The Right REIT at the Right Time

05/23/2012 10:45 am EST

Focus: REITS

Bryan Perry

Editor, Cash Machine, Premium Income, Quick Income Trader, Instant Income Trader

As the financial sector gets over its housing hangover, it's finally in condition to find opportunity in some of the wreckage it helped create during the past few years, notes Bryan Perry of Cash Machine.

More articles keep popping up about distressed mortgages being a real go-to sector for large institutional buyers who are seeking yield and upside.

Cash Machine already has positions in mortgage REITs that invest in conforming and non-conforming residential mortgage-backed securities (RMBS)—and so far, those trades are working very well for us. Shares of American Capital Agency (AGNC), Two Harbors Investment (TWO) and PennyMac Mortgage (PMT) are all within a point of their 52-week highs, which says volumes in the current market.

Since adding those three residential mortgage plays, I also recommended the purchase of Newcastle Investment (NCT), which invests in residential and commercial real estate mortgages while also growing its mortgage servicing sector.

Again, the stock has been a winner to date, and is a smidge away from its yearly high. No complaints with any of these holdings, as we're averaging dividend yields of 13.5% on them.

This month, I'm rounding out our exposure in this very attractive sector with the addition of NorthStar Realty Finance (NRF), a finance real estate investment trust that originates, acquires, and manages portfolios of commercial real estate debt, commercial real estate securities, and net lease properties.

NorthStar also engages in asset management and other activities related to real estate and real estate finance. NRF yields 11.1%.

Unlike the RMBS business that characterizes the three mREITs noted above, NorthStar is more fully engaged in what would be termed commercial mortgage-backed securities (CMBS). The company doesn't just trade in secondary markets, but rather it originates and structures debt investments, net leases, mezzanine loans, credit tenant loans and other collateralized debt obligations (CDOs) that represent approximately 44% of its portfolio holdings.

It wasn't too long ago that CDOs were a toxic acronym being tossed around as the primary security blamed for much of the mortgage meltdown in 2008-2009. It isn't that CDOs weren't a good instrument as a stand-alone structured security; it's the way they were leveraged and packaged that brought about the calamity. Call it another case of a good idea that got into the hands of unchecked greed.

But here's the diamond-in-the-rough part of this investment theme: As of March 31, the principal proceeds that NorthStar could receive from its owned CDO bonds is $706 million, of which $527 million was repurchased at an average price of 36 cents on the dollar in the secondary market with a weighted average original credit rating of AA-/Aa3.


This discount to par of $339 million represents potential imbedded cash flows that may be realized in future periods. That's the honey on the comb that all the bees are buzzing about: deeply discounted mortgages that are getting healthy once again.

The company also is expanding its presence in net lease property management, acquiring commercial real estate assets throughout the United States that are leased to corporate tenants, including health-care operators, general purpose office, industrial, and retail, with the highest concentration in skilled and assisted health-care facilities. The net lease operations make up about 14% of the company's portfolio.

Similar to Newcastle Investment, NorthStar is growing its mortgage servicing business for its portfolio as well as for other third parties on a fee basis, acting as a market maker for non-traded REITs and CMBS securities while providing interim financing to counterparties for secured term financing. There's a lot of continuity and overlap within the various subdivisions of the company, all of which print money.

The main attraction of NRF is the high probability of rapidly-growing dividend payouts based on the recovery of the commercial real estate market in the United States. The stock's highly constructive pattern shows it breaking out to the upside following a strong earnings report and the declaration of a 15-cent quarterly dividend that's 11% higher from the prior quarter's dividend and a 50% increase over the last three quarters.

Seizing on the momentum, NRF announced the pricing of a secondary stock offering of 20 million shares at $5.70 on May 4. That will pressure the stock. But this is providing us a very attractive entry point in a stock that otherwise would be trading well above $6, instead of the $5.20 to $5.30 price where I believe we can establish a cost basis.

REITs have continued to perform well this year as the US housing market finally shows signs of a long-awaited recovery. Record-low mortgage rates, lower prices, and an improving job market appear to be encouraging many potential buyers, and professional money has fallen in love with the lofty dividend yields these stocks generate. In this economy, 10% to 16% in the hand is better than most growth prospects in the bush.

In the first quarter of 2012, the company blew past estimates by 23%, posting 47 cents per share against forecasts of 38 cents, on a total of $7 billion of assets under management. All the smartest people on Wall Street who got the "fall guy" treatment back in 2008-2009 now are working for companies like NorthStar and our other holdings within this revitalized sector.

Shares of NorthStar traded at $18 in early 2007. If they get back up to half that level, we'll book a double with our dividends. Buy NRF under $6.

Related Reading:

Grow with Your Dividends

Look Beyond the Usual Dividend Suspects

How Annuities Can Work Within Your IRA

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