Commercial Mortgage REITs: The Jungle Is Dark But Full Of Diamonds

Willy Loman, the archetypal American (along with Huckleberry Finn, Richard Nixon, and Homer Simpson) lamented his failure to make a fortune like his older brother, Ben, who became rich and appeared as an apparition chanting the above siren song. We won't discuss what became of Willy but value investors don't need a literary reference to understand that bargains are often to be found at the bottom of a series of perplexing and opaque financial statements.

Commercial mortgage real estate investment trusts (CMREITs) went through a nasty cycle during the panic of 2008. Many of the loans they made on the eve of the financial debacle turned bad in a hurry and a lengthy kabuki was played out as borrowers and lenders renegotiated and restructured in complex and confusing gyrations. Many of the pre-Panic loans were packaged into special purpose entities similar to the RMBS arrangements we all learned about as the mortgage market crashed.

The interesting question before the House is how these companies will fare in the Post-Apocalyptic world we find ourselves inhabiting. I follow and hereby provide Friday's closing price and the dividend yield for Capital Trust (CT) (3.48) (0), Gramercy Capital (GKK) (2.50) (0), RAIT Financial (RAS) (5.69) (4.2%), and NorthStar Realty Fiance (NRF) (5.70) (8.8%). Each of these has its own endearing quirks and balance sheet ambiguities. The overall trend seems to be clear. These companies are working out their borrowing problems and are gradually eliminating or at least restructuring recourse debt. For example, CT has eliminated recourse debt. GKK has also reduced debt and NRF obtained an attractive restructuring package from a large lender which has stabilized its finances. There is a gradual trend toward more reliance on management fees as opposed to interest income and capital appreciation. There also appears to be a grudging acceptance of the need to provide financial data in alternate formats so that investors can better understand potential risks and rewards.

Investors often ask me my opinion of the sector and I caution them to read the financial statements of these companies before investing. I also think that investors should diversify within the sector to reduce risk. Each of these companies has a somewhat different risk profile and has different exposure to various parts of the real estate market. Owning all 4 in order to reduce risk may make sense. Given underlying value, I believe that a portfolio of all four will provide very strong returns although an investor will have to be patient. Readers may also want to consider preferred stocks of RAS - (RAS-PA), (RAS-PB), and (RAS-PC); GKK -(GKK-PA); and NRF - (NRF-PA) and (NRF-PB).

For those with a very strong stomach and a very brave heart, Municipal Mortgage and Equity (MMAB.PK) may offer a sizeable upside(along with, obviously, a very real and clear downside). I am not recommending it to investors at this time but I think it is worth a look. The jungle is dark but it is true that there are diamonds in the jungle. Unfortunately, there are also predatory animals, tsetse flies and land mines planted by the folks who passed through during the last business cycle.

Disclosure: I am long RAS, GKK, CT, NRF.