Description

Special Situation: announced intent to liquidate the company on Dec 11, 2009. 

Investment Thesis: the eventual liquidation value is higher than current stock price of $8.2 and the liquidation will be completed in about 5 months.

Reasons for the discount

• Classic orphan stock - there is no sell-side coverage.
• Irrational selling - institutions/retail investors do not want to hold a company that is no longer a going concern and thin trading volume.

Near-term Catalyst: the current management contract with CIT will expire on June 30, 2010, and it is reasonable to assume there won't be an extension with the liquidation intent announcement. 

The Formation of CRE: CIT and Jeffrey Peek:

CRE is a REIT that was listed in June 2007, right at the peak of the RE bubble/credit crisis.  It has no employees and is solely managed by CIT healthcare, a wholly-owned subsidiary of the publicly traded CIT group.  As such, to analyze CRE, one must understand CIT and, more importantly, its ousted CEO, Jeffrey Peek.

Peek, who lost the battle for the Merrill CEO job in 2001, was hired by CIT in 03 and eventually became CEO in 04.  He was eager to use CIT as a means to an end - to demonstrate to his Wall St peers that he is back.  The following summarizes Peek's accomplishment during his reign of CIT.

• Move HQ to a skyscraper on 5^th Avenue, Manhattan from an office campus in New Jersey.
• Started an investment banking division in 2005, focusing on syndication.
• Expanded into subprime mortgage lending, and student lending (we all knew how this movie ended).
• Asset grew at 18% CAGR from 03 - 07. On a managed asset basis, CAGR is 14% for the same period. It is clear in hindsight that Peek believed that "bigger is better" and, unfortunately for shareholders, the expanded asset base contains lower quality investments that ultimately bankrupted the company.

In summary, under Peek's leadership, CIT's strategy changed from "originate and hold" to, what he called, "originate and optimize".  The business model changes from earning spread income generated by proper credit underwriting to transaction fees based on deal volume. 

For every deal, there needs to be a buyer to take the other side.  To earn fees from transactions and management fees from the buyers would be the equivalent of having one's cake and eat it too.  Consequently, to capture profits from both sides of the trade, CIT created CRE.

CRE's Investment Portfolio:

CIT expected to utilize CRE as a vehicle to monetize its healthcare-related loans.  In fact, CRE's investment was 100% mortgage loans at the time of its IPO in June 2007.  It has no employees and is managed by CIT healthcare under a very generous contract favorable to the managers.  The credit crisis has disrupted CIT's plan and forced it to invest in healthcare properties instead.

As of 3Q09, the portfolio consists of 4 parts:

1.      Legacy mortgage loans from CIT Healthcare with book value (BV) of $58m

2.      Bickford Portfolio

3.      Equity stakes in two healthcare joint ventures managed by 3^rd parties (Cambridge and SMC)

4.      $94.7m of cash

Legacy loans:

Did CIT lower its underwriting criteria when originating the loans?  Are the loans still worth BV, or less?  These are reasonable questions because

1) CIT was chasing fees and deal volume, and in hindsight, its underwriting record is poor

2) The initial price paid by CRE for the loans were not arms-length transaction

"The contribution agreement through which we acquired our initial portfolio of mortgage loan assets at the time of our initial public offering was not negotiated on an arms-length basis and we did not receive independent appraisals of the initial assets. As a result, the terms of the contribution agreement, including the consideration paid by us in exchange for the initial assets, may not be as favorable to us as if it was negotiated with an unaffiliated third party."

Source: 2008 10K

I believe that the loans are worth at least BV because

• The loans are held at lower of cost or market (LOCOM)
• All loans are secured by hard, RE assets with very short duration (1.3 years).
• All loans are variable rates based on Libor. $129.2m (68% of loans at cost basis) are subject to floor protection ranging from 6% - 11.5%. Source: 3Q09 10Q note 3
• Management has been selling the loans to build cash on the balance sheet. CRE were able to sell these loans to 3^rd parties and CIT at prices close to BV for the first nine months of 2009 and realized a small gain on sale ($1.18m).

Bickford Portfolio:

CRE bought 14 senior living properties (assisted living, independent living and Alzheimer) in two sales-leaseback transactions during 2008 for $111m.  Annual rents are $9.1m, with 3% annual escalation.  Occupancy was 92% as of 2008 year-end.

Based on earnings call transcript from other healthcare REITs, market cap rate ranges from 7 - 8%.  I added 0.5% for conservatism.

Cambridge Joint Venture

The JVs are managed by Cambridge Healthcare Properties (CHP).  The manager has 22 years of operating history as a developer/owner of healthcare properties.

Investment Structure: CRE paid $72.4m ($61.9m in cash, the rest in stock) for 85% interest of the fund.  A return of 8% (based on $72.4m) is guaranteed which is supported by 1) cash flow to CHP and 2) the cancellation of stocks to CHP.

The JVs owned 9 medical office buildings developed by CHP with 767,000 sf and are 95% leased at 2008 year-end.

Using 2009 FCF is quite conservative because distributions ($6.13m) and 2008 FCF ($3.3m) are much higher.

Senior Management Concepts Joint Venture

The JV owns four independent and assisted living properties which contain 233 IL and 159 AL units operated by Senior Management Concepts (SMC).  The facilities are upscale, 100% private pay and were 88% occupied as of 2008 yr-end.

Investment Structure: CRE bought 100% of preferred equity with 15% yield and 10% of common equity for $6.8m.  The preferred are callable after two years, and puttable after eight. 

In 2008 and 2009, reported earnings = distributions, which implies that SMC can afford to pay the distributions because reported earnings include non-cash charges (depreciation expense).  Given that the credit market has reopened, SMC would likely refinance in 2010 as the preferred becomes callable.  If SMC does not refinance, CRE will continue to receive the distributions.  As a point of reference, HCN (Healthcare REIT with similar properties) series D callable in 03/2010 is yielding around 8%.  For margin of safety I will mark this at BV with 15% yield.

Why liquidate?

• From CIT's perspective, CRE is part of the non-core assets inherited from former management.
• Interestingly enough, the management contract has a termination fee of $15.4m for the manager (CIT Healthcare) even if the manager fires itself. Management has confirmed in earnings calls that this fee is payable in the event of liquidation.

Conclusion: In the worst case scenario, one can still earn 11% in five months, which equals to an annualized return of 28%.

Catalyst

Expiry of management contract on June 30, 2010.

Evenutal liquidation.