Description

Hi, guys --

AHRPRD, the preferred stock of leveraged risky-commercial-real-esatate owning mortgage REIT Anthracite Capital Realty, yields more than 20%, and could therefore obviously double in price if things work out. If things don't work out, there's (squishy) downside protection so it'll probably outperform most long ideas.

I plan to touch very briefly on a bunch of stuff. I like to keep things short and informal, thus, "briefly"; this is complicated, thus "a bunch". Questions and objections are very welcome.

Just so everybody understands my limitations when it comes to the complicated parts: I work in structured finance and sit on the floor, but I don't deal directly with CMBS or commercial real estate for a living, and for a variety of reasons I haven't wandered over to the CMBS desk to pester them with questions. If any VIC members know some real CMBS guys, please send this to them because I'd love the feedback.

In other words, I know enough to be dangerous.

Here's my table of contents:

MACRO
INVESTMENT OPPORTUNITY
OTHER STUFF

-- read 'em in any order you want.

MACRO

- Commercial Real Estate Fundamentals are thought to be reasonably healthy, on the supply-side anyway. Here, courtesy of the BEA via Calculated Risk, is a chart of non-residential construction as a per centage of GDP:

http://bp0.blogger.com/_pMscxxELHEg/SBhuksncvqI/AAAAAAAAB5w/eg_hkSjvQp0/s1600-h/NonRIGDPQ12008.jpg

This is a really long time series, and obviously things can change over time so I don't read that much into it, but I'd describe it like this:

CRE construction fluctuated between 3.5% and 4.0% of GDP between 1960 and 1978. It then went on a huge tear, rising to almost 6% in 1982. It's been at or under 3.5% (the old bottom) since 1990. Industry insiders of course say that there's been no overbuilding this time, a claim made credible by eye-balling this chart. In addition, I'd suspect that some of the recent upturn is due to construction costs rising faster than general inflation.

Looking forward, commercial construction is of course headed down. Again courtesy of CalculatedRisk, here's the American Institute of Architects' Architecture Billings Index, a leading indicator of non-residential construction:

http://calculatedrisk.blogspot.com/2008/09/architectural-billing-index-more.html

- Commercial Real Estate Mortgages are currently performing well, with CMBS 30 day delinquency levels at about 0.5% vs. the recent peak of ~1.5% in 2003. Delinquencies and losses are going to increase; the question is how far and how fast.

- Commercial Real Estate Securities are in the crapper. Super-senior CMBS has recently been trading at LIBOR+400. This is insane. Let's step through a simplified example to see why.

SS CMBS has a 30% subordination level -- the deal has to realize 30% losses (NB, not 30% defaults) before the SS tranche takes a hit. At LIBOR+400, it's pretty much impossible to not receive a least LIBOR.

- $100 deal.
- You own the top $70.
- It goes for 10 years.
- Do whatever you want with the LIBOR component and stick the 400 bps spread under the matress. You wind up with $28.

So the deal needs to have realized losses of ($28 spread + $30 subordination) = $58 before you receive less than LIBOR. That's 100% default with 42% recovery. It's hard to see anyway for super-senior CMBS to underperform Treasuries at these levels because if defaults get that high the Revolutionary Council is going to repudiate the debts of the old regime anyway.

And this is where the safest and most liquid stuff is trading. Value investors might suspect that the riskier and less liquid securities are also trading cheap.



INVESTMENT OPPORTUNITY

38% of par with a 22% yield is all the upside I need; what are the risks? Let's start with the income statement -- in particular, "Adjusted Net Interest Income". (God, I love this game!)

The most recent 10Q suggests (and I'd agree) removing the "commercial mortgage pools" from the calculation of net interest income. I'm going to go further (for calculating ratios only!) and treat the payments to the TRuPS as preferred dividends and chuck in $4MM from an equity investment in a real estate debt fund. We see:

$75MM Interest Income -
$37MM Interest Expense =
$42MM Net Interest Income

- 2.14X coverage, which is a lot. 50% of interest income has to disappear for AHR to be unable to meet interest payments. Preferred and TRuPS dividends are running about $8MM/quarter, so the coverage ratio there is ((37+8)=45)/75 = 1.67x, which is pretty healthy. The market is saying that income is going to evaporate at a rapid rate.

Let's look at the assets. AHR owns equity and some higher rated tranches from the following securitizations (HY stands for "High Yield"):

AHR I -- 2002
AHR II -- 2002
AHR III -- 2004
AHR HY IV -- 2004
AHR HY V -- 2005
AHR HY VI -- 2006
AHR Euro -- 2006

Outside the CDOs are a bunch of CMBS, $890MM purchase price/$540MM fair value, and $600MM of real estate loans. These are financed by ~$600MM of credit lines. In addition, the company has $315MM of term debt (closest maturity in 9 years) and $180MM of TRuPS. The debt and the assets outside CDOs more or less net out. There are some other assets kicking around, but let's throw the whole mess out and take a closer look at the CDOs.

Here are some cashflow projections for CDOs I-V:

Date    Principal    Interest    Cash Flow
    384,945,598    240,929,012    625,874,609
            
09/19/2008    0    0    0
10/15/2008    0    1,978,631    1,978,631
10/15/2009    0    31,123,497    31,123,497
10/15/2010    0    30,096,982    30,096,982
10/15/2011    0    27,554,734    27,554,734
10/15/2012    93    23,853,025    23,853,118
10/15/2013    67,740,482    21,898,332    89,638,814
10/15/2014    29,677,609    22,716,427    52,394,035
10/15/2015    21,732,651    15,077,406    36,810,057
10/15/2016    77,459,295    11,762,007    89,221,302
10/15/2017    21,664,810    10,783,712    32,448,523
10/15/2018    31,258,344    11,597,250    42,855,594
10/15/2019    68,902,253    8,708,967    77,611,220
10/15/2020    8,218,583    8,151,911    16,370,493
10/15/2021    9,935,325    7,464,368    17,399,693
10/15/2022    15,818,211    4,569,583    20,387,794
10/15/2023    27,204,023    1,965,363    29,169,386
10/15/2024    1,060,987    1,066,305    2,127,292
10/15/2025    893,242    223,062    1,116,304
10/15/2026    947,088    168,974    1,116,062
10/15/2027    1,004,629    111,853    1,116,482
10/15/2028    827,088    53,929    881,017
10/15/2029    600,886    2,695    603,581

-- That's about $619MM over the next 15 years. You need to haircut this by $50MM because there's one big loan from '98 ("The Senior Living Portfolio") that's been in bankruptcy since 2002 and is about to keel over. Call it $570MM, or on average $37MM/year.

The assumptions here are 0.9% default -- which translates into 1.8% 60+ delinquency -- with 60% recovery. The intent is to simulate the "Moderate Stress" scenario from Fitch's "Stress Testing: Expected Losses in US CMBS - 2006 & 2007", which can be found here:

http://www.fitchratings.com/corporate/reports/report_frame.cfm?rpt_id=395152§or_flag=2&marketsector=2&detail=

There are tons of knobs and levers involved in this, and I might not be pressing and twiddling the right ones. Factors which tend towards conservatism are:

- Fitch is looking at '06 & '07, which are poor vintages. These CDOs contain a smattering of '05 stuff, but are mostly earlier with a heavy concentration of '98 deals.
- I'm cranking us up to 1.8% 60+ delinquency immediately. If we get there, it'll probably take a year or so.
- I'm assuming immediate liquidation on the loans. In reality, they'll linger in special servicing for -- ? -- 6-12 months.

I left out the Euro CDO because it's got a bunch B-piece loans which makes it unamenable to this kind of analysis, and the AHR VI because I'm not able to run it any more. For what it's worth, under slightly different assumptions, AHR VI PVs to $114MM at a 5% discount rate, and the Euro CDO is something like $50MM at 50% of par.

The main point is that there is substantial value in AHR's older vintage CDOs.

---

Here are some scenarios:

1: AHR goes belly up tomorrow, and you lose your entire investment. Oh, well!
2: AHR is forced to eliminate the preferred dividend. This might happen, but I think losses will be minimal because:

A: It'll take at least a couple of years, so you get to bank 40%, and
B: Distressed preferreds tend to bottom out around $5 purely due to option value. Say assets=$3B, liabilities=$3B, equity=$0. In theory the preferreds are worthless. But if you can purchase them at 20% of par -- $40MM market value in this case -- and the value of the assets increase by 2%/year for 5 years, you've got a 6-7 bagger on your hand.

3: AHR decides to eliminate the preferred dividend. They'll do this if it's not in the common's interest to receive dividends. I don't think it's in the common's interest to receive dividends right now, so this is a real possibility. The preffered might trade down, but I'd welcome this scenario, because given the opportunities available in the market, it would render scenarios 1 & 2 highly unlikely. At these prices, I'm more than willing to defer dividends for a couple of years to ensure ultimate success.

4: AHR staggers along with weak results. You get the coupon and some price improvement.

5: Things are more or less stable at current levels, and the D's go back to $20+.

Whoops, got to go to work, where I can't post; I'll be back with "OTHER THOUGHTS" later in the day.

Yours,
Bowd

Catalyst

Quarterly Dividend
Bailout may return some rationality to CMBS pricing.