Real Estate Credit Investments has shown remarkable resilience for a company whose fortunes read like a history of the financial crisis. It raised €406m (£325m) of capital back in December 2005 to invest in asset-backed securities (ABS), then a new and exciting asset class. But within a year the ABS market started unravelling, precipitating first a credit crunch, then a banking crisis and eventually the ongoing recession - not forgetting huge writedowns in RECI's portoflio.
- Bond investments unlikely to default
- Latent capital growth
- Shares trade far below net asset value
- Generous new dividend policy
- Credit market could worsen
- Complex, niche asset class
Yet the company has reinvented itself over the past 18 months. It has hived off its legacy bonds into a separate vehicle, started reporting in sterling and raised capital to buy a fresh portfolio of mortgage-backed securities - the largest sub-sector of the ABS market - at distressed valuations. It is this portfolio that we are recommending to readers. If you can get past the vehicle's history, the upside looks substantial.
That's because mortgage-backed securities (MBS) are, for all their complexity, simply bonds that will eventually be paid back at par, barring a default. So if, in effect, you can buy them at 77p in the pound - the level at which RECI’s assets currently trade - you stand to make a substantial gain simply by waiting until maturity.
Normally, bonds would only trade at these levels if there were a high risk of default. But in RECI's case this isn't true. It holds bonds backed by high-quality mortgages, both commercial and residential and mainly in the UK and Germany. At least, they should be high quality because they have an average loan-to-value ratio of 57 per cent. That means the bonds are shielded by an equity buffer of 43 per cent - roughly equivalent to the peak-to-trough fall in commercial property prices in 2007-09. Property values are still falling, but the risk of a repeat on the same scale is extremely slim.
Moreover, much of the real estate that underlies the portfolio is prime property. For example, one bond is backed by a sale-and-lease back deal written by Tesco in 2007; another is backed by the More London estate, where the London mayor lives alongside Ernst & Young and law firm Norton Rose.
REAL ESTATE CREDIT INVESTMENTS (RECI) | ||||
|---|---|---|---|---|
| ORD PRICE: | 88p | MARKET VALUE: | £35.2m | |
| TOUCH: | 87-88p | 12M HIGH / LOW: | 111p | 75p |
| DIVIDEND YIELD: | 7.5% | TRADING PORTFOLIO: | n.a. | |
| DISCOUNT TO NAV: | 23% | |||
| INVESTMENT PORTFOLIO: | £84.1m | NET DEBT: | 95% | |
| Year to 31 Mar | Net asset value (¢) | Pre-tax profit (€m) | Earnings per share (¢) | Dividend per share (¢) |
|---|---|---|---|---|
| 2008 | 531 | -22.1 | -59 | 60.0 |
| 2009 | 375 | -59.9 | -213 | 39.0 |
| 2010 | 373 | 2.3 | 9 | 32.0 |
| 2011 | 226 | 15.6 | 46 | 17.5 |
| p | £m | p | p | |
| 2012 | 110 | n.a. | n.a. | 4.5* |
| 2013* | 115 | n.a. | n.a. | 6.6 |
| % change | +5 | – | – | +47 |
NMS: 3,000 Matched bargain trading BETA: 0.4 *Estimates adapted from Liberum Capital | ||||
So why are these securities trading at such big discounts? Mainly because European banks are trying to offload them in huge quantities that opportunists like RECI are simply too small to soak up. This raises an issue of timing - the discounts at which these MBS bonds trade have failed to close in the recovery so far, and show no immediate sign of closing. Instead, they rise and fall with market sentiment towards the euro-zone crisis.
Yet Cheyne Capital, the real-estate debt specialist that has managed RECI since 2005, has timed the market well over the past year, rebalancing the portfolio towards more defensive securities before the market fell last summer. And the discounts will have to close eventually, when the mortgages are paid back and the securities are wound up. It's a case of when, not if.
Unsurprisingly, banks aren't interested in lending against portfolios of the very MBSs they are trying to offload. That explains RECI's unusual capital structure, with no bank debt in sight. Instead, it is funded in roughly equal parts between ordinary shares and preference shares.
