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.
(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:
- any intentional material physical Waste with respect to any Property committed or permitted by any Borrower, the Sponsor or any of their respective Affiliates;
- any fraud, willful misconduct or intentional material misrepresentation committed by any Borrower, the Sponsor or any of their respective Affiliates;
- 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));
- 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;
- the failure of any Borrower, at any time, to comply with Single-Purpose Entity requirements hereunder, in any material respect;
- any failure to pay income tax liabilities of non pass-through entities comprising any Borrower or its Affiliates;
- 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;
- failure to structure and consummate the Merger in a manner that does not give rise to a shareholder lawsuit;
- 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;
- 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;
- 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
- 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
- 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
- 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.
SUM OF THE PARTS
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.
FREE CASH FLOW COMPARABLE: 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:
- 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.
- 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.
- 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.
- 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.