As I look at the flood of earnings reports coming in, one group of companies is blowing the doors off everyone else: Private Equity (PE) firms.
The turbulent markets and low-interest rates have provided a perfect storm of opportunities for these 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 never selling.
It has worked 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 will repeat myself. It will be time to add or initiate a position.
2020 is the perfect environment for private equity firms
The big PE firms are making a ton of cash from their private investments in public equity deals (PIPEs) back in March and April.
PE firms help companies recapitalize. They provide loans to companies with good business but maybe had too much debt on the balance sheet when the virus hit the economy. They are then paid back with interest as time goes on. With reputable partners, it becomes a cash machine.
Led by Blackstone, the PE giants are moving aggressively into real estate at bargain prices for the first time in several years. Blackstone is focusing on self-storage, industrial properties, and life sciences.
We are also seeing PE move back into select office markets. The office market has changed, but it’s not going to disappear. Current pricing would make one think that the future of central business district (CBD) properties 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 we will see PE get even more aggressive in the office markets.
Evaluating Four PE Real Estate Companies
Each of the big three PE firms (Blackstone, KKR, Apollo) has an associated mortgage REIT – all of which are covered below, in addition to a small commercial mortgage REIT that has recently jumped on my radar. Each one has been beaten up this year due to coronavirus and for income investors, they are worth taking a closer look.
- Blackstone Mortgage Trust (BXMT)
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 it doesn’t make any sense why. 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 loan to value (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%.
- KKR Real Estate Finance Trust (KREF)
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 an LTV 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%.
- Apollo Commercial Real Estate Finance (ARI)
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 in this post.
I will hold this one back to buy when they cut their dividend.
- Ares Commercial Real Estate (ACRE)
The Ares Commercial Real Estate (ACRE) 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 in the third quarter, so the portfolio is in excellent shape. Ares is so good at underwriting loans that they’ve never had a credit loss on over $5.9 billion of real estate debt.
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%.
Reward Equals Risk
The REITs above are mostly senior loans that are performing well and have low loan to values (an assessment of lending risk; lower is better). 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.
These underlying facts embody almost everything a value income investor should look for. Adding a small portion of these REITs to your portfolio can potentially add a significant bump to your bottom line.
But none of the REITs are risk-free, of course.
Given the volatile outlook, it makes sense to adopt a go-slow and stay-small-to buy-them approach.
Buy a little today and add on big down days.
– Tim