Friday Additions: Private Equity, Real Estate and High Yields

I kind of suspected yesterday's rally would have a hard time gaining traction. Many of the headlines surrounding the coronavirus look good, and we are edging closer to election day, which I think has the potential to go horribly wrong. It does not help that the big tech companies did not provide the type of earnings report perfection needed to justify their valuation, so we see weakness there as well.

As I look at the flood of earnings reports coming in, one group of companies is blowing the doors off everyone else. The tumultuous markets and low-interest rates have provided a perfect storm of opportunities for private equity companies. So far, they have taken advantage of all the weirdness 2020 has to offer.

Anyone who has been around me for any length of time knows I love the private equity business. I wish that I had been smart enough to go into the PE business back in the 1980s, but at least I can own the big PE firms today and benefit from their growth.

December 2016 was the first time I suggested buying the big three PE firms and just never selling.

It has worked on pretty well for those who followed my lead at the time:

Blackstone (BX) 24.78% annualized return

KKR (KKR) 26.81% annualized return

Apollo (APO)25.51% annualized return

If and when we get a test of the March lows, I won’t just be buying community banks. It will be time to add or initiate a position on the big three PE firms as well.

The big private equity firms have made a ton of cash from their private investment in public equity deals (PIPE) back in March and April. They are recapitalizing companies with a good business but maybe had too much debt on the balance sheet when the virus hit the economy.

2020 was the perfect environment for private equity firms.

Led by Blackstone, they are moving aggressively into real estate available at bargain prices for the first time in several years. Blackstone is focusing on self-storage, industrial properties, and life sciences in a big way.

We are also seeing some moves by private equity back into select office markets. The office market is changed, but it is not going to disappear. Current pricing would make one think that central business district properties' future was the equivalent of nuclear devastation or the zombie apocalypse.

It will not be the end of the world, and some major cities' premier properties represent a massive opportunity. If pricing worsens before we get a vaccine and a new stimulus package, I think you will see PE becoming even more aggressive in the office markets.

I am watching the Mortgage REITs associated with the big private equity firms closely. The big three and Ares Management (ARES) have commercial mortgage REITs that have been beaten up pretty good this year.

Blackstone Mortgage Trust (BXMT) is quickly emerging as a best in class commercial real estate mortgage REIT. Given that Blackstone is now one of the largest commercial real estate owners in the world, that makes sense.

The shares are down 40% so far in 2020, and from my point of view, that makes no sense. They have a portfolio of 100% senior loans done at an initial loan to value 64%. They collected 99% of interest due in the most recent quarter.

We can buy an $18.1 billion senior loan portfolio secured by institutional-quality real estate in major markets, with a weighted average origination LTV of 64 at $.83 on the dollar. The portfolio is performing well, with most interest being collected and only a small amount of COVID-related deferrals.

The portfolio is yielding over 11%.

The Ares Commercial Real Estate portfolio is about 95% senior loans. I like their focus on non-gateway cities for their lending activities. It gives us some balance against the major market presence of the bigger CRE Mortgage REITs that have to operate in major markets.

The portfolio is spread around the country, with 40% of its loans in the Southeast, 20% in the West, 18% in the Midwest, and 22% in the Southwest and Northeast regions of the U.S.

It is a smaller REIT, with about $2 billion of loans in the portfolio. Borrowers made 100% of contracted payments were made in the third quarter, so the portfolio is in excellent shape. These guys are so good at underwriting loans that they had no credit losses since inception in 2012. That’s roughly $5.9 billion of real estate debt with no credit losses.

That’s impressive.

What is even more impressive is that you can buy Ares Commercial real estate for $.64 on the dollar and enjoy a yield of over 13%.

KKR Real Estate Finance Trust (KREF) has been the leader of this group, with the stock "only" down by 16% this year. The $5.5 billion portfolio is 83% invested in multifamily and office loans, so they have very little exposure to the CRE markets' higher-risk segments.

99.5% of the portfolio is in senior loans.

The multifamily properties had a loan to value of 67% when KKR made the loan. For the office properties, that number was 64%.

99.9% of the portfolio's loans are performing, so there are no serious credit issues with the KKR portfolio.

We are paying $.90 on the dollar to buy into this portfolio, and the yield is 10%.

I am holding back on suggesting Apollo Commercial Real Estate Finance (ARI). The REIT probably has the most upside and has the highest yield at 16%, but I am not as comfortable with the loan portfolio as I am with the other three.

I will hold this one back for a dividend cut buy.

None of these are risk-free, of course. They are mostly senior loans that are performing well and have low to loan to values. They have deep-pocketed private equity parents to help them through tough times.

The yields are generous, and they are trading at steep discounts to the loans in the portfolios.

Adding a small portion of these REITs can add a meaningful bump in earnings for income investors.

Given the volatile outlook, it could make sense to adopt a go-slow and stay small to buy them. Buy a little and add on big down days.

Posted to The Community Bank Investor… on Oct 30, 2020 — 1:10 PM
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