Variant Perceptions

Category: net-net

Gramercy Capital: loose ends


The delinquent financials are hiding two big events since September 2010: a large 1 million preferred shares buyback in November 2010 (not retired yet) and the sell to SL Green SLG of several New York leaseholds owned by Gramercy Corporate including the famous Lipstick building.

I also considered that the unrestricted cash in Gramercy Realty was part of the mezzanine collateral and most probably lost in case of losing the division. This is my best estimate of the current unrestricted cash considering the lack of information since September last year.


There are two aspects to consider when valuing the preferreds:

  1. Suspended dividends accumulate: Gramercy suspended preferred dividends in December 2008 so it has accumulated 10 quarters of dividends. That is $5.07 per preferred share in arrears.
  2. December buyback: Gramercy offered to buy 4 million of the preferred shares for $15 per share. That is a 50% discount if arrears are included ($25 par + $5.07 arrears = $30.07) and 1,074,178 shares were tendered

Considering both events, this is an estimate of the new shares count and their total obligation. Let me remind you that the preferred equity is the only obligation at the corporate level.


The following is an estimate of the Gramercy CDO bonds that Corporate currently owns:


The two properties in Gramercy Corporate’s portfolio were the result of distressed transactions.  Gramercy and Lehman Brothers took ownership of Whiteface Lodge in Lake Placid on April 23, 2008 by a deed-in-lieu of foreclosure. Later on in July 2010, Gramercy acquired Lehman’s 60% equity interest financed in part with CDO proceeds. Makalei Golf and Land in Hawaii was foreclosed by two of Gramercy’s CDOs and Corporate took the opportunity and acquired it in an auction with a discounted credit bid.

Both transactions testify for the available  opportunities in distressed properties especially when you know the assets in depth.

Other mREITs are following aggressively this route and I would not be surprised that Gramercy follows that path too.  Arbor Realty Trust ABR is one lender that is taking advantage of this type of opportunities over the next quarters:

Additionally, as we mentioned in our last call, we started to acquire some of the real estate securing our loans and investment taking Type 2 properties in the first quarter totaling $132 million subject to $55 million our first lien debt. Paul will take you through the accounting related to these transactions in a moment.

Additionally, we acquired two sets of properties in the first quarter that were securing certain of our loans in the normal course of our lending operating. One of the acquisitions happened in February and was related to an $85 million performing loan secured by six resort hotels in Florida. The loan had a weighted averages interest rate of approximately $3.75% and a net carrying value of $71.6 million prior to the acquisition.

As a result, we recorded this asset on our books as real-estate owned at fair value and eliminated our loan in consolidation (RR: same thing happens with Makalei and Whiteface, you have to dig for the loan amount since it does not appear in the 10K) and we are now recording net operating income from this property including depreciation expense instead of interest income.

This is a tremendous benefit for Gramercy: it is both a lender and operator of real estate assets. Compared to banks, Gramercy can take control of properties in foreclosure and not be forced to sell to comply with regulatory guidelines. While compared to an average developer, Gramercy has long-term low-cost financing to finance the transaction with CDO 2007 still in its reinvestment period. Even when the reinvestment period ends, the replacement strategy can still be used for some financial wizardry.


Some CDO experts may wonder why I did not mention the interest coverage test; the other important test that can redirect cash flow. The reason is that it does not matter much in the current low interest rate environment.

The IC test is the ratio of the CDO interest cash flows against the interest payments due to the CDO bondholders. Its goal is to make sure that there is enough cushion to ensure interest payment to bondholders. However, with CDO 2005 and 2006 being variable rate instruments and a FED’s zero interest rate policy, the denominator is very low. The IC tests pass easily.

There are other portfolio requirements to ensure basic geography diversification and avoid concentration in exotic or risky real estate instruments. Both CDO 2005 and CDO 2006 pass them and any short term failure can be cured with a replacement strategy.


One concern that I have heard in similar situations is that debt discounts signal significant problems for the equity. Well, a good margin safety especially outside the CDOs, as in this case, should be enough to dispel this concern. Even more, I think sometimes discounts do not signal anything about the underlying assets.

To understand what is going on, it is good to remember that senior CDO bonds were AAA securities with very low interest rates when issued despite being non-recourse, non-marked to market, and long term financing. A very good deal to the borrower if you ask me.

Let’s move forward in time. Having gone through one of the worst financial crisis ever, CDO bonds liquidity is much lower, despite being marketable securities, and their AAA has gone away. Actually, there has been no CRE CDO bonds issuance since the start of the crisis. Most financial institutions are faced with regulatory restrictions on what securities can be used for repos and CDO bonds are not being used for that purpose any more. Also critical stakeholders, burned by other CDOs, just want to leave this episode in the past.

So you have a double whammy where institutions that bought these bonds very expensive are willing to sell them back to Gramercy for reasons beyond the current quality of the security. The compounded effect is a large discount to par just at the precise moment that Gramercy and other mREITs would like to buy them. And Gramercy does not need to buy 100% of those bonds, it just needs a small number of institutions under these very common set of circumstances.

In other words, there is not much demand beyond Gramercy’s own and there is supply. It is not like retail investors can or want to buy CDO bonds.

Also Gramercy has perfect information of what is inside the CDOs. Not many people can or want to do a detail analysis of the assets inside them. Despite CDO 2005 and 2006 demonstrating through out the crisis a good performance compared to other types of CDOs, panicky bondholders can have other reasons not to buy.

Concluding, Gramercy sold its lenders the CDO bonds at the equivalent of Florida real estate prices in 2007 and is buying them back at 2011 prices.


This potential risk was mentioned in the “Risks” section but it might be important to discuss it in a little more depth.Despite he mezzanine loan being non-recourse a foreclosure could still carry costs. Exceptionally these procedures can get messy specially if the borrower, in this case Gramercy Realty, decides to fight the foreclosure. The reason is that the threat of a messy foreclosure procedure is their negotiation card while discussing the terms of a died-in-lieu of foreclosure.

None of the parties would want a messy outcome. But still, if the negotiations break down, because of either party overplaying their cards, Gramercy might be pushed to start a legal fight. The lenders in turn would probably sue under the bad boy provisions or a possible fraudulent conveyance even if these have no merit. See for example the legal fight that iStar Financial is enduring with Rittenhouse.

This sounds worse than it really is and the legal costs should be more than affordable with the current cash hoard. But still, the legal costs can make some some dent on the margin of safety. My comfort is that I do not see Gramercy following this route if they think it could compromise the viability of the company.

Long GKK


CDO 2007

CDO 2006

CDO 2005


Gramercy Capital: management team

With respect to CDO buybacks, a wise man once told me that when you can buy your debt back cheap buy it because you understand your debt better than anybody else – Michael Ashner, Winthrop Realty Trust


It seems that every time someone analyzes management teams it ends up being a pedigree review. I prefer instead to review track records and paper trails because they give a closer understanding of the players’ capabilities and motivations.

Not that Gramercy’s management does not have credentials. Just as an example, CEO Roger Cozzi was the former iStar Financial SFI chief investment officer, a Fortress Investment Group FIG managing director and a Goldman Sachs GS alumni.

However, a closer view of Gramercy’s actions shows survival skills that have been nothing short of amazing. Under the watch of the new management team that took over in October 2008, including among others CFO Jon Clark and President Tim O’Connor former COO of iStar Financial SFI, Gramercy promptly made several right moves. These actions preserved capital and reduced several hundred millions of recourse obligations and tens of millions of expenses while playing near the eye of the credit hurricane.

  • Suspended dividends: for both the common and preferreds. Having just closed the AFR transaction it was tough and crashed the stock price. Painful but it was the right move and shows a team willing to face reality.
  • Exchanged trust preferreds: Gramercy somehow persuaded the holders to exchange their shares for junior notes bearing 0.25% interest. Then came back to them in 2010 for a par-for-par exchange for CDO bonds that Gramercy had repurchased that were trading at 50% of par. The whole transaction saved at least $75 million in recourse obligations.
  • KeyBank facility: Convinced a group of hedge funds which had partnered with KeyBank to accept accelerated repayment of just $60 million on a $175 million facility, for savings of at least $115 million. This was one of the most outstanding negotiations I saw during the crisis.
  • Wachovia facility: First Gramercy managed to extend it to 2011 with covenants and recourse obligations waived. Then they paid it only half in cash and the rest in a mezzanine loan participation for a profit. Nice.
  • JP Morgan facility: Taking advantage of the crisis, Gramercy negotiated with JPM to retire a $9 million facility for $2 million
  • Eliminated management fees: As part of the disentanglement of the relation with SL Green SLG, Gramercy completed its formal management spinoff saving $15 million per year in fees. Most other comparable REITs like Newcastle Investments NCT, Arbor Realty Trust ABR and RAIT Financial RAS still have outside managers siphoning fees.
  • Achieved SG&A reduction goals: The management team had a target of reducing corporate SG&A to $28 million and achieved it. This gives me confidence that they will do what is necessary if they lose Realty.
  • Repurchased preferred shares: Tendered more that 20% of the preferred shares at a 50% discount to par value plus accumulated dividends at the end of 2010 saving $15 million in recourse obligations.
  • Sold joint ventures at book value: Sold at book value several leaseholds to SL Green at book value, generating $89 million in Corporate unrestricted cash. Cash that can take Gramercy very far in the current CRE environment.
  • Bought discounted AAA CMBS: One of the reasons that CDOs 2005 and 2006 were well defended, while being in the center of the hurricane, was the fantastic reinvestment in 2008 and 2009 of close to 15% of their assets in CMBSs, rated AAA at their origination, at very high discounts to par to improve the OC/par test. Those CMBSs price have recovered strongly recently.
  • Bought back CDO bonds at large discounts: Most buybacks were closed by previous CEO Marc Holliday: $128 million par buybacks with the bulk of it in 2008 at 30 cents on the dollar. But the new team did his share of repurchases, under severe liquidity limitations, buying $61 million par at 45 cents on the dollar and was instrumental in using them used to eliminate the junior bonds.

Financial Alchemy indeed.

However we reach a point of contention: the AFR acquisition of 2008. It is very easy now to dismiss it as hubris; it drained cash and saddled Gramercy with debt at a critical point. But let’s consider a couple of things:

  • Negotiated and closed by previous team: The AFR deal was announced in the fourth quarter of 2007 and closed mid 2008. Roger Cozzi became CEO in October of 2008 with the cards already dealt for him while Marc Holliday retrenched to his concurrent job as CEO of SL Green SLG.
  • Partially paid in stock: and not only that, Gramercy’s stock at the time was a very overpriced stock at around 13-15x free cash flow. Valuable currency.
  • Good price: and the price was very good. Bought at a discount to book value and a very reasonable to the buyer 8% cap rates. If not for the credit crisis they surely would had a chance to keep this stable income stream.
  • Provided some cash flow: also the deal was closed with some downside protection since Realty generated more than to $200 million in cash flow to Corporate coffers during the last three years.
  • Depreciation preserved capital: This is an important point. To preserve REIT status Gramercy has to pay in dividends a substantial part of its taxable income. Without Realty’s depreciation, Gramercy would have struggled to preserve capital while delevering the recourse obligations. Other REITs preferred to lose their status or find loopholes by paying dividends in stock. Gramercy chose differently, keeping the benefits of its REIT status and avoiding controversial legal issues.
  • Not the end of the story just yet: while the whole investment thesis is based on the margin of safety provided by the non-Realty assets while planning for the worst outcome, the result of the Realty negotiations is still uncertain.

The transaction was badly timed and had bad consequences. Though, it had some redeeming factors and we have to balance it against the new team’s vindicating deal streak.

Gramercy also managed to preserve cash, cash that they are now ready to invest. There is a future for Gramercy without the Realty division, and maybe even prosperity, if they manage to protect the Finance Division and its CDOs.


If Gramercy loses Realty, management’s time will probably be stretched along three main goals. First, to invest its large unrestricted ($196M) and restricted ($141M) cash hoard. Second, to find alternative funding sources to rebuild the REIT. And third, closely related to the reinvestment of the cash hoard, to protect CDO 2006 and heal CDO 2005.

This last goal is crucial in assessing Gramercy’s margin of safety. Failure of an overcollateralization test can cause “phantom income” problems when cash that constitutes income is diverted to pay down debt instead of being distributed to Corporate.

Without being completely exhaustive, since I imagine management is considering other options too, I put forward three ways to protect CDO 2006 and heal CDO 2005.

Reinvestment Strategy

With CDO 2006 getting to the end of its reinvestment period but with $141 million in restricted cash one option is to invest it to improve the OC test.

So far the best way to improve collateral has been to buy CMBS at a discount. In other words, buy $100M CMBS face value for $70M and you increase the collateral by $30M. CMBSs have recovered in price, the discount decreased, and the collateral positive effect diminished … but there are still opportunities.

Another way is for CDO 2006 to repurchase its own bonds at a discount with its restricted cash. Buying discount CDO bonds would have the same effect as buying discount CMBS; it would increase the par value collateral used in the test.

There are limits to how much CDO 2006 can buy in CDO bonds and CDO 2007 is a dead parrot despite its lighter covenants on this issue. However, there are no restrictions for Corporate’s unrestricted cash.

Redemption Strategy

Gramercy Corporate, among several other mREITs, has chosen to buy back previously sold CDO tranches for cents on the dollar. It makes a lot of sense just as good capital allocation if management is confident in the collateral,.

The math is simple. The average duration of CDOs is like 6-8 years. Let’s suppose it is 7 years and the CDO bonds were repurchased at 50% of par. Using the Rule of 72, that is a 10% annual return plus interests.

And those are unlevered returns! If for example they finance the buyback with a repurchase agreement (repo) backed by the CDO bonds, like Newcastle Investments NCT did last year, those returns can be multiplied by two or three times depending on the repo haircut.

That is jolly good but the repurchase of senior CDO bonds is even more effective for REITs struggling with their OC tests. Along with the outstanding returns and accounting gain, the repurchase can help to recapture diverted cash flows if they cancel enough of those bonds.
This is the redemption strategy, the buyback and cancellation of CDO bonds to reduce the denominator of the OC test.

The redemption strategy is controversial because it is not specifically allowed in the indentures. At the same time, it is not specifically prohibited.

Some senior CDO bondholders liked their accelerated payment of principal so they protested their trustees. Since trustees have many masters to please they kicked the issue to the courts where the Delaware Supreme Court finally upheld the redemption strategy.

Concord (Winthrop Realty Trust) vs Bank of America

I am not going to pretend to be a legal expert and say that this is the last word. What I do know is that, despite fits and starts, cancellations have continued. Maybe not at the brisk pace of 2008 and 2009, where ridiculous CDO bond discounts and some REITs desperation pushed the limits, but still good enough to cure borderline CDOs.

Concluding, the redemption strategy might be controversial and CDO 2006 might be at the end of the reinvestment strategy, but we have seen that they are still useful and powerful. But for the still somewhat concerned, there is a third option.

Replacement Strategy

Even if a CDO is outside its reinvestment period or the CDO bonds cannot be bought at a sufficient discount (or faces legal opposition to cancel them) all is not lost. Gramercy can voluntarily exchange defaulted loans/securities/properties inside the CDO for loans/securities/properties that are current. These new loans/securities should be of an amount at least equal to the defaulted loan/security/property par value plus unpaid interests. The valuation difference is at the expense of Gramercy Corporate.

The math is very favorable because only a couple of quarters of CDOs cash flow can be sufficient to pay for any difference in valuation. And in addition, Gramercy would be taking control of the defaulted loan/security/property.

This strategy is specifically contemplated in the indenture of all CDOs (section 12.1) and it is not limited by the reinvestment period.

Notwithstanding the foregoing, the Collateral Manager (at its option and at any time) shall be permitted to effect a sale of a Credit Risk Security or a Defaulted Security hereunder by purchasing (or causing its Affiliate to purchase) such Defaulted Security or Credit Risk Security from the Issuer for a cash purchase price that shall be equal to the sum of (i) the Aggregate Principal Balance thereof plus (ii) all accrued and unpaid interest (or, in the case of a Preferred Equity Security, all accrued and unpaid dividends or other distributions not attributable to the return of capital by its governing documents) thereon. Notwithstanding anything to the contrary set forth herein, no Advisory Committee consent shall be required in connection with such cash purchase (the “Credit Risk/Defaulted Security Cash Purchase”).

In addition and notwithstanding anything to the contrary set forth herein (and provided that no Event of Default has occurred and is continuing), the Collateral Manager (at its option but only upon disclosure to, and with the prior consent of, the Advisory Committee) shall be permitted to effect a sale of a Defaulted Security or a Credit Risk Security hereunder by directing the Issuer to exchange such Defaulted Security or Credit Risk Security for (i) a Substitute Collateral Debt Security (that is not a Defaulted Security or a Credit Risk Security) owned by an Affiliate of the Collateral Manager (such Substitute Collateral Debt Security, the “Exchange Security”) or (ii) a combination of an Exchange Security and cash, provided that:

(i) (A) the sum of (1) the Principal Balance of such Exchange Security plus (2) all accrued and unpaid interest (or, in the case of a Preferred Equity Security, all accrued and unpaid dividends or other distributions not attributable to the return of capital by its governing documents) thereon plus (3) the cash amount (if any) to be paid to the Issuer in respect of such exchange by such Affiliate of the Collateral Manager, shall be equal to or greater than (B) the sum of (1) the Principal Balance of such Defaulted Security or Credit Risk Security sought to be substituted plus (2) all accrued and unpaid interest (or, in the case of a Preferred Equity Security, all accrued and unpaid dividends or other distributions not attributable to the return of capital by its governing documents) thereon;

(ii) the Eligibility Criteria and the Reinvestment Criteria shall be satisfied immediately after such exchange; and

(iii) the Aggregate Principal Balance of the Defaulted Securities and Credit Risk Securities so exchanged shall not exceed 10% of the Aggregate Collateral Balance as of the Closing (such limitation, the “10% Limit”).

The restrictions to the replacement strategy are standard. The Eligibility Criteria and Reinvestment Criteria are the same as for any acquisition of any loan or security for a CDO. And regarding the Advisory Committee, despite working by unanimity, it does not include representatives of the bondholders just one independent member.


Gramercy Capital is a cash flow positive Graham stock with a dividend trigger event, a good management team to invest the cash, and several other assets to boot, that should provide a good margin of safety and several low-cost options for profit.

Long GKK

PS: There is going to be a part 4 with some loose ends and exhibits

Gramercy Capital: the mystery


We finally get to the mystery part. Most of the recent stock fluctuations have been related to Gramercy Realty’s several short term extensions since March of the $790 million mortgage and mezzanine loans by lenders Goldman, Citigroup, KBS, and SL Green. Gramercy paid $3 million for these extensions but they ended a week ago with the properties not yet foreclosed and uncertainty about the ultimate result of the negotiations.

Information is fuzzy and most of it comes from reading between the lines the recent 8Ks of Gramercy and KBS. However, all seems to indicate that they are negotiating a deed-in-lieu of foreclosure, a peaceful handing of the properties to the lenders with some reciprocation to Gramercy for good behavior. This does not exempt the possibility of foreclosure if the parties do not agree.

Gramercy Realty is the inheritor of American Financial Realty Trust AFR, the REIT they acquired beginning of 2008 for $1.1 billion at a discount to AFR book value and at good cap rates since this was a year after the top of the market. Realty’s book value is $537 million ($10.6 per share) and tangible book value is $842 million; and those valuations assume $120 per square feet for the 25.5 million square feet of mostly bank offices and branches.

The thing is that despite some decent numbers everything indicates Gramercy Capital can or will lose its Realty division. We do not know why that is the case. It could be that the lenders’ conditions for an extension were too high or they just simply wanted to take the properties. Maybe Gramercy overplayed its hand or the Gramercy’s opportunities on the lending  side – Gramercy Finance – were better so why not cut Realty loose. Or there is another possibility, that they are trying to reach middle ground. The short answer is I don’t know; so we plan for the uncertain future.

The key is that these loans are non-recourse to Corporate so the worst pain that the lenders can inflict to Gramercy is a foreclosure on the Realty division collateral, with all the legal costs for the lenders. That is why they may be negotiating a deed-in-lieu of foreclosure with something for Gramercy for good behavior.

Given its importance, I will post in its entirety the critical paragraphs of the loan agreement modified in August 2008 related to the recourse issue; so you will see that it is not that I trusted management’s word and the 10K. These are key points to watch for:

  • Guaranty: This potential recourse against Gramercy are the usual protections against bad conduct by a borrower, and nothing indicates that is the case with Gramercy.
  • Environmental indemnity: Near zero possibility because these are bank offices and branches.
  • Bankruptcy: this section protects the lenders against Gramercy Capital deciding to use chapter 11 to protect its interest in Realty against lenders as General Growth Properties did.
  • Section 5.24: This section is about the prompt release of properties in default encumbered under this loan. I included links to the loan agreement and modification if you want to explore this issue farther.

In conclusion, anything we can get from Realty is mana from heaven, and the potential negative consequences to corporate should be very much limited.

It is important to notice that the Borrower are several entities listed at the end of the loan agreement. All these affiliates are legacy entities from old AFR except for GKK Stars that was the merger vehicle. Gramercy Capital is the Sponsor.

 9.19.       Recourse.

(a) The Loan shall be fully recourse to Borrower.  No recourse shall be had for the Loan against any other Person, including any Affiliate of Borrower or any officer, director, partner or equityholder of Borrower or any such Affiliate, except for (i) claims against Sponsor under the Guaranty and (ii) claims against Borrower and Sponsor under the Environmental Indemnity.

(b) Borrower shall indemnify Lender and hold Lender harmless from and against any and all Damages to Lender (plus the legal and other expenses of enforcing the obligations of Borrower under this Section 9.19) resulting from or arising out of any of the following (the “Indemnified Liabilities”), which Indemnified Liabilities shall be guaranteed by Sponsor, jointly and severally, pursuant to the Guaranty:

  1. any intentional material physical Waste with respect to any Property committed or permitted by any Borrower, the Sponsor or any of their respective Affiliates;
  2. any fraud, willful misconduct or intentional material misrepresentation committed by any Borrower, the Sponsor or any of their respective Affiliates;
  3. the misappropriation by any Borrower, the Sponsor or any of their respective Affiliates of any funds in violation of the Loan Documents (including misappropriation of Revenues, Distributions, security deposits and/or Loss Proceeds and the violation of the last sentence of Section 5.7(d));
  1. any breach by any Borrower or the Sponsor of any material representation or covenant regarding environmental matters contained in this Agreement or in the Environmental Indemnity;
  2. the failure of any Borrower, at any time, to comply with Single-Purpose Entity requirements hereunder, in any material respect;
  3. any failure to pay income tax liabilities of non pass-through entities comprising any Borrower or its Affiliates;
  4. the failure of any Borrower to fully discharge prior to the Closing Date any liabilities, contingent or otherwise, associated with assets that were owned by Borrower or any of its Affiliates prior to the Closing Date (including all employee liabilities), other than the Properties and direct or indirect equity interests therein;
  5. failure to structure and consummate the Merger in a manner that does not give rise to a shareholder lawsuit;
  6. any liability of AFRT or its subsidiaries under any recourse carveout under any Encumbered Property Debt, guaranty or similar obligations, in each case in respect of Borrower, AFRT, Operating Partnership or any holding company;
  7. any failure by Borrower to cause each holder of Encumbered Property Debt to add Lender as a party to whom all notices of default must be given under the Encumbered Debt Documents; and any failure by Borrower to instruct each holder of Encumbered Property Debt to accept any payment from or action taken by Lender during the continuance of a default thereunder as if it were received from or performed by the applicable Property Owner; and any failure by Borrower to remit to any holder of Encumbered Property Debt any amount proffered by Lender in order to cure a default thereunder pursuant to Section 5.21;
  8. any assumption fee, foreclosure fee or similar amount (and related expense reimbursements) owed by Lender to any holder of Encumbered Property Debt or related loan servicer as a result of, or in order to permit, a foreclosure or transfer in lieu of foreclosure of Collateral; and
  9. any failure of the representation made in Section 9.14 to be true and correct.

In addition to the foregoing (x) the Loan shall be fully recourse to Borrower and Sponsor, jointly and severally, upon 

  1. any Transfer of Collateral or any Property, voluntary or collusive Lien on Collateral or any Property, or Change of Control which is prohibited hereunder or 
  2. the occurrence of any filing by any Borrower, Junior Mezzanine Borrower or Property Owner under the Bankruptcy Code or any joining or colluding by any Borrower or any of their respective Affiliates (including Sponsor) in the filing of an involuntary case in respect of any Borrower, Junior Mezzanine Borrower or Property Owner under the Bankruptcy Code; and 

(y) in the event AFRT shall fail to comply with Section 5.24, the Loan shall be recourse to AFRT and Sponsor, jointly and severally, in an amount equal to the Release Price of the applicable Property, plus all related enforcement costs and any Damages resulting from a failure to release such Property pursuant hereto.


Time to sum up where we stand. These are the valuations of the different parts with the uncertainty increasing as we move down the list. I included, almost at the end because of its high uncertainty, an item that estimates an above normal return for the unrestricted cash considering the opportunity of CDO bonds repurchases.

I do not want to push a upside valuation number as scientifically precise. There is no need for such precision when there is such good downside protection. I would say though, CDO 2006 is in excellent shape and CDO 2005 has a very good chance of recovery with the consequent upside.

Some may wonder, considering that Gramercy is a REIT, why I have not used instead a free cash flow analysis to establish a sustainable dividend. The problem is that this approach can easily lead to very aggressive valuations in a market where most non-agency REITs have dividend yields of 10% or less.

Some of Gramercy peers like Northstar Realty NRF (9.2% yield), Redwood Trust RWT (6.5% yield) and Resource Capital RSO (15.2% yield) are paying almost all their free cash flow in dividends and using windows of high valuations to raise capital. With a CRE market where is possible to obtain double digit unlevered ROI, these equity injections have been accretive but valuations are still very aggressive for a value investor soul who is always worried about chasing yield.

Instead, I will compare Gramercy’s FCF to a peer that seems conservatively valued and that some may actually consider cheap: Newcastle Investment NCT.


There are several companies similar to Gramercy such as Arbor Realty ABR, Northstar Realty NRF, Newcastle Investments NCT, Capital Trust CT, Resource Capital RSO, RAIT Financial RAS and Redwood Trust RWT. I chose Newcastle for a head to head not because it is expensive but because it is cheap. Derek Pilecki at Gator Capital has shared much analysis on Newcastle and concludes the same.

Another reason was that it looks like both companies had a similar track record with their CDOs. Two of Newcastle’s CDOs are comfortably passing OC Tests like CDO 2006, another two are close to their OC test triggers like CDO 2005, and its last two are busted CDOs like CDO 2008 (actually three, one was so bad that it is not consolidating). So we can see the current world and potential for Gramercy by analogy

Newcastle’s investments have a very similar mix of CMBS, whole loans and mezzanine loans to Gramercy’s and it also suspended dividends so it is trading, as it should be, at a discount to dividend paying mREITs (like Northstar Realty NRF and Resource Capital RSO)

I made some adjustments to make the comparison fair:

  1. CDO excess cash flow to corporate: Provides the excess cash that is really flowing to corporate and includes the collateral manager fees. This line does not affect the free cash flow multiple but it is important to determine if the CDOs are delevering and if corporate is burning cash.
  2. Net interest income: The preferred equity dividend was subtracted for both company’s considering that it is another form of long term fixed income financing.
  3. Realty’s corporate expenses: A large portion of Gramercy’s corporate activity is for the Realty division so it is expected that SG&A will be reduced in case of loosing Realty. I preferred for conservatism to keep the full amount.
  4. Preferred equity arrears: Gramercy still owes $18 million in accumulated dividends while Newcastle reestablished those payments a couple of quarters ago. I chose to subtract those arrears from the unrestricted cash.

The following comparison is not meant to be an exhaustive analysis, since there may be some GAAP things that I may be missing about NCT. At the same time, I think the direction is very much OK.

Let me repeat, I chose Newcastle because it was cheaper compared to its peers. Surprisingly, Gramercy valued at a similar FCF multiple as Newcastle would be worth $310M or $6.2 per share. Not only that, Newcastle had no problems in March to raise $80 million at a higher valuation.

I must recognize that Newcastle has been more transparent and is probably a couple of quarters ahead in terms of solving its legacy issues. However, considering these points, Gramercy looks very cheap even without Realty.


But Mr Market can completely misjudge a situation like Gramercy’s. Gramercy’s situation provides almost a checklist of all the items that can confuse investors, institutional or retail, to sell their stakes significantly below true value. This is the value investor’s opportunity if true value can be found.

I can only say Lollapalooza! and profit from the situation. To a value investor “issues” are often “catalysts” – elements that when solved can unlock true value. Here are some of those:

  • Dividend cut: Especially a REIT with common and preferred dividends suspended. They have to distribute 90% of taxable income and its dividend paying peers are priced at very high cash flow multiples.
  • Uncertainty: Gramercy Realty’s negotiation outcome is still a mystery. It might be wise to keep some powder dry in case the market misunderstands the effects of losing it.
  • Large hidden asset: $89 million in cash from December 2010 sale does not appear in most recent 10Q so people see things worse than they are.
  • Complex accounting: Muddling a simple downside protection thesis.
  • Ick factor: Alphabet soup stigma (CRE, CDO, CMBS) coupled with opaque CDO information.
  • Headline headaches: Manageable hits but in front page (Stuveysant, Suncal/Lehman, Atlantic Yards).
  • Index Rebalancing: Deleted once from the major indexes, with index funds forced to sell, Gramercy is now even consider as a possible addition to the Russell 3000
  • Delinquent financials: Scares some, but should be a short-term issue that will be resolved when Realty’s outcome is clarified.
  • Threat of delisting: Scary, but easily solved with updated financials.


With a good margin of safety in Corporate cash, it is hard for me to think of ways to lose money on this investment. However, while playing the game of “thinking the unthinkable, and predicting the unpredictable” this is a list of potential negative issues that could impact at least short term:

  • Bad capital allocation with so much cash
  • Second credit crunch including more delinquencies
  • Gramercy deciding on an offensive but uncertain Chapter 11 to defend Realty (aka GGP)
  • Gramercy deciding to expend cash to keep Realty while FCF keeps deteriorating
  • Capital raise at these low prices despite the large cash cushion
  • Conflicts of interest with SL Green
  • On a more technical issue, a drop in price after an announcement of Realty’s foreclosure
  • Legal costs of a messy foreclosure
  • Management lying about Gramercy Realty’s non-recourse and signing a secret amendment to the loan agreement

So the issues are mostly of two types: macro and management. With such balance sheet strength though, savvy management would take advantage of a relapse of bad financial conditions. I am sure they would love to have the opportunity once again to buy CDO and CMBS bonds at 80% discounts to par but those times are in the past.

So all boils down to one thing: management, and this management track record I think speaks for itself. But of course, I will speak for it.

Long GKK

Gramercy Capital: a Graham stock wrapped in a mystery

There has been several discussions of the disappearance of Graham stocks in the current market. However, such opportunities still appear if we do some research and go beyond just screening.

What is a Graham stock? It can mean anything to anyone. In this case, I use it as a company that is very close to being a net cash: a company with more in cash and marketable securities than its enterprise value.

The company is Gramercy Capital GKK, a lender and operator of commercial real estate assets (CRE). Gramercy was formed in 2004 and it was the structured finance arm of SL Green, the New York REIT, with SL Green still holding around 10% of the common shares. It is a real estate investment trust (REIT) and it has two divisions: Gramercy Finance is the owner of the equity portion of three CDOs and Gramercy Realty owns offices and banks branches all across the country.

The contours of the situation are so interesting that Gramercy Capital would have been my pick for the Ira Sohn Conference if it was not for the $1 billion plus market cap limit (damn). I think Michael Price, Seth Klarman and Bill Ackman would have appreciated a cash flow positive Graham stock with a dividend catalyst. Well, can someone relay this write-up to them?


Despite the superficial complexity the thesis is simple: a margin of safety based squarely on ring-fenced liquid assets at the holding company. Let’s start with a rhetorical question: would you be willing to buy a $110 million market cap company with the following balance sheet

That simple and safe balance sheet is Gramercy Corporate’s balance sheet isolated from its two divisions.

Gramercy Corporate by itself is not a bargain but is cheap and it has two more cash flow positive divisions (Gramercy Finance and Gramercy Realty). However, with so much cash, fantastic CRE opportunities, and a discount to tangible book value I think Gramercy Corporate would still be a proposition that could trigger the curiosity of a value investor.  Well, it triggered mine and obviously the great thing was: there were more assets and all non-recourse!

These type of situation raises some typical questions:

  • Quality of the jockey: Roger Cozzi is an iStar Financial and Goldman Sachs alumni and SL Green still has a friendly relationship and stock participation. However, the most important point is that, despite appearances, the track record is quite good. We will review that track record in detail.
  • Corporate SG&A: it has a quite high annual run rate of $28 million but most of it covers the operations of the two cash flow positive divisions. If any of these divisions stopped producing, payroll most probably will be cut. In 2006, when they only had Gramercy Finance, SG&A was $16 million and headcount was less than 15 people.
  • Cash: with the 10K not yet filed, because of the uncertain Gramercy Realty division future, one important cash event is not included in the most recent financial statements. The selling in December of several New York leasehold agreements to SL Green netting $89 million in unrestricted cash. We will review the effect on total cash later on.
  • Real estate valuation: it consists of two properties acquired at distressed prices at large discounts over their stabilized appraised values.
  • Securities valuation: acquired in 2010 at a 50% discount to par. They are obscure securities – my type of asset – that are so relevant for Gramercy’s upside that we will discuss their potential in detail.
  • Preferred equity: the only liability is the $106 million preferred equity that has the benefit that is long term financing. It includes arrears since dividend payments were suspended ten quarters ago.
  • Size of the opportunity: Big! Double digit unlevered returns still exist and the whispered securities of two paragraphs ago being the closest and simplest of them.

Well, we will get to tackle those issues in more detail in due time, but first we will review Gramercy’s two divisions: Gramercy Finance and Gramercy Realty to get a handle of the potential upside.


Gramercy Finance is the structured finance division that started Gramercy Capital with the original mission of becoming a CRE lender by taking advantage of non-recourse, long term, non-marked-to-market, low cost CDO bonds. Gramercy owns the most junior tranches – the equity portion – and is the collateral manager of the three CDOs (2005, 2006, 2007 named by the year of their creation).

One thing I want to emphasize. All these CDOs are non-recourse to Corporate even if you do not believe squat about my expectations of recovery and profit. Non-recourse means that the lenders cannot go for more than the CDO assets to recover their principal. If there was still a deficiency, their only legal recourse is to sue the sponsor or manager for violating guarantees or not complying with the CDO covenants; but after close reading of CDO transactions I could not find any indication that Gramercy had violated either one of those. Non-recourse CDOs are not only the usual standard practice but also Gramercy heavily emphasizes this point in the 10Ks, corporate communications and the CDOs offering memoranda.

CDOs carry a deserving stigma from the abuses in the residential market and managers chasing yield. However, only a couple of CRE CDO REITs collapsed in the process (ie: Anthracite that invested in lowly rated CMBS and Crystal River that was heavy into residential mortgage backed securities RMBS) but most survived (Capital Trust CT, RAIT Financial RAS, Newcastle Investments NCT) and even recovered (Resource Capital RSO, Northstar Realty NRF,  Arbor Realty ABR, Redwood Trust RWT). So, I just prefer to see what is under the hood and reach my own conclusions.

Under that hood you will find that Gramercy’s CRE CDOs are some of the more simple CDOs. CDO 2005 and CDO 2006 have a reasonable probability of recovery and their assets are basically 80% CRE loans (including some mezzanine loans) and 20% CMBS (AAA when they were issued) and they have very little in exotic securities.

How CDOs Work

I  do not want to take too much space explaining how CDOs work, especially when others have done it so well.  The key is to understand how overcollaterization tests work (OC test or par test) and the implications of the reinvestment period. I am embedding some links but probably the most simple jargon-free explanation is this post:

CDOs are like subsidiaries. There are many variations of CDOs (cashflow, arbitrage, synthetic), I will only talk about the ones GKK has. They start out by the sponsor (GKK) putting up $100 million of equity (RR: it has been more, it has been less), much like how you would start a company. Then they borrow $900 million at L+0.5% (RR: issuing bonds called CDO bonds or notes). They can’t just turn around and take the $900 million out of the CDOs and into GKK corporate’s pocket. That is why you have restricted cash. Cash either stays in the CDO company structure, or they gets paid according to seniority (which GKK owns the most junior ones).

GKK as manager and equity tranche owner can decide what assets they want to invest in to earn a return. Of course we want the assets (called collateral of the CDO bonds) to generate a higher interest than our liabilities. No matter what GKK does with the $1 billion, the senior tranches will get their interest first, be it all in cash or REOs, CMBS, whole loans . The interest will be paid from the CDO’s assets (loans, CMBS, others).

GKK gets to keep any interest income over and above what is owed to the senior tranche holders (RR: what I call excess interest cash flow), as long as the CDOs pass an overcollateralization test. Which is a test to ensure there is enough collateral (assets) in the CDOs to pay off the senior tranche principal. (RR: the equivalent of a leverage ratio, if the test fails senior tranches will get paid their principal first and on down until it cures)

CDOs typically have reinvestment periods of 3-5 years after their birth, during which time principal payments from the loans we make can be rolled into new investments. The alternative is to pay down the senior tranche. This is like you being a landlord, when you receive rent, you first pay your mortgage, then you can decide to keep the rest or make additional payment on your principal. Of course GKK would want to keep more interest-earning assets in the CDO.

When the reinvestment period ends, all principal payment received will be used to pay down debt. As debt goes down, so does the CDO’s assets, therefore decreasing the total interest income and distribution to GKK. This is what we mean by “runoff”. Eventually, when all loans are paid back, GKK will get their $100 million back as well, barring any discount payoff/default.

All of Gramercy’s three CDOs pay fees to Gramercy for being the senior collateral manager ($3.4 million per year) but the real upside comes when a CDO passes its overcollaterization test (OC or par test) and distributes its excess interest cash flow, after paying interest to all the more senior notes, to the equity tranches. If it does not pass the test, it redirects that cash flow to reduce its senior CDO bonds to recover on the OC test and can start cash flowing to Corporate again.

How to value a CDO

Some ways to value a CDO would be using a multiple of its net interest income or excess interest cash flow but this could be misleading if the chosen multiple is too high. The problem is that CDOs, after the end of its reinvestment period, are in a loooong runoff where principal payments of the CDO assets go to reduce bonds. This process can last 6 to 8 years slowly reducing liabilities along the way and putting some pressure on cash flows over time. After the bonds are paid back the equity owner keeps the remaining collateral

Therefore, for valuation purposes I prefer the more conservative equity collateral with one caveat: the CDO must have a reasonable chance of recovery of that equity collateral. If not, because the loans will turn bad or the cash flow is not enough to reduce its liabilities, it is better to consider it a zero.

Equity collateral is the equivalent of book value. It represents the residual portion for equityholders if all assets are sold at par and the proceeds are used to pay the liabilities at par. In an environment where the liabilities (aka CDO bonds) are trading at 50-60% of par (keep note of that) while the assets (aka CMBS and loans) are trading close to par, I think it is a conservative estimate.

So let’s see this story of turnaround and profit to see if I can persuade the readers. At least CDO 2006 offers a story of profit with no turnaround needed.

CDO 2006

CDO 2006 is the crown jewel of Gramercy Finance. As of the first quarter 2011 it had $85 million in equity collateral with a reasonable expectation of payment of interests and an equity recovery at the end of the CDO’s life.

Despite taking some big hits – like a very junior Stuveysant mezzanine loan- it has proved resilient and has almost recovered to its original collateral levels. It is well above the OC test trigger of 105.15%, the level where it would have to redirect excess interest cash flow to reduce bonds instead of paying it to the equity portion, and CDO 2006 was consistently above that level during the whole crisis. CDO 2006 has been a cash flowing machine.

It actually improved the interest cash flow received by the equity portion after paying the more senior CDO bonds interest (excess interest cash flow) during the crisis. It also used principal maturities to reinvest in better loans and conservatively increased untapped restricted cash (restricted because it has to be invested in eligible securities for the CDO) in a period where it could instead have closed CRE whole loans at 6%+ interest rates.

To put that in perspective, CDO 2006 generated so much cash flow to Corporate that it more than paid for all Corporate SG&A (including the needed for both divisions) PLUS the preferred shares dividend (in arrear for the moment). And we still have $196 million in unrestricted cash, $3.5 in annual collateral manager fees, CDO 2005 in road to recovery (with an estimated $35 million in excess interest cash flow when/if it cures) and a Realty division that generates $60 million in free cash flow (that most probably will be lost).

However, as I mentioned before, for valuation purpose I prefer to use the more conservative $85 million equity collateral despite the very high $37 million excess interest cash flow (43% return over the equity collateral) and the $1.5 million in annual management fees of CDO 2006.

I will leave CDO 2006 at that for the moment but there is a lot more to talk about. It has a couple of distressed assets (Las Vegas Hilton Hotel, Jemal Properties in Washington, AFR Portfolio) but also much was reinvested after the crisis in very high quality loans while it has today in cash $141 million of its $950 million assets. With so much cash and the reinvestment period ending in August, CDO 2006 has another shot for a big improvement of its test by buying more assets at a discount to par/collateral value.

I would love to discuss more these issues if the idea sparks some interest in the comment section or emails (

CDO 2005

CDO 2005 is a CDO that is failing its OC test and its reinvestment period ended. Therefore, it is redirecting the excess interest cash flow to pay senior CDO bonds until the OC test improves and cures over time. That is what has been happening the last few quarters. The latest count was 115% in April 2011 so it is getting very close to passing its test.

I do not want to overpromise, but it seems like CDO 2005 is on track to heal which would redirect its excess interest cash flow to Corporate at a current rate of around $35 million per year. The equity collateral is a quite high $104 million. This is a CDO from the times when sponsors of the equity tranche were investment partners not just by-standing gamblers.

There are some potential setbacks (Coyote Land in San Jose, California is one loan that I worry about) but also Gramercy has some options despite the end of the reinvestment period. The most important of the options is to repurchase CDO bonds at a discount with Corporate cash and retire them. This reduces the CDO bonds and improves the OC test. Even more, the discounts are still big (40-50%) so it is very good use of unrestricted cash.

I mention some obscure securities bought in 2010 when we reviewed Gramercy Corporate balance sheet at the very beginning. Those were CDO bonds repurchases, the focus Gramercy’s use of unrestricted cash. Here is a good explanation of the incentives behind these repurchases.

CDO 2007

After reviewing the previous CDOs one gets the impression that the investment underwriting for the CDOs was not perfect but that Gramercy has a reasonable chance of recovery from both CDO 2005 and CDO 2006 Gramercy. Even after taking some heavily publicized hits (loan loses from Stuveysant, Cupertino Mall, Suncal/Lehman) the OC tests have not collapsed.

However, I think it is fair to ask how CDOs die and never recover. Or as an old sage would say: I want to know where I am going to die so I don’t go there. CDO 2007 is a good example of a busted CDO.

The problem with CDO 2007 was that it never got off the ground.

  1. Bought CMBSs too early: When the CDO was created, management moved fast to buy a large percentage of its portfolio into what at the time were liquid AAA CMBS trading at some discounts to par. Gramercy was too early in the crisis, with CMBS delinquency rates only recently stabilizing and above 10%.
  2. Thin Equity Cushion: besides the bad investment timing, Gramercy did not put too much equity in this CDO. It was more of a “heads I win, tails I do not lose much” investment.
  3. Fixed Rate Structure: And finally, CDO 2007 was structured as a fixed-rate instrument with hedges for the few variable rate assets. So it could not benefit from low interest rates like CDO 2005 and 2006 did (that are “libor plus” instruments) by using libor floors and other tools that can protect revenues while interest expenses kept going down.

The compounding effect was that CDO 2007 from the beginning did not generate enough cash to even pay the interest on the CDO bonds. It also invested in Stuveysant in a very junior mezzanine that got clobbered. So do not even ask if the redirected excess interest cash flow will in time reduce its liabilities and cure its OC test. It cannot. There is no excess cash flow. It is a dead parrot.

So the key point for a CDO aspiring to have a second life after failing an OC testis cash flow, cash flow, cash flow to reduce the CDO bonds and cure the OC test. In consequence, CDO 2007 does not have an opportunity for recovery but CDO 2005 and CDO 2006 do.

There is only one redeeming factor for CDO 2007: because it was created in 2007, late in the last credit boom, it is still in its reinvestment period and has very light covenants on the type of instruments and concentrations it can invest. Because it is failing its OC excess interest cash flow is redirected to reduce CDO bonds but since it is still in its reinvestment period it can still reinvest principal maturities. Therefore, if Gramercy needs funding for some creative financial engineering, CDO 2007 can be at the center of it.

For example, CDO 2007 can buy CDO bonds from the other CDOs (those obscure securities again) that are trading at a discount and providing such nice yield. Another example is if Corporate wants to negotiate keeping some Gramercy Realty properties in exchange for the deed-in-lieu foreclosure. CDO 2007 could provide a mortgage for those properties transforming its CDO restricted cash into Corporate unrestricted cash. The possibilities are endless with a good jockey managing those proceeds.

GAAP Accounting

Just a brief accounting note. We have discussed how CDOs 2005 and 2006 have positive net interest margin, with CDO 2006 cash flowing to corporate, and that the CDOs are non recourse to corporate assets. Surprisingly, given that the absolute worst case scenario should still leave some recovery for Gramercy, Gramercy Finance has a large NEGATIVE book value.

To understand more this distortion, here is some data from the most recent 10Q that compares the value of the assets and liabilities of the CDOs at carrying value versus fair value (market value).

The reason for the large CDO fair value discount has been the general run on “toxic” securities and the difficulty on deciding which were fine. That run was even more extreme for CDO bonds because of their opacity.

Granted, Gramercy is not going to be able to buy all its CDO bonds at 50% discounts: it does not have that much liquidity and just announcing their intent would cause a price increase. Though at the same time the negative carrying value is not realistic either: the securities are cash flowing and are non-recourse.

If you want to find more about GAAP impact on CDO accounting, a good place to start is REIT Wrecks. Next, we are going to review the mystery: the uncertain outcome of the valuable Gramercy Realty division

Long GKK