JER Investors Trust JRT S W
August 29, 2008 - 7:10pm EST by
claude535
2008 2009
Price: 5.75 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 149 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

Sign up for free guest access to view investment idea with a 45 days delay.

Description

While JER Investors Trust (NYSE: JRT) is one of several commercial REITs formed during the preceding bubble based on a credit-sensitive business model that is no longer viable, several factors distinguish it as an unusually high conviction and timely short. Like several such peers, JRT has served as (and indeed was founded to be) a dumping ground for high risk loans and securitization residual interests to be further levered with cheap credit and equity financed by public shareholders attracted to high (though unsustainable) dividend yields.  In the post-bubble environment, JRT has temporarily avoided total implosion due to such a dividend, a better-than-average loss rate on its CRE loan assets and the very creative sellside coverage of its IPO underwriter.  With the stock down over 50% YOY and trading at 0.6x tangible BV, a skeptic to the JRT short case might understandably argue that the opportunity has passed and question the wisdom of shorting a stock with a 20%+ dividend yield (30c/qtr). However, unlike other “dividend sustainability” shorts in the REIT space, JRT’s leverage is so egregious -- constructively 99x relative to underlying assets supporting most of its dividend-paying capacity -- that only a modest increase in loss rates (already underway) is needed to force elimination of the dividend.  In addition, JRT faces an ongoing liquidity crisis due to its reliance on uncommitted repurchase financing of other illiquid assets that is likely to leave the Company with little to no cash by the end of 2008.  Finally, business model aside, JRT has no going concern value by virtue of its external management by a non-exclusive advisory firm.  In brief, JRT faces two imminent and distinct sets of catalysts for elimination of its dividend and, absent such a dividend, there is no reason for anyone to own the stock.
 

Company Overview

 
JRT is a Virginia-based commercial mortgage REIT organized in April 2004 and taken public in July 2005 by J.E. Robert Company (“JER”), a privately held real estate investment advisor owned and controlled by JRT’s Chairman and CEO, Joseph E. Robert Jr.  While primarily an investment manager of traditional real estate private equity funds, JER formed JRT specifically as a financing vehicle for junior CRE loans and residual securitization interests as it became an active organizer of CMBS conduit transactions to earn lucrative servicing fees. As a result, while JRT is a “commercial REIT” in the structural sense, it holds no direct equity interests in real estate properties and only a nominal collection (2) of senior CRE mortgage loans.  Rather, substantially all of JRT’s investment portfolio is comprised of 10 mezzanine loans (4 of which are loans to portfolio developments of JER) and a large collection of “first loss” interests in highly levered CMBS securitizations originated by JER.  As holder of the most junior interests in these transactions, JRT (the “left hand”) obtains the right to appoint JER affiliates (the “right hand”) as “special servicer” for these transactions. As special servicer, JER earns lucrative fees and, as the party responsible for work out of problem loans, retains broad discretion in defining the status (e.g., delinquency) and treatment of such loans. While this relationship is sadly not uncommon in the CMBS market, it is obviously fraught with conflicts of interest, particularly with regard to JRT’s critical assertions regarding the performance characteristics of underlying loan pools.
 
As an “externally managed” REIT, JRT pays JER management and incentive fees ($8mm in 2007) to oversee this investment portfolio and lacks any native investment management capability of its own. In addition, JER affiliates collect fees as the special servicer for all 21 of the CMBS securitizations in which JRT holds first-loss positions ($7mm in fees) and as the collateral trustee of JRT’s larger CDO financing ($1.4m).  As the residual interest holder in such transactions, JRT constructively pays these fees which, in 2007, equated to 38% of JRT’s AFFO.  In addition, JER’s other funds have originated a large share of the CRE loans in which JRT has invested.[1]  In short, despite exercising nearly absolute control over JRT’s investment decisions (ex/ some independent director review of self-dealing transactions), JER’s financial incentives are far more tied to the span of managed assets that JRT’s levered investments can support than the performance of those investments.
 
Portfolio Investments and Financing
 
As of 8/4/08, JRT’s asset portfolio consisted entirely of 12 commercial real estate loans (face value $398mm) and commercial mortgage backed securities (CMBS) with an aggregate face value of $1.8 billion purchased in 26 conduit transactions originated between 2004 and 2007.[2]  Of the CRE Loan investments, 10 (76% of UPB) are mezzanine loans and 4 are loans to affiliates of JER.  Of the CMBS investments, the vast majority (approx. $1.7bn in face value) are residual interests that effectively bear the first 3% of loss (on average) with respect to their respective conduit mortgage pools ($62bn in aggregate face amount of underlying loans).
 
The vast majority of these financial assets ($1.6bn face value) have been financed by JRT in two CDO transactions that issued a combined $975mm in non-recourse debt. CDO I, organized in October 2005, with $419mm face value of CMBS supports $266mm principal amount of investment grade CDO notes issued to third parties. CDO II, organized in October 2005, contains $889mm face value of CMBS and $275mm face value of CRE Loans, collateralizing a total of $708mm in CDO notes issued to third parties.  In addition to retaining small amounts of lower-tranche senior debt (i.e., BBB) in these CDOs, JRT retained all junior interests (unrated debt and preferred).  As a result, while held in/originated by these special purpose entities, CDO investments (along with CDO notes issued to third parties) are included on JRT’s consolidated balance sheet under GAAP. 
 
Outside of these CDOs, except for a single unencumbered CMBS investment (book value $9mm), the remainder of JRT’s financial assets ($385mm CMBS and $123mm in CRE Loans) are held as collateral / financed through three repurchase facilities with JP Morgan ($27mm o/s at 8/4/08), Bear Stearns  ($14mm o/s) and Goldman Sachs ($59mm o/s).  As in most repurchase financings, these facilities are short-term in nature and constructively uncommitted because the collateral is marked-to-market in the sole discretion of the facility provider and the facilities are continually subject to margin calls to cure any resulting deficiencies in collateral coverage.  Unlike many similar repurchase facilities, all three are recourse to JRT in the event liquidation of collateral generates a shortfall.
 
The table below shows JRT’s balance sheet (on a book and face value basis), segregating assets and liabilities of its two CDOs (non-recourse), from those assets and liabilities directly held by the Company estimated as of 8/4/08 (i.e., 6/30 balance sheet pro forma for a margin call and loan sale that occurred subsequent to the end of Q2). 
 
Estimated 8/4/08
Outside CDOs Book Value  Face Value
Cash & Equivalents   38.4          38.4
CMBS Unlevered     9.3          68.5
CMBS under Repo    90.9         384.6
Total CMBS Held for Sale   100.2         453.1
Whole Mortgages      -            -  
First Mortgage CRE Loans   44.6           48.6
Mezz Mortgage Loans    43.1           74.0
Total CRE Loans Held for Sale    87.7        122.6
CRE not under repo      -               -  
Accrued Interest Receivable    9.4            9.4
Investments in JVs    3.3            3.3
Deferred Financing Fees    2.1            2.1
Other Assets    2.8            2.8
Total Assets Outside CDOs    243.8         631.6
Repurchase Agreements  (100.6)       (100.6)
Junior Subordinated Debentures   (61.9)         (60.0)
IR Swap Liability   (27.3)       (211.0)
Dividend Payable      -               -  
Other Liabilities   (5.4)           (5.4)
Liabilities Outside CDOs                     (192.5)             (377.0)
 
CDO Assets & Liabilities
Cash & Equivalents    1.2            1.2
CMBS Financed by CDOs 390.5      1,307.6
First Mortgage Loans   45.3           47.1
Mezz Loans 208.3         227.9
Total CRE Loans held for Inv.  253.7         275.0
CDO Notes Payable (431.9)       (974.6)
CDO Equity / Cash Flows                   213.5               609.2
Total Investment Equity 262.1      863.8
 
JRT’s recent adoption of “fair value” accounting renders its book value balance sheet meaningless and, consequently, the analysis below largely ignores them in favor of asset performance inferred by actual cash flows.  Following JRT’s FAS159 election in January 2008, all of its financial assets and CDO-related liabilities are carried at “fair value” (or the lower of cost and FV).  However, rather than undertaken to promote transparency, JRT’s “fair value” accounting actually obscures the health of its balance sheet and promotes the mistaken impression that management’s accounting is conservative.  In fact, JRT undertook the FV election specifically to increase the value of its equity interest in CDOs to avoid a potential covenant (net worth) default under its repurchase agreements.
 
It is important to note that while such fair value accounting is typically dubbed “marked to market”, 100% of JRT’s valuation is designated as “level 3” – meaning values are exclusively based on JRT’s theoretical valuation models rather than actual market values. Even more important to note is that such fair value accounting has no impact on the accrual recognition of investment income used to determine REIT taxable income (and AFFO proxy used by the Street) that govern JRT’s dividend-paying capacity. 
 
In so valuing its assets, management has consistently maintained the tortured view that while its own “fair” valuation of assets must be written down to reflect the market’s grim view of recoveries for analogous assets and liabilities (as reflected by hyperbolic credit spreads), no adjustments need be made to its accrual accounting for investment income because it expects substantially full recoveries. Consequently, while the book value of its CMBS portfolio has been written down by over 70% YTD (to $491mm, reflecting 20%+ credit spreads for the corresponding CMBX at 6/30), virtually none of the distributions currently being received from these investments have been re-designated as returns of principal.  Instead they are recognized as interest income to inflate AFFO.
 
Moreover, there are few real checks on the reasonableness or consistency of the methodology employed.  The most egregious example of this is how JRT’s book value has been written up since December 2007 through a non-sensical write-down of its CDO liabilities. While JRT nominally had a GAAP book value of $263mm ($9.88 per share) on 6/30/08, this only reflected a $432mm carrying value for its CDO note liabilities ($975mm face value).  How management determined this value is unclear (presumably some reference to analogous public CDO debt).  What is clear is that it is utterly irrelevant vis-a-vis JRT as the issuer’s affiliate.  Given the magnitude of the discount and the scale of the liability, even if such valuation reflected actual market trading levels, JRT could not possibly repurchase a substantial share of these notes at such prices (the only context where issuer MTM of its own liabilities makes sense). By comparison, according to management, corresponding, CDO assets had a fair value of $645mm – its best estimate of what an “orderly” sale would produce.  In other words, absent this nonsensical write down of JRT’s own CDO debt, management’s valuation of CDO assets concludes that these vehicles are insolvent.  Excluding the “magical” $214mm in CDO equity value created by such re-valuation, JRT’s book value (as determined by management) would be $49mm ($244mm in non-CDO assets less $195mm in liabilities) or $1.88 per share.
 

Cash Flows & Dividend Coverage

 
As with any REIT, JRT requires both sufficient taxable income (proxied by AFFO in its non-GAAP financial reporting) and sufficient cash to pay its 30-cent dividend on a pass-through basis.  In Q2, reported AFFO was 33 cents.  However, excluding $2.1mm in payable-in-kind (PIK) interest recorded (for the first time) in Q2 and the pro forma impact of a loan sale and margin call that occurred subsequent to the quarter, AFFO would have been approximately 29 cents/share.  This compares to a maximum potential AFFO (i.e., with all investments paying currently based on their stated interest rates, adjusted for corresponding IR hedges) of approximately 40 cents/share. 
 
                                                 8/4/08 Est.                           Quarterly CFs  
Outside CDOs                          Face Value     Rate     100% Perf.  Actual (6/30)
Cash & Equivalents                         38.4          2.0%              0.2               0.2
            CMBS Unlevered                68.5          3.9%              0.7
            CMBS under Repo           384.6          5.3%              5.1                      
Total CMBS Held for Sale            453.1          5.2%              5.8               5.3
                                                                                   
Whole Mortgages                              -                  -                  -                  1.6
First Mortgage CRE Loans               48.6          5.7%              0.7               0.7
Mezz Mortgage Loans                      74.0          8.5%              1.6               1.6
Total CRE Loans Held for Sale        122.6          7.1%            2.3               3.9
Accrued Interest Receivable             9.4              -                     -                  -
Investments in JVs                            3.3              -                     -                  -
Deferred Financing Fees                   2.1              -                     -                  -
Other Assets                                    2.8              -                     -                  -
                                                                                   
Total Assets Outside CDOs        631.6                               8.3                9.4
                                                                                   
Repurchase Agreements                 (100.6)           4.3%          (1.1)               (1.9)
Junior Subordinated Debentures     (60.0)            7.2%         (1.1)              (1.1)
IR Swap Liability                           (211.0)          2.1%         (1.1)              (1.1)
Other Liabilities                                 (5.4)           -                 -                     -            
                                                                                  
Total Liabilities Outside CDOs      (377.0)                          (3.3)            (4.1)
                                                                                   
CDO Assets & Liabilities                                                                            
Cash & Equivalents                                1.2         2.0%            0.0                0.0
CMBS Financed by CDOs               1,307.6         5.9%         19.4              17.7
First Mortgage Loans                            47.1         4.6%           0.5                0.5
Mezz Loans                                         227.9         5.4%           3.1                1.0
Total CRE Loans held for Inv.              275.0          5.3%          3.6                1.5
CDO Notes Payable                          (974.6)         5.7%        (13.8)           (13.5)
                                                                                   
Equity / Cash Flows from CDOs        609.2                              9.2                 5.7
                                                                                   
Total Investment Equity                      863.8                         14.2               10.9
                                                                                   
Fee Income                                                                            0.2                0.2
Total JER Fees                                                                     (1.9)             (1.9)
Cash G&A                                                                           (1.8)             (1.8)
                                                                                   
AFFO                                                                                  10.7               7.4
Per Share                                                                             $0.41         $0.29
Consequently, to continue its dividend, JRT must maintain its current AFFO.  In addition, given its challenged liquidity (discussed below), it must also keep non-cash sources of taxable income (e.g., PIK interest) that might be expected to grow in a loan workout environment to a minimum. In doing so, a critical feature of dividend-paying capacity is that more than 300% of current AFFO is dependent on the two most levered components of JRT’s investment portfolio – CMBS investments located outside ($5.3mm in gross QCF) and inside JRT’s CDOs ($17.7mm or $5.7mm (net) in light of the non-recourse nature of CDO debt).
 

Liquidity

 
As of 8/4, JRT’s liquidity was comprised solely of $38mm in cash on hand (versus $88mm at 12/31/07) with no significant unencumbered assets to obtain additional credit. Substantially all of the reduction in JRT’s liquidity has been due to recurring margin calls under the three repurchase facilities financing its non-CDO assets -- eroding aggregate borrowing under the facilities from $262mm at 12/31/07 to $100mm at 8/4/08. This followed $74mm in margin calls in H2 2007.  JRT funded 2008 margin calls under its GS facility (collateralized by CRE Loans) predominantly through sale of its only two whole loans. Both sales generated small book value losses (inclusive of fees paid to terminate associated IR swaps) for what were arguably its highest quality assets.  In contrast, JRT has been unable to liquidate CMBS collateral under i
JPMC and BS facilities and has needed to satisfy associated margins calls in cash and via the sale of its only traditional real estate investment – the remaining 50% JV interest in a single 12-property net lease (the initial JV interest was sold for liquidity to cover margin calls in October 2007).
 

Short Thesis

1.      JRT’s reliance on cash flows from its CDO-financed investments puts its dividend in jeopardy amid even a modest deterioration in loan performance
 
Reviewing the table above, the vast majority of JRT’s gross investment income ($18mm) is derived from CMBS investments held within its two CDOs.  On average, such CMBS investments represent the first 3% of loss on an aggregate portfolio of $62 billion in CRE loans. 
 
JRT MBS Portfolio
Original Face
Total Face Amount Amount of
CMBS Trust Investment Date of CMBS Issuance Investment First-Loss %
JPMCC 2007- LDP10 March 2007              5,331,517         151,616 2.8%
MSC 2006 HQ8 March 2006              2,731,231         105,707 3.9%
JPMCC 2006- LDP8 September 2006              3,066,028         107,158 3.5%
MLMT 2005 CK11 December 2005              3,073,749           96,066 3.1%
MSCI 2007- HQ11 February 2007              2,417,647           89,530 3.7%
CD 2006- CD3 October 2006              3,571,361         110,713 3.1%
BACM 2005 April 2005              2,322,091           84,663 3.6%
JPMCC 2005-LDP4 September 2005              2,677,075           90,352 3.4%
CGCMT 2006-C4 June 2006              2,263,536           84,395 3.7%
CSFB 2005-C2 May 2005              1,614,084           82,261 5.1%
MSCI 2006- HQ9 August 2006              2,565,238           81,338 3.2%
JPMCC 2004-C3 December 2004              1,517,410           81,561 5.4%
JPMCC 2007- LDP12 August 2007              2,310,556           81,402 3.5%
MLMT 2006- C2 August 2006              1,542,697           60,067 3.9%
JPMCC 2006-CIBC15 June 2006              2,118,303           71,493 3.4%
JPMCC 2005-CIBC11 March 2005              1,800,969           70,035 3.9%
JPMCC 2005-CIBC12 July 2005              2,167,039           70,429 3.3%
MLMT 2004-BPC1 November 2004              1,242,650           76,986 6.2%
MSCI 2005-IQ10 October 2005              1,546,863           55,274 3.6%
GCCFC 2007- GG9 March 2007              6,575,924           34,167 0.5%
MACH 2004-1 (CDO) July 2004                 643,261           50,637 7.9%
CSFB 2004-C4 November 2004              1,138,077           52,976 4.7%
CSFB 1998-C1 August 2004              2,482,942           12,500 0.5%
LB UBS 2005-C3 June 2005              2,060,632           39,335 1.9%
WAMU 2007- SL3 June 2007              1,284,473             6,500 0.5%
LB UBS 2005-C2 April 2005              1,942,131             7,000 0.4%
Total              62,007,484       1,854,161 3.0%
 
However, these investments are themselves further levered approximately 3:1 within JRT’s CDOs (total face value of investments $1.6 billion versus senior CDO debt of $975mm).  As a result, JRT’s ability to receive cash flows derived from the underlying loans (ignoring earlier triggering of senior debt amortization due to over-collateralization covenants) terminates completely upon a 1% delinquency/loss rate.  Put differently, these critical assets are effectively levered 99x.
 
To deflect attention from the instability of this structure, management and the Company’s lone bullish analyst (coincidentally its IPO underwriter, FBR) focus Street attention on the currently low delinquency rates for the aggregate CMBS loan pool – i.e., 60-day delinquency of only 31bps as of 6/30.   This compares favorably with delinquency rates estimates for the CMBS market as a whole (e.g., 43bps for loans in July per Fitch).  By contrast, according to Federal Reserve data, the generally delinquency rate among commercial loans held by banks was 4.24%, 3.46%, 2.73% and 1.98% in Q2 2008, Q1 2008, Q4 2007 and Q3 2007, respectively. Delinquencies for loans held by larger commercial REITs also appear much more challenged and deteriorating:
 

Delinquency Ratios

Company         Q1 2008          Q2 2008

CT                   1.0%                2.9%
GKK               1.3%                9.4%
CSE                 4.2%                5.7%
SFI                  8.0%               10.5%
 
While varying definitions of delinquency and loan size composition play a large role in explaining the sizeable difference between general CRE and CMBS loan delinquencies, several less endogenous factors have also played a large role.  First, the sheer magnitude of CMBS issuance in 2005-2007 has dramatically reduced the average seasoning of loans held in CMBS transactions relative to loans held by banks and REITs. Second, the portion of such loans that have interest-only periods (or are I/O for term) has dramatically increased (from 27% for Q2 2004 issuances to 88% for Q2 2007 issuances). Finally, the more prevalent practice of using loan proceeds to self-fund debt service reserves have effectively provided extensive interest holidays for development properties. Not surprisingly, such loans tend not to default while they fund their own repayment.  
 
Rather than reflect particularly prescient management by JER, JRT’s CMBS transactions reflect these factors temporarily depressing near-term delinquency with particularly acuity.  Of the 26 CMBS transactions, 12 (representing 58% of JRT’s total investment) are 2006 vintage or later.  As a result, the substantial majority of loans underlying these transactions are paying interest only and a substantial number represent loans on properties still in development. As an example, looking to JRT’s largest CMBS investment (JPMCC 2007-LDP10), as of 7/31/08 (based on the trustee’s report), 98 of the underlying 216 loans (representing 78% of the balance of the aggregate pool) were in their interest only term and approximately 38 loans (18%) were on pre-operational properties. 
 
During the last peak in the cycle (Q1 2004), CMBS 60+ day delinquencies peaked at 1.63%.  However, many factors strongly suggest peak rates will substantially exceed this figure in the ensuing period,  not the least of which is the aforementioned share of IO loans (very reminiscent of the sub-prime residential crisis). Based on such market factors, a 1%-1.5% estimate of peak CMBS loan delinquencies (used herein) may prove very generous.
 
Moreover, based on August 2008 trustee reports (consolidated by Trepp), delinquency and special servicing rates appear to be deteriorating quickly towards such a peak. Compared to the 31bps delinquency rate reported by JRT as of 6/30, the comparable 60 day+ rate as of August 1 across all transactions was 42bps.  If one includes 30+ day delinquencies, this figure increases to 63bps.  Furthermore, as of 8/1, 55bps of the aggregate loan pool were transferred to the respective special servicer (for workout) and 13.5% of loans (by UPB) were on the respective servicer “watch lists” (in most cases because debt service coverage ratios fell below underwriting forecasts).  Consequently, it is difficult to understand how “CMBS portfolio cash flow projections generally continue to be in line with original underwriting” (JRT Q2 2008 Press Release, p.1).
 
In addition, the 8 CRE loans that also serve as collateral for CDOII also appear to have been insufficiently marked down.  As of 6/30, the 7 CRE loans held within CDO II were only marked down (to fair value) 8% relative to their face amount despite the fact that 83% of such loans are mezzanine investments.  In fact, such mezzanine loans were only written down 9% despite a comparable write-down of nearly 42% on the Company’s mezzanine loans financed under repurchase agreements. This is despite the fact that the average stated interest rate on the former loans in only 5.4% versus 8.1% on the latter loans while the maturities on the former loans are also shorter than the latter (all 2009 versus 2009-2016). While mezzanine loans are certainly not homogenous investments and, consequently, such a direct comparison may be misplaced, it is more than a little curious that loans under repurchase agreements that are “available for sale” by the Company and MTM independently by its facility providers should be marked down at more than 4x the rate of those loans held in CDOs and, consequently, valued only by JRT/JER.
 
In addition, although none of CRE loans comprising the remaining collateral of CDOII were delinquent as of 6/30/08, as notes above, one such loan, generating more than 2/3 of all CDO-related loan interest income went PIK (contractually) in Q2 2008.  The investment in question – a $60mm participation in a mezzanine loan supporting the redevelopment of Stuyvesant Town/Peter Cooper Village in New York City – is also illustrative of the loan seasoning issue described above. Historically a rent stabilized development on the lower East Side of Manhattan, Stuyvesant Town was purchased by Tishman Speyer and Blackrock in late 2006 based on cash flow projections that assumed substantial unit rent growth through the destabilization of units in accordance with NYC rent control law.  Those interested may wish to read a 8/26/08 NYT article (“Fear of defaults after a Flurry of Apartment House Sales”) for additional background but, suffice it to say, destabilization assumptions have proven far too aggressive and, nearly 2 years following its purchase, the development is still burning through its debt service reserve fund.  
 
Pro forma for the realization of static delinquency/loss rates of 1%, 1% and 10% for the underlying CMBS loan pool (on a blended basis), first mortgage and mezzanine loans held directly by JRT, the Company’s AFFO / dividend capacity would decline from 29 cents in Q2 to approximately 7 cents per share. Conversely, at a loss rate slightly higher than 1.2% (CMBS and first mortgage), JRT’s AFFO would be entirely eliminated.
 
Projected AFFO at 1% CRE Loan Delinquency (10% for Mezzanine Loans)
8/4/08 Est.    QCFs @ 100%      Assumed  Pro Forma 
Outside CDOs Face Value        Rate    Performance        Haircut    Quarterly CFs 
Cash & Equivalents          38.4 2.0%                  0.2           0%                  0.2
Total CMBS Held for Sale         453.1 5.2%                  5.8          33%                  3.9
Total CRE Loans Held for Sale         122.6 7.1%                  2.3           6%                  2.1
Accrued Interest Receivable            9.4                    -          -  
Investments in JVs            3.3                    -          -  
Deferred Financing Fees            2.1                    -          -  
Other Assets            2.8                    -                       -   
Total Assets Outside CDOs         631.6                  8.3                  6.2
Repurchase Agreements       (100.6) 4.3%                 (1.1)                 (1.1)
Junior Subordinated Debentures         (60.0) 7.2%                 (1.1)                 (1.1)
IR Swap Liability        (211.0) 2.1%                 (1.1)                 (1.1)
Dividend Payable             -                     -                      -  
Other Liabilities           (5.4)                    -                      -  
Total Liabilities Outside CDOs        (377.0)                 (3.3)                 (3.3)
CDO Assets & Liabilities
Cash & Equivalents            1.2 2.0%                  0.0            0%                  0.0
CMBS Financed by CDOs      1,307.6 5.9%                19.4           33%                12.9
First Mortgage Loans          47.1 4.6%                  0.5
Mezz Loans         227.9 5.4%                  3.1
Total CRE Loans held for Inv.         275.0 5.3%                  3.6             8%                  3.3
CDO Notes Payable        (974.6) 5.7%               (13.8)               (13.8)
Equity / Cash Flows from CDOs         609.2                  9.2                  2.4
Total Investment Equity         863.8                14.2                  5.3
Fee Income                  0.2             0%                  0.2
Total JER Fees                 (1.9)                 (1.9)
Cash G&A                 (1.8)                 (1.8)
AFFO                10.7                  1.8
Per Share $0.41 $0.07
 
 
Finally, the bulk of such decline – the elimination of cash flows from the CDOs – could occur even without a realized deterioration in credit quality. As in other CDO transactions, the investment grade tranches in these transactions are entitled to redirection of cash flows to accelerate amortization upon the failure of various overcollateralization tests (predominantly, value-to-debt and interest coverage). Subsequent to the end of Q2, ratings on bonds issued by 6 of the CMBS transactions in which JRT’s CDOs invested were downgraded.  Buried on page 29 of JRT’s latest 10-Q is a cryptic disclosure related to the impact of such ratings downgrades that essentially asserts that (i) ratings downgrades only impair collateral under tests for CDO II but not CDO I, (ii) overcollateralization tests could support up to an additional $310mm in asset impairment without being triggered and (iii) a relatively insignificant amount of bonds ($31mm) held in CDO II were downgraded. A carefully reading of this paragraph will reveal, vis-à-vis (ii), that despite a disingenuous effort by management to imply otherwise by backdating the testing date, the collateral cushion mentioned was as tested on 6/30 while the downgrades at issue occurred subsequent to the end of Q2.  More importantly, with respect to (iii), the modest level of bonds downgraded was purely a function of the limited scope of the downgrades. As has been common in such ratings actions in the CMBS space, agencies downgraded only the most junior IG tranches of the 6 effected transactions.  In such situations these downgrades are generally followed by corresponding downgrades of other tranches in short order. In total, JRT has invested $380 million in these 6 transactions.  Consequently, it is possible (though not definite) that purely as a function of rating agency “follow through”, sufficient asset impairment could result to redirect cash flows in CDO II, effectively reducing quarterly cash flows by JRT by $3-4 million.
 
2.      Liquidity issues related to the Company’s repurchase facilities are likely to come to a head soon and end badly
 
As a result of the Bear Stearns acquisition, the Company disclosed in its Q2 results that the JPMC and BS facilities would be consolidated into one facility, that they had reached an agreement in principle to extend the facility through August 2009 but that the aggregate facility size would be substantially reduced. The lack of confidence in the CMBS assets collateralizing these facilities has reflected the near complete absence of liquidity in the associated markets.  However, looking to the interim performance of the CMBX (specifically spreads on the CMBX-NA-BB2 between 6/30 and 8/28) as an indication of likely MTM adjustments of collateral value, such spreads have increased from 2300bps to nearly 3000bps (30%) since the end of Q2. In addition, as of 6/30, the average advance rate under the JPMC facility was 35% higher than the rate under the BS facility (61% versus 45%).  Were the new facility to adopt the lower rates, this contraction along with decline in collateral MTM, could result in a more than 50-55% pro forma reduction in the size of the combined facility (e.g., from $42mm to less than $20mm or less).  Moreover, given that both facilities are collateralized solely by (illiquid) CMBS and the absence of additional unencumbered collateral (other than additional CMBS), any margin calls will likely need to be funded out of cash. Consequently, even in the absence of any additional deterioration in the credit markets or funding obligations, JRT’s cash balance can be expected to decline from $38mm (as of 8/4) to $15-20mm by the end of Q3. This assumes that JRT is not required to fund its remaining $8mm capital obligation to the U.S. Debt Fund.
 
Not only is such liquidity plainly insufficient to support JRT’s dividend in the event of substantial non-cash income, but it provides scarce comfort relative to $75-$80mm in uncommitted repurchase borrowing that will remain outstanding under the GS and new JPMC facilities. Moreover, while margin calls under the GS facility have historically been satisfied through the sale of CRE loan collateral, the skimming of higher quality loans (that were nevertheless sold at losses to BV) strongly suggests that such liquidations will still require substantial cash repayments to satisfy margin requirements.
 
3.      Despite management’s comments to the contrary, JRT has no going-concern value and is purely an asset funding vehicle in run-off 
 
While this point may be too obvious to mention, a casual listener on JRT’s conference could easily be astray by the forcefulness with which management lauds its own experience in the commercial real estate market, the scale of its operations and ability to deliver a “uniquely comprehensive set of financing alternatives” to commercial borrowers. JE Robert, the individual, is exceptionally well regarded by many as a pioneer in the market and JER, the asset manager, may indeed be an exceptional real estate finance company.  However, irrespective of the view one may have regarding JER’s investment acumen or capabilities, JRT has no specific right to these services (it contracts for them like JER’s other funds).  In fact, given the current status of the credit markets in relation to JRT’s “target investments” (e.g., CMBS, CRE mezzanine loans and B-Note participations) and historical funding sources (CDOs and high-advance rate repos), JER has little interest in actively managing JRT as a funding vehicle because, in the current environment, it lacks the financing capacity to generate strong origination/servicing fee growth or liquidity to generate performance fees from asset sales.  Not surprisingly, in late 2007, JER raised an outside $220mm U.S. Debt Fund (CALPERS $200mm, JER $10mm and JRT $10mm) with a target investment profile virtually identical to JRT’s and contractual exclusivity to JER investments through the end of 2008 (pro rata exclusivity with JRT after April).  While JRT earns management fees as a co-manager in this transaction, the Fund amounts to a tacit admission that JRT is dead as a funding vehicle for the foreseeable future. Given how squarely JRT’s business model relied on the worst excesses of the credit bubble (overestimating liquidity and credit performance, underestimating default correlation in securitizations), this is hardly surprising. Consequently, there is a high probably that JRT is will never again be a going concern.  However, even if the Company somehow endures until a time when the credit pendulum has swung back to excess, JRT will lack any native ability to capitalize on these opportunities as JER remains free manage whichever assets it sees fit. 
 

Valuation

 
If performance of the CRE loan pool underlying JRT’s investments declines to a level declines to levels in line with the prior 2004 peak (e.g., 1.5-1.75% delinquency rate), its dividend will be eliminated and JRT is a zero (Downside Case).  If such rates peak reach 1.0%, as noted above, would decline to (at best) 28 cents per year with a remaining life for the investment pool (based on the average term of CDO notes) of 7.5 years, implying an undiscounted future value of $2.10/share ($1.29 PV; i= 10%)(Base Case).  Conversely, even in a rose-colored Upside Case in which JRT’s Q2 AFFO of 33 cents ($1.32/annum) is sustainable over this remaining investment life, JRT shares can only be expected to return cumulative dividends of  $8.58 ($6.09 PV, Upside Case), implying approximately 6% intrinsic risk for the short. 


[3] Finally, JER and JRT “co-manage” (and co-invest) in a $220mm capacity U.S. debt fund with CALPERs (formed in December 2007) with target investments that are essentially identical with those of JRT (i.e., CRE loans and CMBS). 
[2] Aside from a $2mm (of $10mm commitment) investment in the U.S. debt fund.

Catalyst

- Elimination of Dividend

- Liquidity Crisis
    show   sort by    
      Back to top