Description

NB: this is my application idea and the price has moved up a +12% during the approval process. The numbers in the write-up utilize the old price. 

Also, as an update to the below write-up, Ladder made a preliminary Q4'15 announcement today. 

Mid-point EPS of $0.44

Small recovery from the disappointing $0.42 in Q3 despite spreads continuing to widen thus likely hurting their securitization margin in Q4. Suggests getting back towards $0.50 (pre January split adjustment) should be possible.

Even at $0.44, its 11.7% annualized ROE, 0.78x book and 6.7x earnings. Dividend of $0.275 is covered 1.6x (9.3% yield on pre split share price). They have a $50m buyback authorization that they should hopefully start using (4.3% of shares).

I like this update at the midpoint of the range.

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Description

Ladder Capital ("LADR") is a simple business that is nonetheless misunderstood and lacks a natural investor base for reasons I explain below. This has led to mispiring 30-40% below liquidiation value while the company continues to generate ample profits and pay out over 10% dividend.

LADR is an internally-managed commercial real estate finance REIT. It has $5.4bn of invested assets split amongst the following:

- Mortgage loans held on balance sheet (33% of assets, 40% of income)
- Mortgage loans for securitization (6% of assets, 25% of income)
- Mortgage securities - predominantly AAA CMBS (45% of assets, 16% of income)
- Leased real estate (16% of assets, 18% of income)

By looking at the share price, one might think LADR invests in particularly risky instruments. However, I think these assets are generally high quality. To give you a sense, the below provides a little more detail about the assets. 


MORTGAGE LOANS - HELD ON BALANCE SHEET

- 85% are first lien mortgages with the remaining amount being mezzanine loans
- Weighted average LTV exposure: 67%
- 75% floating rate portfolio
- $22m is average loan balance (in a $1.5bn portfolio)
- Diversified geographically (37% north east, 32% south, 14% midwest, 7% west, 2% southwest, 8% various)

Ladder has not experienced any credit losses since inception.


MORTGAGE LOANS - CONDUITS FOR SECURITIZATION

Ladder pools originated commercial mortgages and sells them into the securitization market. This is a high return business because they can recycle the capital up to 8x per year. 

An illustrative example is as follows. Originate $100m of mortgages using 40% equity ($40m) and 60% of financing. Sell the securitization for $102.5m (illustrative 2.5% profit margin) shortly thereafter. Thats $2.5m profit on $40m equity = 6.25% ROE.

If you do 8 of these per year, you get 50% ROE. Hence, why this portion is only 6% of assets but 25% of income in the table above.

Due to the experienced management and their underwriting track record, their securitization are in demand in the market.

Note, in 29 securitization transactions since inception to March 2015, the weighted average profit margin was 5.3% (above example used 2.5%). But as markets get frothier and capital looser, the profit margins tend to compress. The LTM profit margins in Q2'15 were still a healthy 3.1%. But they fell to 1.4% in Q3'15 due to temporary factors. This in part is leading to the cheapness and is discussed below.


MORTGAGE SECURITIES

85% of these are AAA rated and 98% are investment grade. All are senior secured instruments, secured by first lien mortgages. The weighted average duration is 3.5 years.

This business are is a fairly simple 'carry trade' where you match up funding / asset duration and earn a spread until maturity. As long as funding is cheap, this business works quite nicely. Its not a massive earner though, hence the smaller contribution to income versus asset intensity.

This business is more profitable due to cheap FHLB funding which is being withdrawn (discussed below). This is a negative headline that is not as bad as it seems.


LEASED COMMERCIAL REAL ESTATE

These are 100% owned net lease properties. Individually financed by non-recourse mortgage financing. 


WHY IS THERE LACK OF FOCUS ON SPECIFIC PRODUCT?

Ladder maintains flexibility to allocate capital towards best risk reward area. Generally, during periods of high credit demand their securitization business does well. During market disruptions, they allocate more capital towards towards mortgage securities (i.e. when spreads widen). And for owned real estate they are opportunistic all the time. 

The purchase history of mortgage securities shows this best:

- Purchased $2.6bn of mortgage securities during the Financial Crisis
- Inactive during Q2-Q4 2010
- Purchasd $915m during the Japan Nuclear Crisis / Euro Crisis / US downgrade in 2011
- Inactive between Q2'12-Q2'13
- Purchased $1.1bn during the Fed Taper tantrum
- Purchased $1.6bn during the Russia-Ukraine fallout. 
- They have effectively recycled capital to where they see the best opportunities. This has allowed them to be more selective in their owned real estate investments.

This has also led to market leading ROEs for a REIT that is not overly levered (discussed below) and invests in First Lien investment grade products. ROEs were above 15% in 2013 and 2014. 2015 ROEs took a hit due to temporary factors explained below.


LEVERAGE

The bank loan covenant limit is 3.5x debt:equity and the unsecured corp bonds net debt incurrence limit is 4.0x.

The company targets a 2.0-3.0x range. However, given certain parts of assets are owned real estate where leverage ratios are typically much higher the actual leverage is lower on the securities portion and the mortgage loan portion.

Right now, Ladder is at the top end of its range (2.8x) with counterparty diversity (besides FHLB discussed below) and match funding.

This is significantly below the leverage levels of pure mREITs with which Ladder is mistakenly compared. However, a lot of them also have high portion of assets in agency backed securities which are guaranteed.


WHY HAS THE STOCK SOLD OFF / WHY THE CURRENT OPPORTUNITY EXISTS

A couple of reasons:

- FHLB funding withdrawal
- Spread widening hurt securitization profits
- Inaccurate dividend yield benchmarks
- Broader REIT / mREIT sell-off

Firstly, FHLB funding. The FHFA has altered its rules so that mREITs can no longer use a loop hole by creating captive insurance companies to access cheap funding. On the face of it, this looks like a massive deal for Ladder as 50% (!) of their balance sheet is funded by FHLB money. The headline that Ladder will no longer be able to use this facility created fears of forced selling, margin calls etc. 

The facts are that Ladder Capital has a sunset period of 5 years meaning nothing has changed in the near future. Assuming the entire FHLB money is replaced with funding that costs 75-125bps more, the 2015 EPS impact would be 7.5-12.5%. At 150bps mark-up, it would be 15%.

That's assuming Ladder would have bought the same securities. AAA-rated CMBS securities yields are low and it might be that Ladder mostly exists the carry trade and moves more into mortgage origination / owned real estate. Even if ROEs fall to 10%, the stock should still be worth book value which is upwards of $14.

There are other conditions for FHLB access such as maximum limits. The one that likely applies to Ladder is that FHLB funding should not be more than 40% of assets. The company has told brokers that their insurance subsidiary has sufficient assets and that FHLB funding is currently 31% of assets and would even have room to grow.

So in summary, the FHLB money was nice. But Ladder does not need it to function and anyway, this is an issue in several years.

Secondly, recent results have disappointed due to spreads widening in the securitization business. Ladder originates mortgages and underwrites them with a certain locked-in spread for securitization. But it holds these mortgages for 1-3 months before they are bundled into a securitization. If spreads widen during that time period, the profit they make on the securitization will be reduced (and vice versa). Q3'15 saw significant spread moves which continued into Q4'15. On the Q3'15 call management illustrated this point:

"In our three securitizations in the third quarter, this class sold at progressively wider spreads of 102 basis points, 116 basis points and 122 basis points over the curve in July, August and September, as investors demanded higher returns as market conditions deteriorated. These wider credit spreads had the effect of causing us to realize an asset average profit margin of 1.42% or $12.2 million on the sale of $860 million of loans in the quarter. This result was 2% below what we had been expecting while we were accumulating loans for the securitizations. In short, our conduit business housed in our taxable REIT subsidiary made $17 million less than we had hoped for in pre-tax earnings during the quarter. While the results in our gain on sale business were disappointing, I was happy to see that all three of our securitizations were profitable and that our pricing model built in enough targeted profit margin to have kept all of our loan sales in the black during a quarter where seemingly no spread product was spared"

This impact may well continue but it should not effect the earnings power of the business on an ongoing basis.

Thirdly, Ladder suffers from inaccurate dividend yield benchmarking due to its mix of businesses. It actually performs the securitization business in a taxable REIT structure and can therefore retain earnings. Its payout ratio was "only" 50% on normalized earnings before the securitization margins hit. Even after, the dividend was more than covered. Therefore to compare the dividend yield to REITs that payout 100% of distributable income severely undervalues LADR's earnings power and its dividend safety. It also means that LADR does not have to raise equity to grow as earnings are retained for internal investment. 

MANAGEMENT TEAM

The management team is led by Brian Harris who is the CEO and founder of LADR. He was a Senior Partner, MD and Global Head of Commercial Real Estate at Dillon Read Capital Management, a wholly owned subsidiary of UBS, managing over $500 million of equity capital from UBS for Dillon Read’s commercial real estate activities globally. Before joining Dillon Read, he was MD and Head of Global Commercial RE at UBS, managing UBS’ proprietary commercial real estate activities globally. He also served as a Member of the BoD of UBS Investment Bank. Prior to joining UBS, he was Head of Commercial Mortgage Trading at Credit Suisse. 

The team has an average of 26 years of industry experience and own over 10% of the company (over $100m equity ownership). 

Pride themselves on discplined credit culture with zero credit losses since inception.


CONCLUSION

A REIT trading at a 30% discount to book value. Book value underpinned by high quality assets and prudent leverage. Management and securitization strategy generates 10-15% ROEs. This puts stock on 5-7x earnings with a well covered 10% dividend yield.

Internal management and good performance deserve a 1.0-1.2x book value valuation implying 40-70% upside excluding the dividend coupon.


RISKS

- Blow up of commercial real estate industry
- Disqualifying itself for FHLB funding somehow before sunset expires

Catalyst

1) First management commentary on impact of FHLB ruling at Q4'15 results (imminent)

2) Spread normalization in securitization business (unlikely before Q1'16 results in April / May 2016)
3) Bottoming of mREIT sell-off
4) Continued good performance