a quote from the CEO in an Earnings call) for assets from the brokerage accounts where RJBank gets basically all its deposits like E*Trade did. RJBank has no checking or other bank services and only one branch. Does the argument they should get the benefit of bank accounting rules make any sense? If other brokerages like Bear Stearns (or a Merrill) had used the RJF savings bank subsidiary approach to buy its riskier assets and protect them from write-downs in a massive way like RJF did, then Bear or Merrill would not have had to write down their assets. Does it seem like RJF should get special treatment from regulators or auditors here? This inconsistency in treatment of brokerage structures and the ability of RJF not to mark to market does not make sense from either a regulatory or investor protection standpoint.

On the other side, even if you say RJBank is a bank then there is still a strong argument that the accounting rules would not protect the Bank from a proper valuation and increased write-down or provisioning against its loans. Whether the RJBank loans should be marked down is a question that depends on whether the loans in its portfolio can properly be considered ‘temporarily impaired’. It would seem clear from the evidence that the loan portfolio is impaired and it is not a temporary condition. RJBank will have a difficult question to answer from the bank regulators. If RJBank is able to buy these loans at a discount from other banks like Citi whose risk managers have presumably required that the loans be categorized as impaired, marked down, and now sold off at ‘impaired prices’ months ago (and conditions have worsened) then how can RJBank continue to say the loans are only temporarily impaired.

The regulators would seemingly also have to be concerned about the relatively low levels of reserves given the deterioration of the type of real estate assets that RJBank holds – a mere 26 bps for the Alt A hybrid loans where losses are projected at 5% to 7%, or even the seemingly higher 194 bps for the commercial real estate loans that the bank has probably been buying at a 500 bp or higher discounts. In the meantime, as you seem to suggest there might be a significant earnings benefit enjoyed by the bank on the loan purchases depending on the way they book these discounted loans.

It seems clear why RJF is avoiding any suggestion of mark to market or impairment for as long as it can. A markdown of the loans would obviously result in a significant difference in the asset value of RJF and in its stock price. Under a strict mark to market, given the problems in the construction portfolio and where Alt A I/O and syndicated commercial real estate loans are now marked, the write-downs could be $450 to $500 million. You mention the CFO’s comment on the record level of earnings at the bank, and correctly question if that is really an accurate picture if delinquencies are coming, the loans are impaired and earnings not sustainable? A relevant question would also be aren’t bank accounting and SEC rules set up to make sure investors know more about the source and quality of bank earnings and the true valuation of the assets?

You are correct in your short call if, as it appears, writedowns are inevitable; but more digging by you or other analysts, or more pressure brought by regulators, would hasten the process.

[Opps Didn't get the Order]

A concerned investor - if a chance shot me an email.