Description

Terra Firma Capital is a specialty finance company with a quality investment portfolio, a highly attractive funding platform, and a top-tier management team with a strong track record of success.  The company however remains subscale, which has caused shares to be deeply mispriced for several years – at $6.00 per share, the company trades for only 0.57x book value.  

Most importantly, management has finally grown tired of being orphaned in the market, and has just announced a review of strategic alternatives less than a month ago.  I believe this strategic review represents a very strong near-term catalyst that has the potential to unlock the value contained in the current significant market mispricing.  As a result, I believe the company now possesses a particularly attractive risk/reward profile: the very low valuation and high quality portfolio provide downside protection while the strategic review coupled with 40% insider ownership significantly increases the near-term probability of the company realizing fair value for its assets, and thus a meaningful return for investors.

The company's size and liquidity make it more suitable for personal accounts.  Shares trade as TII on the TSX Venture in Canada. 

Overview

Terra Firma is a real estate finance company that provides shorter-term loans to real estate developers and owners to bridge a transitional period.  These loans are typically repaid either with lower cost, longer-term debt from other lenders, or by the sale of the asset.  The company targets high growth urban and suburban markets in North America.

Terra Firma is more specifically focused on the niche market of land/lot inventory loans and land/lot banking.  These two loan types are obviously very similar, albeit with different structures, and both represent attractive markets and generate similar return profiles for TII.

It’s important to note that the company’s portfolio is very senior-oriented.  Unlike many other specialty lenders that often focus on riskier subordinated loans to achieve their returns, roughly 85-90% of Terra Firma’s investments are in a 1st mortgage position.  Furthermore, although TII has assets to equity of 3.2x, essentially all of its debt is non-recourse as it is composed of loan syndications.

Land/Lot Inventory Loans

With land/lot inventory loans, TII provides loans (1st or 2nd position) to lot developers to acquire land at an ~80% LTV.  As the lots are developed and value is added to the property, this typically reduces the LTV to ~75%.

The competitive environment for land financing became a lot more attractive post the 2008 financial crisis.  When the Basel III Capital Accord took effect in 2015, a 150% risk weighting was assigned to HVCRE (high volatility commercial real estate), making it significantly less attractive to traditional banks as the need to reserve much more equity greatly reduced their returns from this asset class.  The reduced competitive activity has in turn helped to drive excellent risk-adjusted returns in the market for TII.

The following slide illustrates the economics in detail:

Land/Lot Banking

With land/lot banking, TII acquires land for development using a significant non-refundable deposit from a homebuilder, who then receives an option to purchase finished lots at a predetermined price.

Lot banking has become an attractive market as large private and public homebuilders have increasingly favored an off-balance sheet means of securing lot supply.  The public builders in particular generally option 50%+ of their lots. This demand can be served by traditional lot developers (who purchase lots using 1st mortgage financing from lenders like TII) or by “lot bankers” like TII.

The following slide illustrates the economics in detail:

Loan Syndication Platform

On the funding side, a major driver of the strong returns generated by TII is due to the loan syndication platform that they’ve developed.  Since inception they’ve raised over $450mm USD from private investors in this manner.  Accredited investors participate on a pari passu basis up to 90% of the loan value, with TII earning a 200 - 300 bp spread plus a commitment fee.

The company’s loan syndication platform is probably its most significant asset, and justifies a valuation for the company in excess of book value IMO.  The company has been able to tap this attractive funding source due to the strong reputation and track record that they’ve developed over the last 12 years with accredited investors and family offices.

The below slide summarizes this history, but the main takeaway of course is the fact that they’ve generated 10% annual net returns with zero loss of investor capital.

In recent years they’ve evolved their syndication activities to now also incorporate the raising of debt funds.  The fund model has a number of advantages for private investors in that it allows for diversification of holdings and the use of modest leverage, and thus potentially higher returns.

Valuation

The stock has essentially oscillated around the current $6 price level (from $4 - 8 per share) over the last 7+ years while book value has steadily grown.  In the fall of 2015 book value was ~$7.30 per share and shares traded at $8.50 per share, a valuation of ~1.2x book (technically shares traded as high as $10.50 per share earlier that year).  

Over that same time period, book value has grown by around 45% to ~$10.60 per share while the share price has fallen to $6 per share, thus gradually collapsing the valuation from 1.2x book value down to around 0.57x today.  Most importantly, I don’t believe that there is a fundamental reason to justify the drastic valuation reduction that’s occurred.

I believe the company is worth 1.2 - 1.3x book value, or ~$12.70 per share at the low end of the range, which is more than double the current share price.  If the market environment is sufficiently weak and the company does culminate the current strategic review with a deal of some nature, I do think it is possible that the company transacts at a lower price than this, but I would be very surprised if they didn’t achieve a valuation of at least book value, or ~$10.60 per share, which is 75%+ higher than the current share price.

Finally, there is also certainly the possibility that the strategic review fails to result in a meaningful transaction.  In that event, while I would be disappointed, I would nonetheless be happy to continue owning this business at less than 60% of book value while earning a 4.0% dividend yield and wait for the board to unlock value in a better market environment.

Management & Ownership

Insider ownership is ~40% of the company.  As a result, I believe the board is well incentivized to consummate a transaction that reflects a full and fair value for Terra Firma’s assets.

Most significantly, ICM – a fund manager with $20 billion AUM – owns 20% of the shares, and in June 2022 received a seat on the board.  I would note that the timing of this board appointment and subsequent announcement of the strategic review does not seem coincidental to me, although it is impossible to know for sure the full impetus to the recent decision.

Furthermore, in 2017 Great Gulf Group, a large and very well respected property developer in Canada, bought 500,000 shares of TII in a private placement at $6.50 per share (the book value was ~$8.09 per share at the time and is now ~$10.60 per share).  Jerry Patava, Great Gulf’s CEO at the time, joined Terra Firma’s board of directors, where he remains today.  I think it’s fairly significant that a major residential property developer would partner with, invest in, and have their CEO join the board of a comparatively small specialty lender like TII.  I believe it at least partly speaks to the quality of the assets, the people at Terra Firma, and the attractiveness of the opportunity that the company is targeting. 

Risks

The company fails to consummate a meaningful transaction in their current strategic review.

The company consummates a transaction at either an unattractive price or with unattractive terms.

The company experiences an adverse development in its loan portfolio.

The company has difficulty sourcing new loans with attractive terms.

The company has difficulty raising future debt funds and loan syndications.

Catalyst

The current strategic review results in a sale or other transaction that places a full and fair value on Terra Firma’s assets.  

The company announces a share repurchase program or a tender offer.

The company raises its dividend.