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Newcastle: Leveraged to CMBS Price Recovery

Newcastle Investment (NCT) is a commercial mortgage REIT with an asymmetrical risk/reward for equity investors.  The near term down side is limited because the management has improved the balance sheet and eliminated short-term recourse debt.  The upside is a multiple of the current share price because the company is leveraged to a continued recovery in commercial real estate mortgage security (CMBS) prices.

Historically, NCT purchased mostly CMBS and securitized them into CDO’s.  When the capital markets closed in 2007-08, Newcastle was caught with some short-term recourse debt obligations at the same time its assets were declining in value.  This caused financial distress, and the stock declined to as low as 15 cents in November 2008.

In the last two years, management has done a solid job of cleaning up the balance sheet and taking advantage of opportunities in the capital markets to resolve the company’s financial distress.  Currently, the company has no short-term recourse debt.  Plus, four of its CDO’s are still paying cash to NCT as the equity note holder.  Finally, NCT has the opportunity going forward to create additional shareholder value through repurchasing its CDO notes at a discount and/or making new high return commercial real estate loans.

NCT’s CDOs

Newcastle’s ultimate value will depend largely on how much cash they’ll receive from their seven outstanding CDO’s.  The picture doesn’t look great because each CDO is still underwater and the cash flow could be reduced if any of the CDO’s fail the overcollateralization trigger tests in the future.    However, Newcastle’s management has done a good job managing the CDO’s to preserve and restore value.  The CDO’s assets (or collateral) have made some recovery in value, and NCT receives about $10 million in recurring cash flow from the CDO’s a quarter.   NCT can still extract more value from the CDO’s.  Here are the possible positive scenarios for NCT’s CDO holdings:

1.    Collateral assets continue price recovery – The collateral in NCT’s CDO’s averaged 14% appreciation in the 1st half of this year.  Based on moves in the credit markets, it looks like they will have further appreciation in Q3.  Continue asset price recovery and ultimate asset payoff at closer to par will be the easiest way for NCT to realize value from its CDO holdings.
2.    Invest restricted cash – NCT can increase the recurring cash from the CDO’s by investing the restricted cash held within the CDO’s.  By investing all $138 million of the restricted cash at a 10% return, the quarterly cash flow from the CDO’s would increase by $3.5 million.
3.    Reinvest principal paydowns – NCT last three CDO’s are still in their reinvestment periods.  To the extent that NCT receives any principal paydowns over the next couple of years, the cash can be used to make new investments at higher yields.
4.    Repurchase and retire CDO notes – NCT can make purchases of the outstanding CDO notes and retire them.  The purchase discount is an immediate gain for NCT.  For example, in the second quarter, NCT purchased $64 million face amount of CDO notes for a 73% discount.

NCT’s Current Liquidation Value

We can calculate NCT’s current liquidation value using the fair values provided by the company in the 10-Q.  This analysis assumes that NCT sells all of its CDO assets at fair value and redeems the appropriate liabilities at par.  Of course, this is not a value maximizing strategy, and the company should not pursue it.  However, this analysis gives us a window into the current worst case for NCT and shows us how the worst case has improved over the last 2 quarters.

This shows that NCT has enough assets for the equity to have a positive liquidation value.  In addition, this analysis shows the progress that NCT has made over the last two quarters.

I am not concerned that the current stock price is above the liquidation value of the company.  I believe there is value that will continue to be realized in the company’s assets.  Plus, this liquidation analysis assumes all of the CDO liabilities are paid out at par.  In reality, the CDO notes trade at a discount to par.  Also, since the company has so much financial leverage, the stock price premium to liquidation value could be viewed as small compared to the potential leverage.

Leveraged to Higher CMBS Values

I believe NCT’s equity value is leveraged to continued recovery of CMBS prices.  The following table shows the value of NCT’s holdings of CDO notes within its own CDO’s if the each CDO was liquidated at the fair value of assets.  Normally, NCT would only own the equity tranche and maybe some of the most subordinated tranches of a CDO.  However, with the market for securitized debt still not orderly, NCT has been able to repurchase some of the more senior tranches at attractive prices.

The table shows each CDO and NCT’s estimate of the fair value of the underlying collateral.  I’ve applied the fair value to the waterfall listed in the 10-Q to see if any of NCT’s CDO tranche holdings would have value.  As of June 30, I estimate NCT would get just under $26 million from its holdings within its CDO’s.    Most of this value comes from CDO VIII.  To show how leveraged NCT is to rising CMBS prices, I created another scenario where the fair value of assets is 5% higher than the June 30 value.  In this scenario, NCT’s holdings are worth almost $52 million.  So, a 5% move in asset prices results in a 65% change in value.  13x leverage is very high.  I also show a 10% scenario where the CDO assets rise in value 10%.

I do not think a 5% or 10% further appreciation in the collateral value is extreme.  In the first 2 quarters the collateral value increased by a weighted average of 14%.   As of June 30th, NCT was carrying the CMBS held in the CDO’s at 60% of face value.  The average CMBS had 10.2% of subordination and own 5.0% of loan delinquencies.  For the 60% price to be correct, every loan in all of their CMBS would have to default and only recover 50% of the original loan amount.

NCT’s Negative Stated Book Value

Comparing NCT to other commercial mortgage REITs, the stock market is not giving NCT credit for a stronger balance sheet because of the optics of its negative book value.  NCT’s balance sheet is stronger than peers because it has no short-term recourse debt.   Stated book value is negative because NCT mark the assets in its CDO to market, but leaves the CDO liabilities at par on its balance sheet.  This is overly conservative because the CDO obligations are non-recourse to the company, so if the collateral in the CDO’s do not cover the liabilities, then the CDO does not have recourse to NCT.  For example, earlier this year, NCT deconsolidated CDO VII from its balance sheet because the CDO note holders have the right to replace NCT as the CDO’s manager.  When CDO VII was deconsolidated, NCT’s book value actually increased by $290 million.

There are two possible correct ways of viewing NCT’s current book value rather than looking at the stated GAAP book value.  First, we could view it as the value of its non-recourse asset and liabilities + the liquidation value of CDO notes – preferred stock.  I calculated this number above to be $0.86 for June 30.  The other way to view NCT book value is an adjusted book value to take account of the market prices of its CDO liabilities.  However, management doesn’t provide current estimates of the mark-to-market on the liabilities.

Negatives

Not everything is rosy with NCT.  Here are some of the problems and issues I have with NCT.  This is not meant to be an exhaustive list.  The company has listed plenty of additional risk factors in its securities filings which you should read prior to purchasing the stock.

1. Cashflow from CDO’s Could Decline – Although NCT received $15 million in cashflow from its CDO in Q2, this cashflow could decline.  Management identified about $5 million of the cashflow as non-recurring payments from loan fees and prepayment fees.  Plus, a large portion of the CDO cashflow comes from the four CDO’s passing overcollateralization triggers.  If any of these four CDO’s fail future overcollateralization triggers, cashflow will be decline.  I believe that NCT management has a few options to manage around the triggers to preserve as much cash flow as possible.

2. Poor transparency into CDO portfolios - Neither the trustee nor NCT management will provide the collateral reports for the CDOs.  They claim this is due to the bond indenture, which does not allow the reports to be distributed to non-owners of the securities.  I would feel multiple times more confident in our view of NCT if we could read the trustee reports.  If anybody has access to the reports and would not mind sharing, please email them to me.

3. Externally-managed – NCT is externally managed by Fortress Investment Group.  We not fans of externally managed REITs.  External management leads to higher costs and misaligned incentives.  Given the value of NCT and my outlook for potential return, I’m going to overlook its management structure.

Conclusion

NCT is an interesting investment for equity investors because of the asymmetrical risk/reward payoff.  To invest in NCT, you have to have a positive view of the potential recovery of CMBS values.  NCT is leveraged to higher CMBS values and general recovery in commercial real estate values.  Management has done a good job of eliminating short-term recourse debt, so there is no near-term potential for financial distress.  The company has potential to create additional shareholder value going forward by either repurchasing CDO notes at a discount or making new high returning investments.

I own NCT for clients in the Gator Small Cap Portfolio.  This fits our investment strategy of owning companies with asymmetrical risk/reward payoffs.  We offer the Gator Small Cap Portfolio through the kaChing investment platform, where the minimum investment is only $10,000.