PennyMac's big discount

Of all the 2009 MREIT IPO's PennyMac Mortgage Investment Trust (PMT) trades at a worst discount to book value. This creates plenty of head scratching as to if PMT is pregnant with opportunity or pregnant with something else.

Reading the S-11's gives a number of reasons not to invest in PMT beyond those concerns with the target asset class; credit impaired residential mortgage assets requiring intensive servicing.

• The people who run this REIT, are same ones who created this mortgage crisis.

  "Certain of the officers of PennyMac who are former employees of Countrywide, including Stanford L. Kurland, our chairman and chief executive officer, who was chief operating officer of Countrywide until September 2006, have been named as defendants in lawsuits in which Countrywide and other employees and former employees of Countrywide are defendants."

• The management fee structure is not attractive. (1.5% base + 20% xs 8%), incentive fee's in a structure with potentially high leverage (typical of RMBS/Residential investors) can be dangerious
• The external manager has split ownership (37% Blackrock, 37% Highfields Capital, and only 26% "Management") which raises potential issues of stability and management buy in at the external manager level.

  "BlackRock and Highfields Capital, PennyMac's strategic investors, are not obligated to provide us with any assistance and could compete with us."

• There is a built in cash leakage due to the assignment of servicing to party related to the manager yet outside the REIT: PennyMac Loan Servicing (PLS). It is so important when dealing with externally managed company's to look at all sources of potential cash leakage in favor of management. What you are trying to avoid is any sort of "gross asset" based compensation arrangement, which is very open to abuse.
• There is an even worse conflict of interest in that PLS may earn origination fee's.

  "This may provide PLS with an incentive to refinance a greater proportion of our loans than it otherwise would and/or to refinance loans on our behalf instead of arranging the refinancings with a third party lender. It may also provide PLS with an incentive to provide financing to facilitate sales to third parties with regard to the disposition of real estate that we acquire through foreclosure."

• The public REIT is competing with two PennyMac managed private investment funds for investment opportunities and does so without co-investment rights. These funds have roughly $300M+ in uncommitted capital.

  "No assurance can be given that PCM will act in our best interests with respect to the allocation of personnel, services and resources to our business."

• Finally the fairly unique risk now facing holders of residential loans: a hostile court system.

  "The borrowers under sub-performing or non-performing mortgage loans may have a variety of rights to contest the enforceability of the mortgage loans and prevent or significantly delay and increase the cost of any foreclosure action, including, without limitation, allegations regarding fraud in the inducement by the original lender or broker, failure of the lender to produce the original documentation, improper recordation of the mortgage, various theories of lender liability, and relief through the U.S. Bankruptcy Code and similar state laws providing debtor relief." This sort of thing has been a real stinger, as judges have been known to vacate a mortgage over the holders inability to produce documentation, or are otherwise unsympathetic to the holders of sub-prime loans.

• Another issue is the companies long URL: www.pennymacmortgageinvestmenttrust.com. No one is ever going to remember or bother to type that into a browser.

Why new is better than old, when it comes to REIT ipo's.

Way back when, (September 23 2009) Tom Petruno of the LA times wrote about the troubles of starting up a new REIT as a blind pool offering (Real estate vulture Colony Capital set to launch REIT IPO and Why investors are balking at IPOs of new vulture mortgage funds).

Buying into such an offering is making a macro bet that there are good investments out there, and a micro bet the management team will be able to identify these investments, generally run the company in a way that keeps it going for the long term and attracts investor interest.

With the exception of Lodging REIT Pebblebrook trust (PEB) these blind pool IPO's have been externally managed. There have been a number of S-11's for internally managed Hotel REITs (and as of Dec 11 an Class A Office REIT), which involve industry veterans with star (not iStar) power. Investing in any of these equity REITs means taking a macro view on the recovery of their target property sector. Financial reits require less operating expertise, since their assets are passive by nature, and if they need active management you are doing it wrong. The key skill is to carve a good investment out of a (pre-existing) messy situation, or be able to avoid messy situations

External management has a benefit in that you know what the companies cost structure is going to be. Incentive fees are tricky, since if not properly structured they can lead to "moral hazard" due to an emphasis on short term income. In theory an internally managed company should be prone to less empire building, but they can have more subtle issues of excessive compensation and awards of stock options.

Incentive fee's and a business model based on financial leverage leads to trouble. The temptation to crank leverage as financing spreads (or gross yields on assets) decline is irresistible. And yet, a fixed management fee is an annuity to the manager. Which can create an incentive to grow the equity base of the company.

The upside to starting a company from scratch is that there are no "legacy" issues. Old debt maturities to refinance, formerly performing assets now non-performing, etc. Unless a REIT is into development, the very nature of the REIT model is that of accretive growth (via acquisitions) instead of internally generated growth (from re-investment and asset management). This is especially true for REITs owning passive financial assets, where there isn't much asset management to be done because you can't raise rents on a mortgage.

A brand new company with just cash is poised for a large amount of growth and corporate transformation relative to its initial state, compared to most public REITs which are just trying to stay alive and have no capital for growth. It is that combination of legacy issues and strangled capital that makes most existing REITs uninteresting. They trade an high multiple to their ability to generate FAD at the corporate REIT level.

This makes blind pool IPO's kind of fun, since they often trade at only a slight premium (or more often discount) to book value till the company shows signs of ramping up and gains some analyst coverage. As the company becomes fully invested, the dividend stream grow at the same time that the to Price/book multiple will increase to that of a stable proven company.

The new generation of mortgage REITs

So when I last posted, the mortgage crisis was just beginning. And I thinking it was a good time to get into the banks. Because they were looking pretty cheap, relative to their performance over the past 8 years or so at the time. Pretty much all the old line players in commercial mortgage REIT space were wiped out, or never fully recovered. (CT, AHR, CRZ, JRT, GKK, CBF, NCT).

Which is not to say that commercial mortgage lending is a bad idea, especially now that the main competitors in this space are on the ropes (banks, and to a lesser extent insurco's).

That has inspired a new generation of MREITs to sort out through the carnage, and enjoy the tax arbitrage of being a REIT rather than a C-Corp. So far around $1.7 Billion has been raised for these new MREITs, and that has been hard going except for Starwood Property (STWD) which raised $800M despite having a high fee structure and being associated with Barry Sternlicht. Most everyone else (except Colony/Pennymac) had to make some concessions on management fees.

• Residential Credit oriented
  
  
  
  1. Pennymac (PMT) -- Started up by ex-countrywide people (who created a good chunk of this mess to begin with). They have incentive fee's.
     
  2. Two Harbors (TWO) -- SPAC that became an MREIT targeting credit/interest rate sensitive residential assets, externally managed by ex-Cargill folk.
     
  
  
• Commercial Credit oriented.
  
  
  
  1. Starwood Property (STWD) -- Barry Sternlicht's venture. The last one he sponsored (with BFF Jay Sugarman) iStar (SFI) didn't do so well.
     
  2. Crexus (CXS) -- Commercial focused MREIT started by friends of NLY. Run by ex-TIAA-CREF (insurance company) folks, but with a highly outsourced business model. So far the market seems to think that a externally managed REIT that outsources its core operations is questionable. Also the history of dilutive capital raises at Chimera (CIM) isn't helpful.
     
  3. Apollo Commercial Real Estate Finance (ARI) -- A low cost venture set up by Apollo to managed commercial assets for 1.5% with no incentive fee's. Unfortunately the management agreement lacks real exclusivity in favor of ARI and it is very likely that the more interesting opportunities will steered towards private Apollo funds with the more traditional 2/20 fee scheme. Depending on your outlook, that could be a good thing.
     
  4. Colony Capital (CLNY) -- Thom Barrack's new venture. High fee's 1.5% + (20% incentive fee on a 8% hurdle). Most importantly they have a co-investment right with other Colony capital funds.
     
  
  
• Generalist Investors
  
  
  
  1. Invesco Mortgage Capital (IVR) -- Invesco made huge concessions to get this to be the first 2009 externally managed MREIT IPO. Low fee's (without the overhang of recouping underwriters discounts etc). So far mostly invested in agency RMBS, while very slowly gathering more credit sensitive assets.
     

What I'm really waiting for is new BDC's, but till then I'm holding onto a few shares of CLNY and IVR for old times sake.