Owens Realty Mortgage

http://www.chateauatlaketahoe.com/

Disclaimer: The content below is for educational and entertainment purposes only and should not be construed as investment advice or a recommendation to buy or sell any security. I own shares of Owens Realty Mortgage (NYSEMKT:ORM) but have made investment mistakes in the past and will make more in the future. Please do your own diligence.

Owens Realty Mortgage (NYSEMKT:ORM) is an externally managed real estate investment trust (REIT) primarily focused on commercial mortgage lending. ORM specializes in short-term, bridge loans in the $500K to $20M range that typically require speed and flexibility. The company also owns and manages real estate assets due to prior foreclosures.

In that brief overview, there are two very concerning descriptors:

  • Externally managed REIT: This structure requires ORM to pay fees to a management company that employs the majority of investment and administrative personnel. Aside from the onerous fees, this structure is particularly worrisome due to misaligned incentives. The management company is motivated to grow the asset base and increase fee income, which is often at odds with maximizing shareholder value. As a basketball fan, I always enjoy when analyst Jalen Rose yells at below average three point shooters, “You’re open for a reason!” The investing corollary regarding externally managed specialty finance companies is “You’re cheap for a reason!”
  • Prior foreclosures: The purpose of a commercial mortgage REIT is to generate an adequate risk adjusted return on capital by lending money to real estate developers. If the REIT is forced to foreclose on a substantial number of loans, the investment discretion of the manager should be called into question.

Despite these initial red flags, management has done an impressive job managing the business since going public in 2013 and has prioritized shareholder interests. I believe ORM has a very attractive return profile with~40% near-term upside potential and limited downside risk.

Company History

Owens Mortgage Investment Fund, ORM’s predecessor, originated as a privately held Limited Partnership in 1983 specializing in short-term commercial real estate loans. The Fund became a public filer in 1988 and the average distribution yield to investors was 8.4% from 1989 through 2007.

When the real estate market collapsed in 2008–2009, the majority of loans became non-performing. The Fund foreclosed on over half the portfolio which led to declining distributions and redemption requests. The Fund was in stasis due to illiquid assets and an inability to make new loans with outstanding redemption requests. Instead, management focused on optimizing the real estate portfolio by improving properties and generating rental income.

Although the Fund owned valuable and appreciating assets, distribution yields were very low since the majority of value was tied up in development properties. Management faced continued pressure to provide liquidity since most LPs were retail investors in search of yield. In 2013, ORM was formed when the Fund was converted from a Limited Partnership to a REIT and began trading on the NYSE MKT exchange.

In the three years since going public, ORM has (i) sold over $150 million of owned real estate, (ii) ramped the loan portfolio by over 2x, (iii) continued to fund attractive development projects, and (iv) repurchased close to 9% of the company.

Loan Portfolio

ORM specializes in short-term bridge loans to commercial real estate investors primarily in California and other western states. The company has built a reputable brand in the real estate community and borrowers value ORM’s speed and flexibility. Loans range from $500K to $20M in size and are typically interest-only with one to three year terms. 98% of loans have a senior position and management targets 60–75% loan to value ratios. Below is a sample transaction:

Source: ORM Investor Presentation, June 2015

As of Q2 2016, the loan portfolio was $118 million with an annualized yield of ~8% and duration under two years. The below charts provide a breakdown by property type and geography:

Source: 10Q as of June 30, 2016

Monetizing Owned Real Estate

ORM went public in mid-2013 with ~$130 million of owned real estate on their balance sheet. Despite sizable value realizations (see Exhibit A), the balance grew to $165 million as of Q2 2016. The increase was due to additional investments in two key properties, Lake Tahoe and Miami. However, over the past few months ORM has done a tremendous monetizing these assets at attractive prices.

On September 15, 2016 ORM announced they closed the sale of the Miami condos known as Treasures on the Bay (TOTB). Intrawest Capital purchased the property for $75.5 million, representing a gain on sale of $19.3 million. After accounting for minority interest, the gain on sale to common shareholders is $15.6 million or approximately $1.50 per share. The transaction led to cash proceeds of $32.9 million and a reduction of debt of $32.9 million which should allow the company to significantly ramp the loan portfolio over the next few quarters.

Pro forma for the TOTB sale, ORM has $110 million of owned real estate on their books and over 60% of this value is related to the South Lake Tahoe property. This asset is an 11.5 acre resort with prime Stateline location across the street from the Heavenly Valley ski resort gondola and two Nevada casinos. The property consists of four separate assets: 

Source: ORM Q2 2016 REO Portfolio Report

I believe there are at least $50 million of embedded gains in the Lake Tahoe assets. Before ORM foreclosed on the property, the prior developer had invested $43 million for construction, design, permitting, and local fees. Additionally, the assets were appraised at $105 million in 2009 which represents well over $50 million of embedded gains compared to book value before ORM started investing additional capital to develop the property.

ORM is another step closer to realizing these gains as they recently announced an agreement to sell the Chateau residential asset for $42.5 million, representing a $19.3 million gain. However, there is closing risk since the agreement is non-binding and is subject to a tentative map approval by the City of South Lake Tahoe. Additionally, the prospective buyer is a Chinese developer that is difficult to diligence. On the positive side, however, the developer has invested substantial time and money over the past month to diligence the property and has hired a US contractor. There also appears to be limited financing risk. The prospective buyer initially offered all cash but ultimately agreed to a short-term seller financing note enabling ORM to push the majority of tax gains into 2017.

Net Asset Value and Price Target

The table below shows ORM’s evolution as a public company. Book value per share (BVPS) has increased significantly due to land sales above carrying value (see Exhibit A) and share repurchases (see Exhibit B). With the closing of the TOTB sale in September, ORM should report book value per share of approximately $21.35. Furthermore, I project net asset value (NAV) per share to be above $26 due to the estimated $50 million of embedded gains in the Tahoe properties.

Sources: ORM company filings

ORM is currently trading at 64% of my NAV estimate. Over the past couple of years, the stock has generally traded between 0.8–0.9x reported book value (See Exhibit C), which is a reasonable range for an externally managed REIT. At those multiples, ORM would be worth ~$21.00 to $23.60 per share, implying ~25–41% upside.

Potential Catalysts

In addition to being cheap, there are near-term catalysts which may help close the gap between price and intrinsic value.

  • Book value per share growth: ORM will report earnings on or around November 9th and BVPS will increase significantly due to the closing of the TOTB sale. As the company continues to monetize owned real estate with embedded gains, reported book value will march closer towards net asset value.
  • Increased dividends: The cash proceeds and debt reduction associated with the TOTB sale enables ORM to ramp the loan portfolio. The increased income will lead to higher dividend payments and will likely attract yield investors.
  • Additional share repurchases: ORM has another share repurchase program in place allowing the company to buy back up to $7.5 million of common stock. If the wide margin between price and value persists, I expect management to take advantage of this plan and repurchase ~4–5% of the company.
  • Closing the Chateau Residential sale: Management is hopeful the transaction will close late this year or in early 2017. If everything goes smoothly, the sale will result in a gain of ~$1.90 per share.

Key Risks

  • Management de-prioritizes minority shareholders: As discussed above, this is always a risk with externally managed specialty finance companies. However, the prior share repurchases (See Exhibit B) give me comfort it is unlikely to happen in this instance. The $12.9 million spent on buybacks the past couple of years has been accretive for shareholders at the expense of management. If that money had been invested in loans, ORM would have had to pay an additional ~$385K annually in fees to the management company. It is rare to find a management team with this external management structure that prioritizes shareholders over their own interests.
  • Poor lending performance: The thesis relies on management’s ability to identify and source compelling lending opportunities to generate an adequate return on equity for investors. If management makes poor investment decisions, loan defaults will obviously lead to lower income and dividends for shareholders.
  • Real estate downturn: The real estate industry is cyclical and a downturn may lead to additional foreclosures and/or lower values ascribed to owned real estate.

Exhibit A: Value Realizations since 2013

Sources: ORM company filings and investor presentations

Exhibit B: Share Repurchase History

Sources: ORM company filings

Exhibit C: Price / Book Value since IPO

Source: CapitalIQ
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