Tag: real estate

A Ladder Over Pandemic Waters: Short Duration, Quality Loans Give $LADR Rung Up

Reading Time: 9 minutes

Ladder Capital stock is a high conviction name for me. It is one where I see little downside and significant upside and also a situation where you are paid to wait (~10.8% dividend). Lastly, I can’t say enough how high I hold management (which also owns ~10-11% of the equity).

Ladder Capital is a mortgage REIT. Unlike typical REITs that specialize in the actual real estate, mortgage REITs specialize in… you guessed it… the mortgages that secure property.

Mortgage REITs have sold off significantly as the market becomes more concerned with commercial real estate. Several mortgage REITs used significant repo financing coming into the COVID crisis, so when there was a disruption in the mortgage market and all securities were crashing, several seemed unable to meet their margin calls…

That did not really impact LADR. In fact, management issued an unsecured corporate bond in 2019 to reduce reliance on repo funding… very timely. Did I mention management is A+ quality?

I tend to think of LADR as an investment company. We want them to make high earning, good risk/reward assets and we understand that they will use leverage in normal course of business. “Do what you think will make money, just don’t blow yourself up.” It’s clear to me they realize all of this.


LADR trades at a steep discount to book. In a hypothetical scenario, we need to ask ourselves that if we foreclosed on LADR, would we get book value or not. What price could we liquidate the assets for in an orderly liquidation. If we can get book value, the stock has 65%+ upside.

See, a lot of times investors buy financial assets below book value. But if the assets are earning a low ROE, the book value may be worth a low amount. Or you may not realize that book value for a long, long time (think of a 100 year bond with a 1% coupon when prevailing rates are at 6%… it will take a long time to get “book value”.)

My goal of this post is to show you that you can bank on book value here. And that because of the short duration of the assets, we know cash will be coming back in the door soon. As a friend put it, soon a large majority of Ladder’s book will actually be post-COVID loans…

Here is my thesis:

  • Ladder’s book is high quality; Stock at ~60% of GAAP book value, 52% when incorporating appreciation of real estate
    • Book consists of transitional first lien mortgages (which I’ll define later), but also investment grade CMBS, small amount of conduit loans, and they also have a portfolio of triple-net leased properties and other CRE that they own outright.
    • ~93% of their market cap in unrestricted cash; Or 14% of assets
    • 43% of asset base is unencumbered, 74% of which is either cash or first mortgages. This means the company has significant borrowing capacity as well (which is important, as LADR is like a bank – you want them to take $1 and make $2 or $3 of loans with it).
  • Mgmt is top notch and has history of deploying capital attractively. Dare I say, the Warren Buffett of mortgage REITs (patient, cash not burning hole in pocket)
  • Buying back both bonds and stock – both at discounts to par / book value
  • Cash is both a downside backstop, but opportunity as they deploy into distressed sectors

Let’s Break Down Ladder’s Book: Here I will detail the bulk of Ladder’s assets. Note, this is just the bulk. They also have a small amount of conduit loans (which means they make loans which will soon be bundled and sold into CMBS).

Transitional Mortgages (43% of Assets, 53% of Equity): These are loans to commercial properties undergoing a… transition. LADR has a first lien on the property, while the borrower uses the capital to bridge it through renovations, repositioning of the asset, lease-ups, etc.

While COVID has created “income uncertainty” for a host of real estate assets, these transitional properties are inherently not generating much income at the time of the loan! And here’s some commentary on that from Management’s Q2 call:

[Our transitional loans] are close to stabilization and require minimal capital improvements. Our balance sheet loans have a weighted average seasoning of 18 months, which is a little over 15 months remaining to initial maturity and 27 months remaining to final maturity. Further reflective of the lightly transitional nature of our portfolio, we have less than $150 million of future funding obligations over the next 12 months and less than $250 million in total, all of which we can comfortably meet with current cash on hand. The majority of these future funding obligations are conditional and are subject to the achievement of predetermined good news events like tenant improvements and leasing commissions due upon the signing of new leases that enhance the cash flow and value of the underlying collateral. We continue to have limited exposure to hotel and retail loans, which comprise only 14% and 8% of our balance sheet loan portfolio, respectively. Currently, almost half of our loan portfolio remains fully unencumbered, and our exposure to mark-to-market financing on hotel and retail loans is just 1% of our total debt outstanding.

As such, they typically are low duration (<2 years), lower LTV (67%), and as mentioned – 1st lien on the property. In a sense, the property value would have to be marked down 33% for Ladder to begin taking a loss. Here’s a comment from the Q1 call on the borrower – you have to think they’ll want to preserve that equity value if they can and have a long-term view:

These same loans currently have a 1.26x DSCR with in-place reserves. The significant third-party equity our borrowers have in these loans provides strong motivation for them to protect their assets and provides the company with a substantial protective equity cushion. Like all prudent lenders, we’ll be very focused on asset management to protect and enhance the value of our loans

Here is more commentary on the assets performance and the short duration:

The property types are highly varied too. In other words, it’s probably a good thing it’s not all Hotels right now. But even so, they have significant cushion above the loan value.

Let’s say you don’t like this situation. Well think about this: We are buying LADR today below book value. Therefore, you could look at as us buying 1L mortgages on a look-through basis of ~40 cents on the dollar (i.e. 60% of Book value * 67% LTV). Do you think a 60% haircut is coming across the board?


Securities (23% of Assets, 8% of Equity): These are primarily AAA-rated real estate CMBS that has very short duration (2.1 years as of 9/30/2020) and significant subordination (i.e. it would take a lot of losses for the AAA tranche to lose money). In fact, even at the height of COVID where gold, treasuries, investment grade corporate credit were all tanking, the company was able to sell assets at 96 cents on the dollar. This speaks not only to the quality of the loans, but also liquidity.

As I think about this portfolio and the low duration, you should think of it this way: in 2 years, if the company did not re-deploy this capital, they’d have ~$1.45BN on loans that would pay off. They do have ~$1BN of leverage against them, so you’d have $383MM of equity back in cash. Keep this in mind for later.

Commercial Real Estate (16% of assets, 6% of equity though the assets are carried at historical cost, so there is significant unrealized gains not captured by GAAP)

  • Net Leased Commercial Real Estate (~65% of CRE): Ladder outright owns triple net leased properties, where the primary tenants are Dollar General, BJ’s, Walgreens and Bank of America.
  • Diversified CRE (~35% of CRE): these are other properties Ladder owns across office buildings, student housing and multifamily.

Now that I’ve discussed the book, it’s important to quickly discuss how they capitalize themselves. Again, very limited repo facilities and that source of funding continues to decline.

Note the unsecured corporate bonds. This brings me to one of my investment points: Ladder issued these opportunistically and has since been able to repurchase them at a discount to par. Ladder has repurchased $175MM of bonds.

At the time of writing, their 2027 4.25% unsecured notes trade at ~86 cents on the dollar. Every dollar used to repurchase these notes at a discount builds equity value on the balance sheet. There’s also the added benefit of decreased interest, which is a drag when they have so much cash.

As an example, let’s say we had a company with $200MM of assets ($100MM of which is cash), $100MM of debt, which would imply $100MM of equity. Using $25MM of cash to pay down $25MM of debt at par would not build book value on the balance sheet. However, if you paid down debt at a discount, it would.

Here’s that illustration shown below. Notice you actually build incremental equity. Given financials typically trade on a P/BV, I feel like this topic is warranted.

As mentioned, Ladder also has around ~90% of its market cap in cash… so as the market has firmed, they are buying back stock as well (though it’s still small). Buying back stock at a discount to BV also increases BV per share.

But obviously more importantly, it’s an attractive return of capital to shareholders if you think the stock is worth at or above book value. However, management may have opportunities to deploy this in attractive assets, noted below in the management section. 


Adding up the pieces:

I wanted to do a build up of “what you need to believe” here. Maybe you don’t like the assets, even though I personally view them as very low risk. Well, the securities portfolio itself is worth $3/share. That’s very liquid and something you can take home in a few years if they decided not to reinvest the proceeds. We could get those assets tomorrow.

I also started with the corporate debt, subtracted cash, and looked at the equity value after paying that all back against the balance sheet loans (the transitional mortgages). I didn’t assume this debt was retired at a discount at all.

As we discussed, the transitional mortgages are low LTV properties and worth ~$6 share. You could haircut this by 40%, add in the securities portfolio and everything else is free.

Next you have the real estate assets, worth $1.8 share on the books. Fine, don’t give credit to the unrealized value here (another $1.8), but the company did sell 3 properties in Q3’20 for a gain relative to BV.

Our downside is very well protected. Given the short tenor of the loans, we will either see Ladder receive cash or take-over properties and sell above the loan amount (which they did with a hotel in the quarter, one of a few assets in trouble per mgmt).


Management

Often, the missed piece of any thesis is management. Boy, all I can say is go read their calls. These are truly savvy investors, which is what you want in an mREIT.

Here are some examples of great quotes from mgmt:

From the Q2 Call – I get Buffett vibes:

My instincts are telling me that it might be better to actually be the borrower in a market like this as opposed to be a lender. Occasionally, we’ve talked about that on some of our calls. Conduit lending is back in a very soft kind of way. And a lot of cleanup from inventory that was sitting on the shelf is getting done. But I would say the typical conduit loan today that’s getting written is a 3.5% to 4% 10-year instrument at 50% LTV.

I think if we begin to deploy capital, and I think we will, we’ll probably be a borrower of funds like that because I think we can find some attractive situations where, perhaps, somebody has to sell something. And in addition to that, I would say that a stretched senior used to be, if a guy bought a property for $100 million, he could borrow $75 million. I think $100 million purchase today, you can probably borrow about $60 million. And so a stretched senior now goes from maybe 60% to 70%, 75%, and I think that is a sweet spot for risk/reward right now on the debt side.

If you remember, in 2008, when we opened, we had quite a few mezzanine loans in our position because we felt that the capital markets were very fearful and maybe too fearful. And so then once we got to around 2012 or ’13, we stopped writing mezzanine loans because we felt at that point, markets were priced right. And then around 2016, we felt that mezzanine money was too cheap. So I would imagine it will feel and smell like equity in some cases, or at least in some scenario where somebody is forced to transact.

And another from Q3’20 from Pamela McMormack, the other Co-Founder

I’ve been with Brian, forgot, I’m turning 50, I think, since I was 30. And so I’m a little bit of the cycle in that regard. But what I’ll say is, I remember, when we opened the doors in 2008 with the private equity guys, and they were begging us to make loans, make loans, make loans. And we were sitting on a lot of cash, we had raised over $611 million back without placement agent in 2008. And Brian was very patient, had a set up to become a (inaudible) borrower. We’re buying securities, and they said they don’t pay people to invest in securities.

And we were very patient about making loans until we felt like the market was right. We’re not incapable, we’re not afraid. We are intentionally and purposely waiting for what we think is a better risk-adjusted return.

There in lies WHY they have so much cash right now. Unfortunately, COVID is not going away tomorrow and there will be some desperation out there. I like this management team’s ability to take care of it.

Here is LADR’s ROE over the years. Not too shabby! I’d add this to the rationale that the company should trade at at least 1x BV (this ROE excludes gains on sale).

3 Reasons to Do a Cash Out Refinance of an Investment Property

Reading Time: 4 minutes

One benefit of real estate investing is being able to take your initial capital out of the deal and still own the property. My wife and I just did this through a cash out refinance on investment property we’ve owned. It is fairly straightforward, but let me try to explain the mechanics and benefits we saw.

Simple Explanation

The simplest example would go like this: Let’s say you bought a $100k property and put 20% down, so you have $20k of equity and $80k of debt. you bought extremely well and it turns out your property just so happened to be the next hot area. You appraise the house and its new market value is $175k. Because total assets = liabilities + equity, if your mortgage was still $80k (in real life, it would probably be paid down some), your implied equity would now be $95k!

You could sell the property and take the proceeds or you could do a cash out refinance of your investment property.

How much could you take out?

Since this is an investment property, a lender will typically only lend up to 75% LTV against the property for it to qualify for Fannie / Freddie backing (which gives you access to low interest rate, 30 year loans).

The way the lender looks at it is, if you were to buy the property today we’d feel comfortable giving a 75% LTV loan, so we shouldn’t care where the money is going per se. You could still sell the property and take the money so in this case, they are agnostic.

The mechanics are pretty simple. A new mortgage is done on the new property value, they pay off the original mortgage and cut you a check for the difference. In this scenario, you could take out $51,250! That’s 2.6x your initial investment and you still own the property!

Now, obviously you may decide that taking all the equity out is better for you, but for us, we didn’t want to sell the property and wanted some liquidity so it added up for us.

Cash out refinance example

To be clear, this is real estate we are talking about here, so don’t expect to be able to take out your equity immediately. We did ours after owning the property for 10 years. We could’ve done it earlier, but the timing lined up and rates moving lower made it an attractive time. There are closing costs that can be a few thousand dollars, so you want to make it worth it.


So some of the benefits of a cash-out refinance are obvious, but let me lay out my favorite: 

  • Able to Take out Initial Equity with Limited Tax Consequences

As shown in the example, we were able to take out our initial equity, which we can now use for other investments. But the even better part is that the cash doesn’t count as taxable income or a gain on sale, because we are technically taking out a loan.

That is a sweet benefit. You will also be able to claim the interest as a expense on your tax statements going forward to reduce taxable income. I view it as a win-win-win.

  • Can Redeploy in Another Investments, including Real Estate

Many people use cash out refinance proceeds to invest in other real estate properties, but my wife & I decided that we should (i) put some money back into the investment property (ii) use some of the proceeds for some projects around our personal home and (iii) fund tuition savings account.

I personally like the idea of building a real estate empire on cash out refinances. Personally, our proceeds that we received could easily go to buy two new properties. In about 8 years, we probably could take our equity out of all three again and go buy two more properties. You can do a cash out refinance many times, as long as you have enough equity built where it makes sense to cover closing costs. Its a “Get Rich Slowly” scheme.

At the end of the day, you could use it for whatever you’d like!

  • More attractive rates than a Home Equity Line of Credit (HELOC)

I often see people debating a HELOC vs. a cash out refinance. We went with a cash out refinance because we had built up significant equity and even though we were refinancing a primary residence loan with an investment property loan, since interest rates have gone down our total monthly payment didn’t move much.

The interest rate on a cash out refinance can typically run 50-100bps wider than what the primary residence market is (we got ours at 4.25% when market rates for primary residences were around 3.60%) and will obviously depend on credit score.

HELOC’s are akin to getting a second mortgage on a home, because you are tapping the equity behind the existing mortgage. Therefore, if first lien mortgages are already higher than primary, you should expect second lien mortgages to have an additional risk premium built in (i.e. come at a higher rate).

In our situation, a HELOC was going to be high-4%-5% range and has faster payback terms (5-25 years). We preferred to lock in a new 30 year mortgage at an attractive rate. HELOC interest also isn’t tax deductible anymore.

HELOCs do have lower closing costs, though, given in a cash out refinance a lender will want the typical closing items: appraise the property (fee), you’ll need a real estate attorney in many cases (another fee), a title search for the lender (fee) and other closing costs.

 

Cash on Cash Return of Real Estate – Will #COVID19 Create Opportunities?

Reading Time: 5 minutes

COVID-19 has already produced some interesting investment opportunities in the stock market. Fortunately or unfortunately, part of investing is being prepared to buy an asset that others NEED to sell. Perhaps the cash on cash return of real estate will improve

This happens in the stock market all the time, but I think real estate could again become attractive given unemployment is rising, there has been disruption in the mortgage market, and a cease in travel may pressure liquidity of those who bought short-term rental properties (think airbnb). Since I am seeking investment opportunities for myself, I figured I would share. My wife & I already own one investment property purchased in 2010 and I can clearly see the benefits.


Here are a few positives of buying real estate:

Cheap leverage:

You can finance around 75%+ of the purchase price with very cheap, 30 yr debt. Our property is an investment, so interest rates are around 50-75bps higher than the national average, and we are paying 4.25% over 30 years.

Compare that to buying a cash flow producing business and you’re likely going to have to pay 8% and carry risk that the business fails, whereas you can generally have decent protections in real estate (location, location, location)

Asset is then paid for by tenants:

The next best thing is that you have that rate locked-in for the tenor of the loan, but rent typically rises each year or over a long period of time. So you’re typically getting “more profitable” each year. Also, you’re not the one paying for it – the tenant is!

Rinse & Repeat – Taxes are favorable:

Thanks to 1031 like-kind exchange rules, when you sell a property (hopefully for a gain) you can roll your original investment & gain into another property and avoid paying capital gains. In other words, it’s akin to a deferred tax account.

You can buy a property on the cheap, realize gains & maybe move rent up to a market rate, sell for a profit & repeat. Also, mortgage interest is tax deductible.

You can essentially conduct a dividend recap on the property:

Also known as a cash-out refi, we did this with our rental property. The lender will appraise your property and allow you to re-lever back up to 75% LTV. So a new mortgage is created against the higher property value, the old mortgage is paid off, and the bank cuts you a check for the difference.

This is a great feature because you can buy a place that needs to be rehabbed on the cheap, fix it up, rent it, and then go and refinance the property on likely a higher value and take out all of your original equity! This has also been called the “BRRR” strategy, Buy, Rehab, Rent, Refinance, Repeat.


I do, however, have a few complaints.

Not quite passive investing:

I can go out tomorrow and buy a bond fund that pays interest and pay the manager a few basis points for their trouble. Real estate though is tough. If you’re managing it yourself, you need to find tenants (a challenge) and be prepared to find someone to fix an issue at any time. A property manager can ease this concern, but there still is generally some back-and-forth here.

Are the returns really that great?

This is what I plan on investing in this post. My wife & I just hired a property manager, but there have been times while we were self managing the property where we asked ourselves if it was all worth it in the end.

Liability:

You can finance properties in an LLC, but typically that interest rate won’t be nearly as good. You can instead get insurance to help cover some of the liabilities involved with renting properties, but will you lose sleep wondering if its enough? (biggest fear for me is a party where someone falls off a roof railing or something like that – personally I should be covered in several ways there, but still a concern in the back of my mind).


Understanding Cash-on-cash returns vs. IRR vs. Cap Rate in real estate

There’s a lot of jargon thrown around in investing, particularly real estate. First is probably cap rate, which is your NOI (net operating income) over the asset value (or purchase price). NOI is just the annual rental revenue less the operating expenses (such as ongoing maintenance costs, utilities, property taxes), but does NOT include financing costs. It’s just a rough proxy for what the return on the property will be unlevered. So it’s likely a lower rate of return given you probably will finance your purchase.

I sometimes look at cap rates, but only as a quick proxy for value, similar to EV/EBITDA — in fact, a cap rate is really just EBIT/EV. So clearly, it is missing financing costs (interest) as well as any capex needs and I prefer to know what my cash returns are as an equity holder.

Cash on cash return removes what we just discussed. This takes out financing costs and any recurring annual capex to find out what a real cash on cash return is.

Note, by financing, I just mean interest cost. That’s because a pay down of principal is paying down debt permanently and therefore building your equity (as I’ve said before, when a company pays down $1 of debt, this is a $1 to the equity). Some investors add the principal amount to cash flow, but I don’t do that because I’m not actually benefiting from that cash flow in the period. Doesn’t make intuitive sense to me.

Example:

I wanted to share some math that I’ve been looking at so, here is a spreedsheet snapshot I’m working on (perhaps this is a legible picture…). Hopefully the assumptions are clear enough. This assumes purchasing the property at a ~6% cap rate and a 8% cash on cash return, which I would say is somewhat typical.

I also highlighted when you could expect to refi out around ~95%+ of your original equity. Not bad – I can cash out my equity by year 8 and still own the asset. I could probably then go buy another property with that cash.  Unfortunately, as of right now, the areas I am comfortable investing in are more like 4-5% cap rates… not that great.

One thing that should be somewhat obvious is that the more equity you put down, the closer your cash-on-cash return will be to cap rate.

What does this mean from an IRR perspective?

The IRR in this example was around 9%, including closing costs on both sides of the transaction. Clearly that is much closer to the cash on cash return. The problem with IRR is it basically assumes you can reinvest each dollar you receive back at the project rate, which may not be realistic.

That brings me to another thing to focus on: total return. Just add up all the costs in vs. costs out. This ratio is called the multiple of money. I like to use it to compare returns. Subtract 1 from it and you have the % total return as well.

All-in-all, these returns aren’t bad. Especially for a “stable” asset class. That said, I have to think about the balance between buying this asset, some of the headaches that come with it, and not have much liquidity. I’d need to either find a way to put less equity down (to juice returns) or find properties at a steeper discount.

If you want to look at some properties yourself and run the math, you can check out this company called Roofstock, which to me seems like its trying to make long distance relationships & real estate a thing. Its an interesting concept and I have to commend them on their tools as well. You can even buy fractional shares in a home on their site (not sure how the financing and taxes works though… I’ll have to give them a call), though inventory seems limited. I’m not getting a kickback from them or anything, but I do monitor their site so thought I’d share.