Gramercy Capital Corporation (GKK) is an interesting stock that should offer investors a limited downside, due to its strong cash position, while potentially representing, on the upside, a kind of an "option" on the turnaround of commercial real estate property in the USA.Some lateral thinking, however, rather than a more classical investing approach, may be necessary/useful to understand why the company, in spite of its recent near-death experience, can belong to the "value investing" category, although some risks that could derail the happy ending still exist. Patience may also be required, as the story doesn't really seem close to get a catalyst.
There are several interesting articles about this stock on the Internet that we suggest you should read, including Plan Maestro's analysis, available also here on Seeking Alpha (I, II), as well as a recent post by Laminar Capital Management - we'll try to add to this commentary our view and an update to the most recent Q4 2011 results.
Some background
Gramercy Capital Corporation was formed in 2004 to assume, and then expand to a national scale, SL Green Realty Corp.'s (SLG) structured finance lending business.
The company organized itself into two complementary areas: Gramercy Finance, focused on the direct origination and acquisition of whole loans, subordinate interests in whole loans, mezzanine loans, preferred equity, CMBS and other real estate securities; and Gramercy Realty, focused on the acquisition and management of commercial properties net leased primarily to regulated financial institutions, mostly banks, throughout the United States.
As we can see from this chart, the company reached its peak in 2007, when it distributed about $4.50 in dividends, and had its shares trading in the mid $30 range:
In 2005, 2006 and 2007 the company issued, through its subsidiaries, 3 CDOs, of about $1 billion each. In connection with these CDOs, Gramercy agreed to provide certain administrative services , in exchange for a senior and a subordinate management fee, while also investing in the lowest level CDO classes, including the preferred.
Back in those years, these financial instruments were considered, at least for the most senior classes, slightly more risky than treasury bonds, while offering subscribers a relatively better return. Ratings were excellent for the most part of the CDO:
It is important to mention this now not-so-obvious fact, as it explains why interests are quite low, in absolute terms, for the owners of the first CDO classes, as resumed in this chart for CDO 2006:
The post-Lehman economic landscape gave these assets a completely different valuation, and it is no surprise that all CDO classes started trading well below face value, as they were seen like risky assets with relatively low returns, and especially soon after the real estate bubble burst, as we may get from this quote from the company s Q4 2008 Earnings Call Transcript:
We purchased $55 million of investment-grade CDO bonds, thereby generating gains of $43.9 million in the fourth quarter.
This excerpt is taken from the same conference call Q&A session:
David Fick - Stifel Nicolaus
Can you address your investment strategy in terms of buying back the CDO bonds, given your capital needs and your ongoing negotiations with your lenders? Why wouldn't you be reserving that or retire debt at this point?
Roger Cozzi
Well, let me take that, David. Yes, sure, we - here is how we think about it. I mean, frankly, if you look at where our CDO bonds are trading, and you take into account - despite the fact that the CDO bonds obviously have a long term to them, I mean in some of these instances, depending upon the class of bonds each of the CDOs, you are in effect retiring $5 of debt for $1 of cash. So, from our standpoint, it looks like a really attractive investment.
This quote is useful as it introduces us to one of the ways GKK management worked, even in difficult times, to "protect" its CDO lower class investment (or, to say it better, the cash flow deriving from it): using corporate cash for bonds redemption (another interesting tool is loans replacement within the CDO, to strengthen its value).
While CDO bonds are now trading closer to full value, GKK has still been able to buy back some of them at a decent discount (about 30%), even recently. Later now we'll see how this can be instrumental to guaranteeing a strong cash flow to GKK corporate, as they are cancelled to reduce the total outstanding and improve compliance with overcollateralization tests (OC tests).
At this link is a quick overview of how CDOs work.
While the "cash flow waterfall" is relatively complex, what matters is that GKK has the opportunity, also by buying back and retiring its own CDO bonds, to maximize the potential cash flow to corporate, something management has done quite proactively in recent times.
A quick mention of another important step taken by the company while it was preparing for the worst: in Q3 2008 the company elected to stop paying dividends on its preferred stock, to improve its liquidity at corporate level.
Recent developments
Fast forward to Q4 2011 - GKK is quite a different animal, today.
The company transferred to KBS the ownership of most of its Realty assets, while retaining a portfolio of 56 buildings (about 750,000 sq.ft. with an aggregate carrying value of about $40 million, and very low occupancy, at about 40%). GKK also entered into an asset management agreement with KBS, to provide for continued management of the former Gramercy Realty assets in exchange for a fixed fee of $10 million per year, plus reimbursement of costs and several incentives. By March 31, KBS and Gramercy should finalize a definitive agreement for the management of these assets, as the existing one is going to expire on June 30, 2012.
Gramercy Corporate owns about $ 163.7 million of unrestricted cash, or roughly $ 140 million, after deducting the interests due to the preferred, and still unpaid. The company also owns about $ 51.4 million (par value) of its own CDOs at corporate level, with a fair value of $ 38.2 million. As these bonds may be used by the company to improve the CDO overcollateralization tests by retiring them, we'll value them at zero. In total, the company still owns about $121.1 million (book value) of commercial real estate.
In other terms, and considering only the cash available at corporate level, GKK has liquidity of about $ 2.75 per share (after considering the preferred arrears). While a true shareholder "liquidation value" should take into consideration deducting the preferred (about $ 88 million), such a calculation should also attribute some value to existing assets that we have basically considered as zero. As we will see, a shareholder who owns both preferred and common equity, Indaba, has recently done a similar exercise coming out with an interesting "fair value" for the company. While we will not consider this level of cash as a floor for the stock, it may be a safe assumption to assume that it may represent a psychological incentive to prevent existing investors from selling the stock, absent major negative news, and as the company keeps adding more cash each quarter.
However, Gramercy Finance is where investors should be looking at for potential upside, in a best case scenario.
In the last few quarters, CDO 2005 and CDO 2006 have been contributing to the company's cash flow, while CDO 2007 has not passed its OC tests. We'll concentrate our attention to the first two CDOs - here is a quick look at their performance, compared to the trigger:
While CDO 2006 has been positively contributing to the company's cash flow in the last few quarters, CDO 2005 has only recently regained results slightly over the OC test.
Let's have a look at what this all means, in terms of cash flow to Gramercy Corporate (from the company's most recent 8-K):
In 2011, GKK received about $ 40.6 million from its CDO 2006 and CDO 2005, while spending about $ 15.5 million (face value of cancelled bonds, probably translating into about/less than $ 11 million really spent by the company, according to the latest valuations of these bonds).
In all honesty, GKK Finance doesn't certainly represent an easy investment to analyze, as we are confronted with what we would call an "Edward De Bono investment approach".
We probably need to consider the investment originally made by GKK into its own CDO lowest classes as lost money - in line with the fact that the market is giving these assets no value. What is left, however, is the opportunity, for GKK corporate, to benefit from the strong cash flow that can be generated by the same CDOs - or at least two of them, right now.
Let's consider these two performing CDOs (2005 and 2006) like the opportunity to have slightly less than $1 billion, for each CDO, invested in CRE, (other people's money, really), with an agreement that allows to keep the largest share of the return obtained - as the CDOs are paying about/less than 1% only to the most senior classes.
Say getting most of the rebates, using someone else's money to pay for the goods.
To add more complication to this kind of lateral thinking, buying back these CDO bonds, useful to guarantee cash flow to corporate by retiring them, costs considerably less than their face value, so you're really spending 70 cents to get a face $1 value, that can be used to generate several other dollars in cash flow (the "$11 million spend" in 2011 with a $ 40.6 million cash flow advantage for GKK). These 70 cents may also end up being lately repaid as $1, if "unused".
We understand this may not represent a very professional way to discuss the advantages (and potential returns) of buying back and retiring CDO bonds, so we invite you to have a look at this post from BMExpress for a more solid explanation.
From a different point of view, while all this activity can guarantee an interesting cash flow to the company, the real bet on Gramercy is represented by the potential improvement of the CRE owned by the company, both at corporate level and in its CDOs - which is the reason why we mentioned this investment, at the very beginning of this article, as (potentially) an option on USA CRE.
While examining all the real estate owned, directly or not, by the company is a difficult task, it is not impossible. The feeling is that the worst may now be behind the company, and a few good news are emerging. For example, the company just reported that a three-building commercial office complex was sold in January 2012, with a $16.1 million benefit for the company in unrestricted cash (about $0.31 per share), including repayment to the company's CDO loan (there are several incestuous deals like this hidden in the balance sheet).
Which leads us to Q4 2011 results, but just after mentioning in more details Inbada's analysis of the value of the company, contained in their 13/D filing made on September 30, 2011.
As you may see in this summary, these investors are evaluating the company, in a sum of the parts analysis, in between $ 4.05 and $ 7.11 a share.
Q4 2011 results
First, the good news, before we talk about the reasons why the market was not excited by these numbers, sending the stock down in the following trading sessions.
Unrestricted cash increased from $154.5 million at the end of Q3 2011 to $ 163.7 million, or $ 9.2 million in a single quarter - say $7.5 million after deducting the preferred shares interests (i.e. $ 0.15 /share net of preferred payment).
In Q1 2012, both CDO 2005 and CDO 2006 will distribute to the company about $16.3 million - let's add to this about $2.5 million for the KBS management fee, and the $ 16.1 million obtained for the sale of the three-building commercial office complex, and we should see unrestricted cash experience another nice leg up (we speculate in excess of $ 25 million, or $0.49 per share).
Mr. Market, however, did not like these numbers - or, better, what the company did not say.
As we noticed, GKK needs to find a new, definitive agreement with KBS for the management of their assets, as the existing one is going to expire at the end of Q2. Mr. Market doesn't like uncertainties.
The company also reiterated that it is looking for strategic alternatives, as the existing business model is insufficient in the long term (the company's CDOs, by their nature, will "wind-down" sooner or later, and the existing cash, while at a good level, is not enough to pursue different business models) - here is a quote taken from the company's 10K, pg. 3:
In June 2011, our board of directors established a special committee to direct and oversee an exploration of strategic alternatives available to us subsequent to the execution of the Settlement Agreement for Gramercy Realty's assets. The special committee is considering the feasibility of raising debt or equity capital, the possibility of a strategic combination of our company, a strategic sale of our assets, or modifying our business plan, including making additional debt repurchases or investing our available capital outside of our CDOs. At the direction of the special committee, we engaged Wells Fargo Securities, LLC to act as our financial advisor and to assist in the process.
While an acquisition might be made at a premium for shareholders (and GKK could represent an interesting platform for the buyer, not to mention the potential value of the assets), raising equity wouldn't probably strengthen the share price - again, there's uncertainty, and Mr. Market isn't delighted to know that the direction isn't clear.
Having also said that SL Green Realty Corp. has been liquidating its position in the last few months, adding selling pressure to the stock, there are several other reasons explaining why the stock reacted negatively to the quarterly report. REIT investors usually love reinstating dividends (or, in case of GKK, at least the payment of the preferred arrears), and also this news did not come with Q4 2011 results. Add no conference call, and the fact that Gramercy's financials would probably need a lot of management effort to be properly presented to investors (something the company isn't exactly doing, as its communications to the market are rare and mostly forced by the need for filings), and we get enough reasons to justify a sell off.
If you believe time might be finally on the company's side, as CRE improvement in valuation translates in more value for GKK, and the company has no real pressure looking for the best possible exit way to re-launch the company, GKK may represent an interesting investment for what looks like the medium to long term, absent buy out news or other catalysts that don't really seem to be close to materializing, right now. Glad to be proven wrong, if good news arise sooner than later …
Disclosure: I am long GKK.
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