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Subject: GKK: Humbled (Again) on Wall Street Date: 3/8/2008 4:28 PM
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Sorry for the length of the following post; however, I want to provide some thoughts on a difficult and uncertain situation. I also want to note that I haven’t yet read the posts on GKK on our board; accordingly, much of what follows may be a repeat of what others have observed. However, given my positive views towards GKK in prior posts, I thought it important for me to express my current thoughts – for what they may be worth.

Back in 1975, about 33 years ago, the well-known and widely-respected investor Martin Sosnoff wrote a book about his experiences in the investment world. The book, now out of print, was entitled “Humble on Wall Street.” The point of the book, of course, was that the investment world can make even the shrewdest investor very humble in a very short time.

I certainly don’t claim superior investment intelligence (although our track record in REIT investing over the years has been quite good). Nevertheless, particularly in light of my recent experience with a well-known M-REIT, I do want to acknowledge the need to be humble when it comes to making investment decisions. Let’s consider the trashing of a stock on which I have been very positive for several years, Gramercy Capital (GKK). I have never been a big fan of lending REITs (the reasons for which were noted in “Investing in REITs” and in prior posts), but I did make an exception for GKK.

Although Gramercy’s stock has consistently outperformed its peers in the commercial lending REIT segment since its IPO in July 2004, this year it has bitten its investors badly, myself included. The stock is down about 37% year to date. Its outperformance last year vs. peers NRF and CT has been reversed, as the stock prices of those REITs haven’t fallen as much this year. GKK, closing at $16.37 on Friday, presently trades at just 5.7x estimated 2008 FFO and at a dividend yield of 15.4%. This company, affiliated with the widely-respected office REIT, SL Green, was once a very highly-respected REIT; today, apparently, it’s respected as much as a 12-year old junkyard dog with no teeth.

What happened? First of all, Gramercy hasn’t announced any disasters or stepped into anything really foul-smelling. No bank has pulled its credit lines, there have been no significant increases in non-performing loans, and its CDOs haven’t been down-graded by the bond vigilantes. It did reduce 2008 guidance about a month ago, from $3.05 – 3.10 to $2.85 – 2..90 (about 6.5%), due to a reduction in the pace of American Financial’s asset sales (causing GKK to have to finance an additional $150MM of the acquisition price), increased capital costs and reduced lending volumes due to the credit market dislocation.

There was no hint of anything more draconian, and GKK’s $2.52 dividend would seem to be well-covered. Furthermore, the AFR acquisition, which is scheduled to close later this month, will broaden and diversify GKK’s cash flows, while making it less reliant upon new commercial real estate loan originations in an uncertain environment. Everyone seems to agree that the pending AFR acquisition is a very favorable development.

But GKK’s stock has continued to slide into the muck, and Citibank – for what it’s worth – cut its rating on GKK (as well as other lending REITs) this past week from “buy” to “hold,” citing the prospects of a recession and resulting credit deterioration. This down-grade neatly encapsulates the reasons for GKK’s miserable performance of late (although, as is usually the case, it was done well after the horse had left the barn).

It’s no secret that we are experiencing what may be the equivalent of a 100-year flood (though these events seem to be happening with more frequency in the investment world). We have veered 180 degrees, from obscenely lax lending standards to the most tight-fisted stance in decades, all within less than nine months. Before last summer, investors were willing to buy the paper of anything short of goat farms in Algeria at spreads of a few hundred bps; now, they aren’t even willing to buy Fannie- or Freddie-backed mortgages. Risk aversion has run amok.

This, of course, is affecting the prices of bonds, stocks, real estate and virtually everything else, as nobody wants to step up and make investments. Housing-related debt has been affected the most, but anything and anyone in the mortgage business (or, indeed, any business that involves debt securitization) has been getting killed. While defaults of commercial real estate mortgages are very low, and are unlikely to rise to worrisome levels – a situation very different from the residential mortgage markets – investors are refusing to buy loans. Period.

So here’s the picture at the present time. Even though Thornburg Mortgage (TMA) has a well-deserved reputation for quality underwriting and very low loan losses, it is on the verge of bankruptcy; its stock plummeted 86% just in the past week. Its crime? It is a residential mortgage REIT. It must, under relatively new accounting rules, mark to market its mortgage securities. As they have fallen in price, TMA has had to mark assets down to “market price” – a price that’s being set by vulture investors while major long-term investors cower in their boardrooms and salivate over T-bills at sub-2% yields.

The reduced market value has resulted in margin calls by anxious lenders, forcing a mass liquidation of TMA’s securities investments (about $8 billion, per today’s WSJ) – which, of course, reduces the “market price” further, causing more margin calls, more liquidations, yada yada. (Carlyle Capital is another recent flood victim). So we have one of the most widely-respected mortgage lenders forced to the brink of bankruptcy, even though the default rate on the mortgages it has originated and owns remains very low. Its only crime is being in this business and, like most in this business, including the banks themselves, using large chunks of debt (and modest equity) to carry its loan investments.

Gramercy and its peers are not immune to these very difficult – should we say panicked? – markets. Defaults – or, rather, the lack thereof – within GKK’s loan portfolio is not the problem. Nor will GKK be required to write down the value of its discrete mortgage investments (if I understand it correctly, the mark to market rule applies to mortgage securities). But Gramercy (and its peers) DO have a problem, and it relates to their debt-levered balance sheets – and some of this debt is fairly short-term in nature.

High debt leverage at lending REITs is as normal and expected as dumb statements from professional athletes. Nevertheless, while such a business strategy isn’t unreasonable during most periods of time (and helps to generate respectable earnings growth along with unusually high dividend yields), it is quite risky in times like these. At the end of 2007, Gramercy had approximately $3.3 billion in debt obligations of various types (the most significant of which was $2.7 billion in CDOs), and book equity of $749 million; debt to total assets, at book, was 78.6%. This is typical for an M-REIT; and high leverage today is a liability.

So GKK’s stock has been trashed. What to do now? Buy, hold or sell? We must each make our own investment decisions, but I will describe what I have done, and why.

First, and I think most important, I have sold down to a level where a permanent price decline, in the unlikely event it happens, won’t inflict unacceptable pain upon me or my portfolio. GKK now represents just 3% of all my REIT shares. Let’s be honest with ourselves; an investment in GKK today bears much greater risk than it did just a few months ago.

Why? There are increased risks, alone, in a highly levered balance sheet. Engaging in the lending business (even the much safer commercial real estate lending business), due to what appears to be a US economy that’s declining rapidly, is also much riskier today. So, I have tapered my GKK position over the past week and taken investment losses. It was the right thing to do, I think, from a risk management perspective – although I think that, with hindsight, I will regret the selling of a single GKK share. I still love the company, but am not willing to keep as many chips on the table.

But, if I didn’t already own the stock, I would buy it at today’s price (assuming I was willing to accept above average amounts of risk). GKK’s stock has, IMO, over-reacted to current events, and is cheap under any scenario short of some type of Armageddon. Book value, as far as I tried to calculate it, is about $18.18 per common share, and that values GKK’s business platform at zero. Market history suggests that the most profitable time to buy a stock is when everyone else hates it.

But, I remain humble, and admit to a lack of conviction in the face of a scary and unpredictable credit contraction that just seems to be getting worse. Nobody really knows where today’s loony and panic-crazed credit markets are headed. Should they get even worse, investors will be kicking themselves for not bailing out when “the handwriting was on the wall.” Should they stabilize, and the extreme risk aversion of today evaporates, GKK’s stock will move up with blinding speed, and investors will be wondering why they didn’t back up the truck when it was wallowing in the mud at $16. Such is the nature of markets and horse races; the right calls seem so obvious and easy on the following day.

Ralph
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