Description

     In the 1970's Wall Street provided the investing public with the opportunity to lose a lot of money in mortgage REITs. The most famous of these was Chase Manhattan Mortgage & Realty Trust which almost put the bank under. I purchased the bonds, preferreds and common of many of these REIT s at prices greatly reduced from their original IPO prices. I made some money - actually a very nice rate of return. A man from Jackson, Mississippi, the late Leland R. Speed, was much smarter than I was. He bought control of the debt of several mortgage REITs and reorganized them. EastGroup Properties (EGP) is his creation and has a $6+ billion market cap. His other creation was Parkway Properties which was merged into Cousins Properties (CUZ) with a merger value ~$1.9 billion. While I was short-shortsightedly trading paper, Mr. Speed was investing in the enduring asset of real estate. He had a magnificent rate of return.

     I have been thinking about the possible fallout from the turmoil in banking. Private credit and BDCs have financed a lot of operating companies. It seems to me that business conditions might tougher today than they have been. Financing will be tougher than in the recent past. Operating businesses will be challenged. Operating businesses are fragile. Well capitalized, unlevered businesses will seek to take advantage of their leveraged competitors. As Ray Kroc said, "If my competitor were drowning, I'd walk over and put a garden hose right in his mouth." So, I think that loans made to leveraged businesses might come under pressure and the risks to business valuations is high. I want to avoid those risks unless there are very steep discounts.

     Let me state some obvious items. A reasonably aged, well located, well maintained and well tenanted building is a durable asset. The ownership of most real estate is such an easy business that you cannot make "folding" money without leverage. So there is a lot of leverage used in the real estate business. Moreover, commercial real estate financing is generally non-recourse to the borrower so the most that you can lose on your leveraged investment is your equity. Importantly, there is an exception to this for tax payers. If a tax payer bought a building for $1,000,000 some years ago, depreciated its value down to $100,000 on his tax return, saw the building appreciate handsomely over the years, mortgaged the new, improved building value for $4,000,000, banked/spent the $3,000,000, and then defaulted/walked on the loan - the tax payer would create a tax liability of $3,900,000 on "recapture". "Recapture" provides some motivation for a borrower to support the mortgage to the extent of his tax liability. Last, leverage provides borrowers with the opportunity to speculate on interest rates. A borrower who in underwater today, might believe that rates will be lower in 12 to 18 months and that the cost of continuing to service the loan is equivalent to the purchase of an option on rates. Statista reports that office cap rates were 4.18% in 2019 and 5.80% at year-end 2022. A building with NOI of $1,000,000 was worth ~$24mm in 2019 and is now worth ~$17mm - a loss of ~29%. It is the same reasonably aged, well located, well maintained and well tenanted building, it just worth 29% less.

     BrightSpire (BRSP) is one of a number of mortgage REITs. I own shares in it and others. I have chosen to write-up BRSP because its unique history causes it to trade at a slightly lower price to NOI and NAV than the rest.

     BrightSpire is the successor to Colony Credit Real Estate (CLNY) which was run by Tom Barrack, a friend/adviser to Donald Trump. Colony Capital was the outside adviser to CLNY. Colony Capital was taken over by David Hamamoto's NorthStar who proceeded to spin out NorthStar Realty Finance (NRE), NorthStar Asset Management (NSAM) and NorthStar Realty Europe (NRE) with NSAM holding the management contract on BRST. Hamamoto ran all of these into the ground. The NorthStar companies were liquidated or the assets folded into a new company now know as DigitalBridge (DBRG) which continued to hold the management contract on BRSP and 35mm shares of stock. DBRG is a public hedge fund which concentrates its efforts in the communication/technology space. DBRG wanted to monetize its ownership of the management contract and its ownership of the shares of CLNY. 

     On 4/1/2020 Michael Mazzei was brought out of retirement to run CLNY. He had been the President of Ladder Capital (LADR) from 2012 to 2017. Prior to Ladder he had senior positions with Bank of America Merrill Lynch, Barclay's and Lehman Bros. He retired in 2017 but continued to be a member of Ladder's Board of Directors. Ladder is a well regarded mortgage lender and real estate owner. In March of 2020 Covid hit. Mortgage lenders who had been warehousing loans to package into CMOs received margin calls from their warehouse lenders. All mortgage lenders struggled to find liquidity. Ladder was bailed out by a Goldman Sachs $310mm collateralized loan and a $206mm secured financing from Koch Industries' real estate division. The 4/22/2019 proxy for Ladder shows Mr. Mazzei owned 1.2mm shares of Ladder. Ladder shares traded at $18.86 on 2/12/2020 and fell to ~$3.29 on 4/3/20. They now trade at $9.22. Ladder paid regular dividends at a $1.36 annual rate in 2019. In 2020, the dividend rate was cut to $0.80 a year. Mr. Mazzei's Ladder stock went from ~$22.6mm of value to ~$3.9mm in less than 2 months. His Ladder dividends went from ~$1.9mm a year to ~$1.1mm. "When a man knows he it to be hanged in a fortnight, it concentrates his mind wonderfully." While watching your portfolio implode is not as bad as the prospect of being hanged, I believe that Mr. Mazzei's experience with Ladder has concentrated his mind to clean up the problems he inherited and run a solid lending business. He owns ~1.2mm shares of BRSP and has options on another ~600m shares. The rest of the executives are seasoned and incented by share ownership. The board appears to be first rate.

     On 4/30/2021 BRSP paid DBRG ~$102mm to purchase its management contract from DBRG and become internally managed. On 3/2/2023 BRSP stock closed at $6.90 a share. On the morning of 3/3/2023, DBRG sold its ~35mm shares of stock into the market at $6.00 without a road show. A lot of new shareholders were created in a market unsettled by the problems in the banking industry, and the shares now trade at $5.60. In 2022 BRSP generated distributable income of $0.98 a share. GAAP net book value was $10.77 and undepreciated book value was $12.06. At $5.60 a share, BRSP sells at 5.7x adjusted distributable income, ~52% of net book and ~46% of undepreciated book. Book value is net of $107mm of a CECL (Current Expected Credit Losses).

     BRSP has assets of $4,750mm, liabilities of $3,361mm and equity of $1,389mm. The loan portfolio is 49.1% multifamily (59 loans), 33.3% office (32 loans), 11.9% hotel (5 loans), 4.3% other which includes commercial and residential development and predevelopment (4 loans), and 1.4% industrial (3 loans). There is reasonable geographic diversification. Management has been cleaning up the portfolio since coming on board and booked realized and unrealized losses of $480mm in 2020 and 2021. Of the 103 loans, 9 are risk ranked "4" meaning that there is a high risk of default due to property performance being behind plan. The risk "4" loans have a principal balance of $550mm (16.9% of the portfolio). There are four loans ranked "5" meaning that the loan is in default or expected to default and they have a principal balance of ~$92mm. All but one of the "4" and "5" loans were made by former management. This is a somewhat meaningless point as loans go bad in the fullness of time, and new management has only been in place since 2020.

     Two of the "5" rated loans have been well reported. In 2016, The Related Companies and BentallGreenOak bought two properties in Long Island City, NY for $104mm and refurbished them for $45mm. The two properties are 350,000 sq ft. Work From Home (WFH) has been unkind to the NYC office market. One building is 10% occupied and the other 30%. Former management gave the owners mortgages off $129mm. Current management has written the loans down to $80mm - ~$228/sq ft. The buildings are being marketed. Another "5" loan made by former management was for a Los Angeles development. It consists of a mezzanine loan and a preferred equity investment for a total of ~$162mm. It was written down to $0.00 in a prior year by new management.  The last "5" was also made by former management. It is a ~$12mm mezzanine loan on a 289 room NYC hotel property which is carried at face. Its maturity has been extended to 12/15/2023 which indicates some progress. Writing down the Long Island City properties to $150/sq ft creates a further loss of $27.5mm or ~$0.21 a share.

     Of the "4" loans, three are hotel loans made pre-covid. The largest is a ~$185mm loan to the Fairmont Hotel in San Jose, CA. Plans are to split the structure in two with the smaller 264 room south tower being sold for residences. The northern 541 room tower would continue to be a Signia Hotel by Hilton. If the sale of the south tower goes through, the proceeds will reduce the loan and a better loan will result.  A ~$128mm loan is against the Claremont Hotel & Spa in Berkeley, CA. It is a 4-star 279 room Fairmont hotel on 22 acres. It too was affected by covid and is recovering. Two "4" loans are on multifamily properties located in Santa Clara, CA and Milpatas, CA and total ~$101mm. The Santa Clara loan is ~$57mm. It was originally a $108mm development loan which has been paid down by ~$50mm with the proceeds of a successful development and sales process. The remaining loan is for the development of 900 dwelling units. Financing uncertainty causes it to be a "4". A ~$44mm mezzanine loan on a development in Milpatas also has financing uncertainties. Although 81% of the multifamily is leased, the retail space remains unleased. BRSP's loan is subordinate to a $84mm 1st mortgage. As a consequence it is rated a "4". The remaining "4" rated loans are for office properties located in Washington, DC (~$57mm), Baltimore, MD (~$56mm), Oakland, CA (~$25mm) and San Francisco, CA (~$22mm). They total ~$160mm. The worst appears to be the Washington loan. Applying a 50% loss to it and 25% losses to the others creates an impairment of $64mm or ~$0.50 share.

     Seven loans are rated "2" for ~$210mm and 83 are rated "3" with a balance of ~$2.6bil - ~$2.6bil in all.

     BRSP also has a net leased portfolio of 8 properties carried at $~$608mil and owns two office buildings carried at $~$161mil for total owned property of ~$768mil. These assets seem to be trouble free at the present time.

     Last, BRSP finished 2022 with $306mm of unrestricted cash and ~$93 million of restricted cash.

     At year end 2022, total assets were $4.75bil, total liabilities were ~$3.4bil, and stockholders equity was ~$1.4bil. At $5.60 a share the market value of the common is ~$724mm - a 48%, $665mm discount. If my haircuts on "4" and "5" loans are realized, book is reduced by $0.71 to $10.06 and the discount to book is ~44%.

     BRSP pays a dividend of $0.80 annually. That rate was an 81% of distributable income. At $5.60, it is a 14%+ yield.

Risks

1) The banking crisis worsens and the condition of the credit market deteriorates.

2) Interest rates rise farther than expected - more than 50bp

3) The office market continues to deteriorate.

Catalyst

1) Interest rates decline.

2) Recognized losses ("4s" and "5s") are cleaned up and off the books.

3) Discount to NAV narrows.

4) Commercial mortgage lending normalizes.