Description

Price Target: $15.00 (45% up); risk price: $9.00; risk-reward: 1 to 3

Resource Capital Corp is a commercial mortgage REIT that languished for years under the Cohen family’s Resource America. The manager was purchased in 2016 by Andrew Farkas’s C-III Capital, which (1) slashed the dividend; (2) announced plans to divest non-core businesses; and (3) haircut NAV by nearly 15%. The market reaction to these curative actions was severe, sending shares from $12.50 to $8.50. One year later, the turnaround is nearly complete, yet the shares have only recovered half of that drop and still trade at a sharp discount to NAV.

Early this year, ele2996 wrote up the company, focusing on the pedigreed team from C-III (whose quality has been further demonstrated over the past few quarters). A number of events have transpired since then that have de-risked the story and enable us to project the path forward.

Resource Capital is a commercial mortgage REIT. Its core business is transitional real estate lending: short-term, first lien debt backed by non-stabilized commercial real estate. Examples of “non-stabilized” real estate include: apartments having their kitchen appliances upgraded; adjacent hotels that are merging into one; and dying retail centers being repurposed as medical office complexes. In a typical transaction, RSO will underwrite and pool a portfolio of three-year loans at 70% LTVs and L+500, then sell off the 0-50% LTV slice at L+150 to create synthetic mezzanine loans generating a low-to-mid teens yield. The legacy team at RSO has been pretty good at this: since 2014, they originated $1.7bn of CRE loans and generated double-digit levered returns without significant losses (note: RSO did recognize some losses on pre-crisis deals during this period).

However, this was not enough to satisfy RSO’s former managers, who tried to use the mortgage REIT to seed other AUM-gathering strategies, including:

• Middle market lending, which barely broke even over the past three years, despite tying up over 10% of RSO’s capital;
• Residential mortgage banking, which generated negative returns over the three years that they operated it;
• Small equipment lease financing, which has generated single-digit returns over the past few years;
• CLOs, viaticals, etc.

Management raised high-cost corporate debt and preferred equity to feed these challenged, subscale, non-core businesses, wrapping the whole package in an unsustainable dividend policy to hide the poor returns. Thus was the stage set for C-III in assuming management of RSO in late 2016.

Given the extent of the mess created by the Cohens, it is impressive that C-III was able to right the ship in just one year. Consider the following:

• Non-core businesses divested – in the year prior to C-III taking over, non-CRE lending businesses accounted for 30% of assets. This included several assets that were difficult to value and expected to take years to sell. Management announced the divestiture of the largest of such assets in July, selling the equipment lease finance for $1.30 per share above its mark. After this sale, non-core assets are down to just 10% of assets, with nearly all of that balance accounted for by loans with deep markets and decent price discovery (residential mortgage and broadly syndicated middle market loans). There remain MSRs ($20mn) and viatical contracts ($6mn), but, even if these sold for a 25% discount to mark, the impact would be immaterial. This key step in the transformation is essentially complete and de-risked.
• Capital structure fixed – the Cohens left RSO with an imbalanced capital structure consisting of more corporate unsecured debt and preferred equity than common equity. C-III has stabilized NAV, and they carried out a debt exchange last month that lowered the cost of unsecured debt by 300bps. More importantly, the exchange was into convertible debt that strikes at a modest discount to NAV, setting the stage for a debt-to-equity conversion that would shrink corporate debt by half and increase common equity by a third with only modest NAV dilution. Furthermore, the majority of RSO’s preferred stock becomes callable next month, and we expect a similar exchange/issuance of convertible preferred stock. Pro forma for the two exchange/conversions, common equity jumps from under 45% of the stack to over 75%.
• Modest leverage – even without addressing the capital stack, RSO’s asset sales have brought its leverage down. Now, for every 1% change in the fair value of its risk assets, NAV moves 3.7%. Pro forma for the conversions discussed above, this metric falls to 2.3%. Both compare favorably to peers: 3.9% for BXMT, 4.0% for similarly-sized ACRE, and 18% for similarly-sized RAS. While we expect leverage to move up over time as they deploy capital, the balance sheet puts them in a position of strength and mitigates near-term market risk.
• Access to a best-in-class lending platform – those unfamiliar with C-III may not fully appreciate the value that they bring to RSO, but their expertise is on par with best-in-class peers. As the special servicer to over $80bn in CMBSs, they are a top-three special servicer alongside Starwood (LNR) and Rialto. The brokerage NAI global is also part of C-III’s platform. Access to this platform gives RSO strong deal flow, institutional resources, and deep expertise to aid in underwriting and working through any problems that arise.
• Cost of debt already reflects successful turnaround – though the equity markets may not yet reflect C-III’s turnaround of RSO, the debt markets already do. Consider their most recent CRE debt securitization, closed in July at L+103—the tightest of any post-crisis CRE CLO. This compares to RSO’s last securitization, which priced in August 2015 at L+171. Or consider the unsecured convertible notes they placed in August at 4.50%.  This is 350bps tighter than the unsecured convertible notes that they replaced, issued in January 2015. And it is a mere eighth of a point wider than the analogous issue placed by BXMT one day later. Indeed, the debt markets are treating C-III’s turnaround of RSO as complete.
• Secular Tailwinds – in principle, this is a commodity lending business; however, we are in a regulatory environment that is favorable to lenders such as RSO. Transitional CRE loans offer lower cash flow coverage than corresponding stabilized CRE loans because the underlying properties generate less revenue while under construction. During the financial crisis, many banks that extended transitional loans found themselves foreclosing upon properties that were not generating cash, putting additional pressure on their liquidity. Regulators have responded by pressuring banks to exit the transitional lending business (e.g., Basel III risk weightings on “high-volatility” CRE loans). With regulation crimping the supply of capital, mortgage REITs (e.g., RSO, BXMT, STWD, etc.) and other private lenders benefit from higher deal flow and improved terms/pricing.
• Earnings Power– RSO has $900mn+ of capital (common + preferred + corporate debt). If we assume $100mn is required for working capital, we are left with $800mn+ of deployable capital.  Investing this capital at 12.5% (note: their most recent securitization yields over 14%) gives an EPS over $1.25:

• Earnings Growth Paced by Capital Deployment – the high cost of debt + preferred equity, combined with the capital trapped in low-return assets, has led to negligible core earnings in H1 2017. One-time expenses (e.g., debt exchange costs) should dominate Q3, but core earnings should start to become evident early in 2018, with growth limited by the time that it takes to deploy the newly freed-up capital into the core CRE lending business. Management commentary and historical precedent suggest they can originate $100mn+ net CRE loans per quarter. The $800mn of deployable capital assumption from above requires an incremental $1bn net originations to fully deploy, which should take until late 2019 at that rate. However, if we consider that they will apply $100-200mn of excess liquidity toward CMBS trading activities, then the ramp to $1.00 run-rate EPS should take just a year.
• Dividend Ramp – RSO currently pays a $0.20 annual dividend. We expect this to ramp to $1.00 per year by the end of 2018, with the ability to rise above $1.25 a year later. This would represent a covered 12%+ yield, while quality peers’ yields range from 6.8-8.8% (STWD, BXMT, KREF, TRTX). On a $1.25 annual dividend, this range represents 40-80% upside from RSO’s current trading price.

Catalyst

• Demonstration of positive core earnings (anticipated Q4/Q1)
• Rebranding and analyst day (anticipated H1 2018)
• Earnings and dividend growth (anticipated late 2018)