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GKK: The Good, Bad, and Ugly

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By Reitnut
July 25, 2008

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I wish I could have gotten to the Board earlier, but am bogged down this week with all sorts of stuff, not the least of which is earnings season. As I suspect that some of you may be interested in my reactions to GKK's Q2 earnings release and conference call -- although, given my track record regarding this company, I have no idea why -- I decided to write up my thoughts and post them here. So, here goes:

Let's be blunt. There wasn't much to like in GKK's Q2 earnings release. Of course, based upon how the stock has been acting, we knew it would look like 40 miles of bad road -- but we didn't know how bad the pot-holes would be. Here are a few thoughts, for what they might be worth (but keep in mind that I have been very wrong about this company, and should probably confine my thoughts to equity REITs - so you should take what follows with many grains of salt).

The Good. First, in our anger and disappointment, let's not forget to note the bright spots, and there were a few of them in Q2. The AFR assets are performing reasonably well. They generate $225MM in NOI, with much less volatility than income from a mortgage loan portfolio. Results exceeded GKK's expectations in Q2, and there is upside potential from leasing significant vacant space in the portfolio.

Sales of AFR's "held for sale" properties are going OK; of the $367MM in targeted sales for '08, $265MM has been completed, and another $49MM is due to close shortly. As for worries about banks defaulting on leases, over 70% of the AFR tenants have unsecured debt credit ratings of A or better; the average weighted lease maturity is over 11 years. This should alleviate some of the fears about AFR's banking tenants.

In the process of shrinking its balance sheet, liquidity appears to still be adequate. They are reducing "warehouse" credit lines and repo agreements, as they don't intent to use them (although some of this may have been due to pressure from lenders - hard to say). GKK's loan assets are burning off through repayments, albeit slowly. They have cash and immediate cash availability of $200MM, plus $733MM of additional borrowing capacity under existing credit facilities. So, nobody's gonna yank their credit lines in the near future.

Although there has been no change from prior quarters, another positive is that about 67% of GKK's loan assets are first mortgage loans, which puts it in a good spot when defaults occur. GKK has been aggressive about taking properties back when lenders violate covenants, and aren't anxious to renegotiate with defaulting borrowers. And approx 40% of GKK's loan portfolio is secured by assets located in NYC, where there is more liquidity and asset values are more stable.

They promise to - at last! - provide a supplemental package with more detail at the end of every quarter. (Analysts tend to place more importance on full disclosure when a stock performs poorly - nobody cared about Enron's disclosure, or even bothered to try to understand it, when the stock was skyrocketing).

The Bad. And yet there were many more negatives in Q2.

First and foremost, GKK's book equity represents just 14% of total assets. While this isn't a new development - and all M-REITs have very levered balances sheets - it does result in very high leverage, where any decline in asset values, perhaps due to write-downs or big boosts to loss reserves, will have a dramatic impact upon earnings and book value. More on this topic later.

Earnings guidance has been reduced to a figure even below the Q2 run rate. FFO in the second quarter was $.69, but management expects approximately $.50 in each of Q3 and Q4. Reasons: (a) increasing non-performing loans, (b) expected additional provisions for loan losses, (c) higher incremental borrowing costs due to greater spreads at which GKK must pay for money, and (d) the effects of GKK's de-leveraging.

There were more non-performing loans, and provision for loan losses increased dramatically in Q2 to $23.2MM, from $2.9MM in Q2 of last year and $8MM in Q1. More provisions are expected in coming quarters. These problem loans, while they shouldn't be surprising in this economy, tend to cast doubt upon the quality of GKK's loan underwriting - there is a fear that it expanded its loan business too rapidly and thus became sloppy.

Management, on the conference call, signaled a cut in the common stock dividend. We won't know the new level for another couple of months, but management stated, "the dividend could be lowered so that the yield would be in line with those of other hybrid, diversified or non-mortgage firms." What does this mean? Would the new yield be 12% or 7%? Assuming a yield of 10%, and a current stock price of only $7.50, the new dividend would be chopped to $.75 (this would be consistent with a Q2 earnings per share run rate of $.20, or $.80 annualized).

Of course, management put a happy face on this pending cut, stating that it would create lots more capital to deploy in a "target-rich environment." A valid point, perhaps, but the company isn't handling this issue very well; it should have been put in the press release. Most investors bought into GKK for the yield, not the growth prospects (if any), and perhaps many would like them to maintain a dividend equal to at least 90% of free cash flow. That could mean a dividend of $1.80, rather than, say, $.70-.75.

Another bombshell, discussed on the conf call but not in the press release, is the possible "internalization" of management, i.e., severing the management agreement with SL Green. Of course, some would applaud this, as internal management is the best business model in REIT world, saves fees paid to outsiders and eliminates conflicts of interest. However, the Green connection has been a net positive for GKK, and many of us would never have invested in it but for that formal relationship. No decision has been made, and the companies may not go through with this separation; however, it is, IMO, another negative and remains a cloud over the company.

And the Ugly. "Investors" - and I use the word loosely - responded to these negatives by trashing the stock horribly. It closed at $9.29 the day prior to the announcement, but closed that day at $7.73, down 16.8%, and is off another 8% this morning as I write.

But the thinking investor's response should be: "Yeah, yeah, yeah; however, the waterfall in the stock price has discounted all those bad things, and more. The stock should've risen despite this bad news. After all, isn't this what happened to the stock of Wells Fargo, which rose 33% in a single day after reporting a decline in earnings due to higher loan loss provisions?" And, perhaps more important, "But GKK's book value is $21.78 (or approx $19.50 if we look at only common equity, without the preferred stock). The stock is trading at less than 40% of book value, fer chrissake."

These are good points, of course, but we need to be careful not to take them too far. It is nearly impossible to value the common stock of this company. Book value is relevant, but we cannot cavalierly assume that book value is real tangible value. Because most of GKK's investments are direct mortgages and other loans, it doesn't have to report their values at anything other than cost, i.e., it doesn't need to mark them to market and run the reduction in value through the income statement, which affects the balance sheet. And the values of these loans are undoubtedly less than their book value.

If GKK's debt investments of $3.2 billion were marked down by, say, 15% to reflect "fair market value" today, that would be a decline of $480MM, or a reduction of book value of $9.35, to approximately $10.15 per share. I don't know if that number should be 15% or 5% or what. And what kind of discount to book value would be appropriate for a stock in this environment, where investors hate all highly-levered companies and where so many uncertainties abound, including rising loan loss provisions?

But let's try to come up with some sort of valuation. Assuming GKK's new FFO run rate is 50 cents per quarter, or $2.00 per share (per management guidance, and about a 10% return on equity), what's a fair price for this turkey? NorthStar, another highly-levered M-REIT, is expected to generate $1.45 in FFO this year, and the stock currently trades at $8.50, or 5.9x '08 FFO. If we apply a similar multiple to GKK's $2.00 in FFO, we get a value of $11.80, which is about 60% of stated book value, or about 90% of pro forma book value if we give GKK's loan portfolio a 10% valuation haircut.

So, if someone held a gun to my head and told me to value Gramercy's stock, I'd come up with a value of close to $12 (compared with a current trading price of a few pennies over $7). But I have as much confidence in that $12 valuation assessment as I do on the topic of the best way to feed baby wombats. As a result, I am not selling my (reduced) position in GKK; however, for right now, I am too chicken to add to it. That's my story and I'm stickin' to it. But don't place any reliance upon it. I am as lost here as the rest of you.

Ralph