Description

LNR is a real estate investment firm with the unique pairing of an extensive due diligence process and workout skills. This combination generates ROEs of 20%. It also provides a barrier to entry in its largest and most profitable segment, investing in junior tranches of CMBS securities. LNR sells at a discount to NAV, and with growth about to accelerate, LNR stock is poised to provide a 40% return in 18 months, with very little downside risk.

OVERVIEW

LNR operates in three segments. LNR’s Property segment develops new properties or repositions older or distressed properties in the marketplace for substantial operating improvements. NOI on operating properties is 13% on historical book, compared to market 8-9% capitalization rates. LNR’s Loan segment invests in high yield loans or discounted loan portfolios. It has the experience of working out over $13B in non performing loans in the US and Japan in the 90s. The Securities segment invests in the junior end of the CMBS market, and is LNR’s primary focus going forward. LNR’s business is to ENHANCE the CASH FLOW of the underlying properties, and so it derives superior returns on its investments

In addition, LNR participates in partnerships which are accounted for using the equity method. Only $36.5MM of $1.91B in partnership liabilities is recourse to the company. LNR also generates substantial fees operating the partnerships, and for acting as the special servicer of CMBS pools. Its investments are well diversified in various sub markets of commercial real estate, and represent properties in all 50 states, and now in Europe as of 2nd quarter 2002.

CMBS PERFORMANCE

Since the first of the year, LNR has been the largest buyer of nonrated CMBS securities. LNR’s process is to examine each underlying property in every pool, and underwrite it once more. This due diligence requires extensive legwork and is the ‘moat’ in this lucrative niche that has limited new competitors. LNR negotiates to remove the more risky assets from the pool. It then buys the lower rated or non rated tranches at very significant discounts, with the provision that LNR will serve as the special servicer. The special servicer works to resolve problem loans that arise in the portfolio. Thus LNR is in the position to actively manage those elements of its investment that need workout. LNR is approaching 2.4B in face amount of CMBS at a cost of $1.1B. Market delinquencies in these securities have run just under 2%. LNR’s own experience has been 1.3%

In its most recent CC, the results of this are seen in its nonrated CMBS of at least 3 years holding: on a book value of $140MM, $355MM has been collected, $630MM more will be collected. These statistics account for 43% of LNR’s unrated CMBS pool.

In the 2/02 10Q, LNR’s amortized cost for all its CMBS securities is 45 cents on the dollar. The cash yield is presently 15.0%. The ‘book yield’ is 17.1%, which is based on interest income recognized. The share of operating earnings from this segment grew from 52% in 2000 to 58% in 2001.

CONSERVATIVE ACCOUNTING

LNR establishes a level yield estimate for each CMBS it holds. Cash amounts received in excess of those estimates are used to reduce the cost of the security and are not reflected in earnings. Last year this was $25.2MM or 73 cents/share. ‘Fair Value’ accounting was applied to the entire CMBS portfolio in 2001. LNR did not run this adjusment through earnings, but it resulted in an increase in equity of $10, pretax. At the end of the second quarter, LNR estimates there is a remaining $400MM in non balance sheet fair value, 89% in the Properties segment. This is $6.96 net after a 40% tax rate.

OVERALL FINANCIAL PERFORMANCE

At the end of the 2001 fiscal year, LNR earned $135MM (28% profit margin) on revenues of $478MM and held total assets of $2.8B. Debt was $1.4B, market cap is 1.2B, and LNR’s EBITDA for 2001 was $342MM. Thus it is valued at a multiple of 7.6 x EBITDA, just 2/3 the multiple of comparable entities. EBITDA has grown at a 29% compounded rate in the four years since the end of FY1997.

Stockholder’s Equity Nov. 1997: $15.75

Stockholder’s Equity Nov. 2001: $32.54 compounded ROE 20% (NOT including the unstated appreciation (after tax) in the properties segment...with this compounded ROE on approximately $40 of equity would be about 26%) At the end of the second quarter, book is $33.32, and NAV is $40.25.

Diluted Earnings Nov. 1997: $1.22

Diluted Earnings Nov. 2001: $3.87 compounded growth 34%


EXPECTATIONS

Earnings are flattening this year in comparison to 2001. Quite simply, LNR pulled in its horns in the second half of 2001 as the economy slowed. LNR increased liquidity to take advantage of better deals ahead. LNR is now resuming its expansion. It’s deal rate for the first 6 months for FY2002 is around $700MM in pipeline and closings. At the end of 5/02, LNR had $950MM of available liquidity. LNR will be pricing (some at a discount) a securitization of $416MM of face value of its CMBS portfolio to further enable capital expansion.

Based on my estimated earnings of over $9 in 2002 and 2003, book value will exceed $41.50 at the end of 2003. Add in $7 for present net non book equity and NAV is at $48.50. Further add in $1 or 2 for additional unrealized appreciation of newly operating properties and seasoned CMBS securities and LNR NAV hits $50 easily by year end 2003. LNR has traded within 95% of NAV this year. That suggests an 18 month target price of $47.50, or 40% return in 18 months (from $34.00).

This is without any kicker of expanding multiples. Should that occur, returns would be substantially higher.

Catalyst

LNR is expanding its asset base once more, and earnings and equity growth will follow. Comparisons will become increasingly favorable in the year ahead promoting renewed appreciation for the stock. Additional documentation follows in four posts in the message section.