I’ve spent quite a good bit of time recently talking about preferred stocks- I mentioned them in my powerball article on ATPG, and my two largest positions are NCT preferreds and GKK preferreds. So the fact today’s idea revolves around another preferred stock trading at a huge discount should come as no surprise.
The company is RAIT Financial Trust (RAS). Much like GKK, they are a self managed REIT. The upside of this is huge- unlike NCT, they don’t have to pay out a % of their asset as management fees every year, meaning more cash is left over for shareholders.
***Note: I started writing this before RAS issued this press release, issuing their 1st quarter dividend on the preferreds. Not huge news, but I feel it only reconfirms the thesis.***
RAS has one more key difference from GKK and NCT. Remember that these companies have two levels: first, the corporate level (which is what you buy into when you buy the stock) and then the subsidiary / CDO level. The corporate level owns all (or almost all) of the common equity in the sub level, but the two entities are completely distinct. Thus, if the subsidiary is overwhelmed by its massive debt and goes under, the corporate can only lose the value of its investment in the sub- it will never have to put in additional capital. Also remember that investments from one level to the other are cancelled out in consolidation when reporting to investors. So if the corporate level buys the senior debt of the subsidiary, it is cancelled out in consolidation even though it is a real asset of the corporate and real liability of the sub. This cancelling can make for a significant “hidden asset” at the corporate level.
In fact, both GKK and NCT had such significant liquidity at the corporate level that they could basically cover the value of their preferreds with corporate level assets. RAS does not have that (note that in both cases I am ignoring the value of “hidden” bonds). Basically all of RAS’s value stems from its interest in the equity of its subs. All else being equal, this makes RAS more risky… but the value of their interests in their subs is worth so much more than their preferreds in a liquidation that I am very comfortable with it.
So let’s start by looking at the balance sheet as a whole. As of their latest 10-Q, RAS should total shareholder equity of $915m. Their preferreds are on the book for just ~$60k (thousands, not millions), but this needs an adjustment. The preferreds are held on book at their par value of $0.01, while their liquidation value is $25. Adjusting for this leavves preferred value of $165m and thus left over value for the common equity of $750m. So book value of common equity covers the preferreds almost 5x! Not bad.
So where is all that equity coming from. Basically, all of it stems from their interest in their subs- see page 19 of their 10-Q. The equity value in their subs almost perfectly equals their overall equity value. However, again remember this- any debt or other securities aside from common equity that is owned at corporate would be melted away in consolidation.
Now compare that table on page 19 to their consolidated balance sheet. You’ll notice something very interesting- their commercial mortgage numbers goes down by $800m, while their commercial real estate assets go up by a similar number. So what’s happening here? RAS owns at the corporate level a portfolio of real estate with the mortgages held by their CDOs!
This actually proves to be pretty valuable. Think of this sequence- one of the CDOs lends someone the money to buy a property. The property falls in value and defautls. Now, RAS can choose to either turn the keys over to corporate and keep all of the mortgage in place. They can then try to turn the property around to recover the value. Or they can sell the property and try to recover their mortgage value. But the real value comes here- RAS can buy back their CDO debt at a huge discount (how much of one depends on which level of debt they are buying). Since the CDO owns the mortgage on the property, RAS can, in effect, take control of the property at 33-50% of the original mortgage value!!!!
So now let’s try to break down exactly what they own of their four consolidated subs: RAIT I, RAIT II, TAB VIII, and TAB IX. Page 32 of their financial statements shows the assets each sub is made up of and how much RAS owns at the corporate level. RAIT I has $1B in assets and RAS owns $244m of the securities ($44m pledged as collateral for a loan). RAIT II has $822.7m in assets, of which RAS owns $245m ($104m pledged as collateral). Tab VIII has $590m and RAS owns $133m. Tab IX owns $619m in assets, of which RAS owns $187m. (Note that they also own TAB I, which they collect mgmt fees for but do not consolidate).
In other words, at the corporate level, RAS owns a substantial amount of the securities associated with these subs. Of course, it’s difficult to tell exactly which securities they own. For example, if RAS only owned the common equity for the subs, they would take the full brunt of any losses. In contrast, if they only owned senior securities, it’s possible they wouldn’t take any losses. The truth is likely somewhere between those two, though it’s much closer to the first than the second.
But it’s important to note that they own a bunch of securities in all 4 subs and that the four subs are built very, very differently. RAIT I and II are both significantly overcollateralized (definition). RAIT I is 123.7% overcapitalized (versus a trigger of 116.2%) and RAIT II is 119.1% overcapitalized (trigger of 111.7%). This overcollateralization is important for two reasons.
First, as long as a CDO is overcapitalized beyond the trigger, all of the lower trenches (which RAS owns) recieve cash flows and RAS recieves all excess cash after all the securities are paid.
Second, such large amounts of overcollateralization means there is a high likelyhood of all of those lower level securities RAS owns getting paid. Both the TAB portfolios are significantly undercollateralized, making the likelyhood of RAS recovering anything much lower. However, this doesn’t mean the TAB portfolios are worthless- RAS still collects mgmt fees from them, and in the event of a recovery they’d realize significant upside from the CDOs.
But the collateralization issue is important for another reason. Both TAB portfolios are not just significantly undercollateralized, but their collateralization is below 100%. This means that their liabilities are greater than their assets, and thus the two portfolios are on the books for negative equity. Because RAS will never have to put in a dime to bail these two portfolios out, RAS’s true value is significantly higher than what a quick glance at the book would reveal.
So hopefully by now I’ve convinced you that there’s a significant degree of asset protection for the preferreds at these levels. At this point, you may be wondering- why invest in the preferreds? Why not the common? After all, after adjusting for the preferreds the common has an understated BV of ~$750m versus a market cap of ~$225m.
I’m not going to say I wasn’t tempted. Especially after reading this exchange on their most recent conference call.
Analyst- “Right. And then, if we factored in reinvestment and better spreads, I mean, it looks to me like you’re approaching $0.30 per share in adjusted FFO. So, I’m wondering now that you’ve resolved really all the debt maturity issues have you given a thought to buying back stock, given as trading is like four times AFFO?”
CEO – “Yes, we have given thought to that. And currently I will tell you that we discussed it every quarter with our board. And up until now we have always been focused as you can tell within our – to payback our debt with the repayments and maturities that were coming to in the short term. So, we will continue to discuss it. And as cash permits, if the stock price is still trading at what values or levels that we believe are well below real value. I think the board would have a positive reaction going forward.”
But here are my two problems with the common.
One- management has shown no problem in significantly diluting shareholders over the past year or two. They’ve issued shares with abandon to shore up their capital position. This has been a boon for the preferreds, as the company never missed a preferred div payment and the preferreds now find themselves significantly overcapitalized. But I have trouble investing in the common of any company so willing to dilute their shareholders- if the asset value had been there and the stock was truly undervalued, why would the company need to issue shares instead of monetizing the assets?
Second, the company is massively, massively leveraged. Another downturn would cut a big piece of the common equity assets out. It’s really tough, nearly impossible, for me to envision a scenario where they would lose enough to impair the preferreds, but it’s not tough to envision a scenario where the common is worth less than it is today.
So now let’s talk which preferred makes the most sense. I personally went the the class C. The A’s look to be a tad bit cheaper, but I like a security feature in the C’s enough that I was willing to pay a bit more for them. (Btw here are all 3 prospectus: Series A prospectus, Series B prospectus, Series C prospectus). The C series have a feature in them that boosts their interest rate from 8.875% to 9.875% in the event the C’s aren’t listed on a public exchange or if they C’s are outstanding and RAS isn’t reporting (if RAS got acquired and the acquirer kept all of the preferreds outstanding). I’ve seen both cases happen with several different preferred stocks I’ve investigated, so having this extra bit of protection was worth paying a bit more to me.
Here are a few bonus items- RAS has only $4.3m of debt at the corporate level coming due within the next four years. Obviously, this is a drop in the bucket for them- this means the company has the liquidity and balance sheet to stomach any volatility in the markets. In fact, they’ve done a great job of repurchasing debt as markets swooned- they grabbed ~$15m worth of debt for just $5m during their most recent quarter. Much like a bank repurchasing shares below tangible book, repurchasing debt below par can greatly increase RAS’s equity ratios and drive up shareholder value.
RAS also has $100m of interest rate hedges that were done at much higher prices that just rolled off. This will increase cash flow by ~$5m per year. This may sound small, but consider that the cash flow from preferred divs is just under $14m per year. The $5m will give added cash flow to cover those divs or repurchase CDO debt.
Finally, RAS is looking to IPO a seperate REIT they own, Independence Realty. RAS will continue to manage Independence and collect manager fees, as well as own a portion of Independence. The range of the IPO will be from $2.5m to $1b+., and RAS is looking towards the high end of that. If the IPO goes off and is successful, RAS would find themselves with a very valuable management fee stream and potentially gain a good deal of liquidity. Worth keeping in mind.
Please feel free to add comments / questions / concerns, as RAS is an extremely complex situation. I feel like I learn more every time I even glance at the 10-K.
Investor webcast- http://www.wsw.com/webcast/fbr26/ras/
Disclosure- Long GKK, NCT, RAS
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