Trez Capital Senior Mortgage (TZS.TO) – Liquidation – 30%+ Upside

Current Price – C$2.38

Liquidation Value – C$3.12+

Upside – 32%+

Expiration Date – TBD

Q2 2018 Financials

This idea was shared by Chris

 

This is sister investment corporation of TZZ.TO and is operated by the same management company. It is also in liquidation mode  and trades at significant discount to book value. Final stages of TZZ.TO liquidation are working out very nicely and it looks like shareholders will be cashed out at book value sooner than expected. Same might happen with TZS, but situation is a bit more complicated and uncertain, which is the main reason for the larger spread.

TZS book value as of Q2 stands at C$3.12/share. Company has liquidated majority of portfolio already and has two mortgages outstanding:

  • C$12.1m residential mortgage with C$1.65m provision and LTV of c. 80% due in Dec 2020 and;
  • C$2.7m residential mortgage with no provision and LTV of c. 50% due in 2024.

Although both loans are classed as performing currently, the larger one might appear problematic going forward - it already was in default before and new extension and payment schedule have been agreed recently. Here is full dossier from Q1 results:

A borrower defaulted on a first mortgage with a carrying amount of $11,443,815 and interest receivable of $70,619. The mortgage was subsequently renewed and was no longer considered in default at March 31, 2016 after the borrower provided additional security on the mortgage, made partial interest and full principal payments.

In May 2016, there was a severe fire in Fort McMurray, Alberta, resulting in mass evacuation. The loss of rental income from the property caused the borrower to temporarily cease making mortgage payments.As the building was undamaged, the Company expected occupancy to increase above levels seen before the fire, resulting in continuation of mortgage payments and ultimately, full repayment of the loan.

In September 2016, the loan sharing partner in a senior position requested full repayment of its loan portion. A demand letter was issued to the borrower and the mortgage was again considered to be in default.

In October 2016, the borrower entered into negotiation with the Company, in an attempt to ease the demand. The borrower made payment of the missed interest payment and accelerated the timing of a $5,500,000 pay down from May 1, 2017 to November 15, 2016.

During the second quarter of 2017, the loan sharing partner requested a further pay down of $3,000,000 and additional principal repayments of $83,000 per month. The Borrower contributed $1,000,000 and the remainder was split between the Company and a related Trust based on their proportionate share of the mortgage. The Company provided $1,610,516 and the related Trust contributed $389,484. The monthly $83,000 was also being paid by the Company and the related Trust based on the same proportionate shares in the loan. The loan was set to be due on June 1, 2018.

In the first quarter of 2018, the borrower requested a new 3 year loan agreement with pay down of $1,000,000. Management approached the loan sharing partner who still holds the senior portion of the loan and requested their input regarding a potential renewal. A new term for 31 months was agreed to between the parties, with the borrower also agreeing to pay on a go forward basis the portion of the principal that was being paid by the Company. The borrower has also agreed to make the requested $1,000,000 pay down on June 1, 2018 and additional payments of $500,000 every six months thereafter until December 1, 2020 when payment in full is due.

At the time of renewal due to continued risk and the challenged nature of the loan, the Manager reassessed the cash flows expected from the borrower and the obligations to the loan sharing partner and recognized a further fair value provision of $700,000 against the loan. The Manager applied a discount rate of 15% to the expected cash flows based on the revised payment terms of the new loan agreement.

At March 31, 2018, as a result of the renewal of the loan and agreed to pay down schedule, management considers this loan to be currently performing and did not record any further fair value loss provisions against the loan. The total fair value provision at March 31, 2018 is $1,650,000.

The 1st of June C$1m payment was received on time, however high interest rate on the loan (7.5% for a loan backed by real estate) clearly shows that this borrower is considered to be high risk and likely struggles to find cheaper financing alternatives. Nevertheless, couple factors suggest that full loan amount will be recovered:

  • LTV ratio is c. 80% so even if the buyer defaults, collateral is likely to fully cover mortgage value;
  • Looking at BV of the loan (i.e. net of provision) the underlying collateral covers it 1.5x;
  • Provision was calculated assuming 15% discount rate to expected cash receipts on the mortgage, rather than actual expectation that some portion of the loan will not be recovered. If the loan is eventually repaid in full, book value would increase by C$0.18 to C$3.30 (resulting in 40% upside to current share price).
  • Lastly, the successful case of TZZ (including sale of the underlying real estate on the defaulted loan) gives confidence that collateral value in LTV calculations is not overstated and that management will sort this out favorably eventually (obviously every mortgage and underlying collateral is different, so might turn out that comparison with TZZ was not appropriate).

Besides the problematic mortgage there are few other concerns. Firstly, company already sits on C$10.7m in cash (C$1.46/share), and management has no intentions to distribute it to shareholder yet (management is getting 0.85% of gross assets, so this cash balance that does nothing nets them C$90k annually). From Q2 earnings release:

Given the limited amount of principal and interest payments expected in the future, the company intends to maintain its current cash levels until the senior position is fully repaid by the borrower. The Board anticipates making further special distributions as the two remaining mortgages in the portfolio mature or are sold, subject to reasonable expected operating expenditures and repayment of the senior loan participant.

So if the remaining two loans are not sold and mature on schedule, shareholders should not expect any distribution before 2021. This is quite different from the timely distributions seen in TZZ liquidation, so there is a chance that this statement was put in place to give management flexibility and that the distribution of the C$10m will happen earlier.

Management fees add up to C$200k/annually and G&A will probably be below C$400k/annually going forward. Interest income from the smaller loan is c. C$115k/annually and C$909k/annually from the larger one (however, interest from the larger loan is accrued to the loan balance rather than paid in cash). Thus if if both loans and accrued interest get repaid on schedule, there should not be any BV erosion due to operating expenses. Assuming expense levels outlined above till 2020 and then afterwards at C$30k for management fees and C$100k for G&A (2021-2024 with only one loan loan on BS), the company would generate cumulative incremental C$1m in cash (C$0.14/share). This should provide sufficient buffer for any final company liquidation expenses or potential incremental costs of putting mortgages in default and liquidating underlying the real estate.

Expected incentive fees at current book value are already provisioned.

The IRR in this situation depends not only timely mortgage repayments and absence of any further issues but also on timing of the distributions (which is at management's discretion). I arrive at IRR of 12% assuming:

  • Mortgages and any accrued interest get repaid on schedule (2020 and 2024);
  • There are no incremental income/loss from interest receipts or liquidation expenses (i.e. the above mentioned buffer of C$1m assumed to be zero);
  • Distributions take place right after maturity of each loan (2021 and 2024).

IRR would be substantially higher if mortgages get sold prior to maturity or another asset manager offers a buyout at NAV (as happened for TZZ).

I consider the downside to be limited at current prices mostly due to collateral protection on the potentially problematic loan as well as large discount to NAV. The underlying real estate would need to be sold at 1/3 of its estimated value for investors to break-even at current share prices (ignoring any time value of money).

23 COMMENTS

  1. dt

    TZS sold-off materially over the last couple of weeks. Q3 results and updated NAV should be announced any day now (last year was on Nov 10th).

  2. work 22

    Bloomberg has 11/26/18 for the next announcement, not sure if that’s correct- i don’t see any confirmation of it from the company. The real estate market in Ft. McMurray can’t be great with Canadian oil differentials being slammed so bad (Canadian oil sells for around $16-17 a barrel, no joke, compared to $56 headline price!).

  3. dt

    Q3 results have been released. No update on any of the two remaining mortgages. Next payment on the potentially problematic loan is on the 1st of December.

    Book value per share increased to C$3.14 (40% upside from current prices) as interest income exceeded expenses. However, majority of the interest income was non-cash and relates to the potentially problematic mortgage.

    So now there will be another 3 months of waiting before we get to know whether the $0.5m payment was made on time. And if this mortgage will not get sold, the same situation will continue till Dec 2020 when the full balance is due.

  4. Ilja

    Annual results have been released. It seems that that the borrower has met its obligations and C$0.5m payment was made. BV stands at C$3.18 (35% upside from current prices).

    1. dt

      Where did you get that C$500k payment in December has been made?

      Looking at cashflow statement I can only see C$19k of loan repayment and C$60k of interest paid during Q4. Also from table 11(a) additional C$253k of interest payments have been capitalized, but the problem is that figures in this table do not add up with a total of C$195k missing.

      So really no sure what happened with the C$500k payment that was due in Dec’18. Management has only stated that “The borrower has met all its’ required payment obligations in 2018”, but that does not show up in cash flow statement. So the whole situation is a bit puzzling.

      1. work 22

        Maybe there was a grace period on the December 1st, 2018 $500k payment? Which would not be good if it had not been paid yet or they needed a grace period. But it seems mgmt would, or should have, updated the report if the money was still not paid 3 months into 2019. Puzzling to me too. So far Trez Capital has managed these two wind-ups conservatively, so i’m inclined to believe them and hold on. Hopefully that’s right, we’ll see….

        1. fishwithwings

          Couldn’t some of the 500k be categorized under “Principal repayments or sold investment in mortgages”?

        2. dt

          ‘Principle repayments’ – changed only by C$30k during the quarter, so half a mil payment can not be here. The same can be seen from cash-flow statement.

          Maybe as work suggests it was paid after the quarter end.

  5. Ilja

    Interim results are out. BV increased to $3.24/share (40% upside from current price).

    1. work 22

      thanks, that’s about the range on BV i got too- also the larger mortgage continues to perform. I wonder how the final principal full repayment will go? Hopefully well of course.

  6. Bulrathi

    The problem in this one is what Munger says “Show me the incentive and I will show you the outcome”. Management has an incentive towards delaying this as much as possible. And by the way they structured their compensation plan, they are clearly corporate assholes. The investment might work out but its probably a bad idea to get involved in these unless the price is just way too good

  7. dt

    TZS Q3 report showed BV increase from $3.24/share to $3.27/share, however this increase was mostly driven by interest accruals on one of the loans than actual cash receipts. Management notes that both mortgages are continuing to perform and that semi-annual payments (C$500k) on the renegotiated loan are being made on schedule. However, this does not seem to be reflected in the cash-flow statement or cash balance – instead interest accruals are recorded.

    The simplest explanation is that the indicated C$0.5m semi annual repayments are being made to the TZS co-investment partner (another fund operated by the same manager) on this mortgage. Disclosures on Note 7 appear to show that the combined loan balance is actually decreasing.

    As at September 30, 2019, the Company has co-invested in one (December 31, 2018 – one) mortgage investments with other funds managed by the Manager. The total amount of the coinvested mortgage is $28,328,443 (December 31, 2018 – $29,315,281), of which the Company’s share is $13,395,442 (December 31, 2018 – $12,610,765). During the nine months ended September 30, 2019, the Company sold investments in mortgages of nil (September 30, 2018 – nil) to entities under common management.

    The respective loan expires in Dec’20.

  8. Ilja

    Annual report was released. Both loans are continuing to perform and so far all the required semi-annual C$0.5m payments are being made on schedule (apparently to the co-investment partner).
    BV decreased from C$3.27/share to $3.11/share due to the fair value re-assessment of the larger loan (Alberta) that has resulted in C$1.8m loss provision.

    “The Manager considers this loan to be performing however, due to continued risk and the challenged nature of the loan, the Manager has reassessed the cash flows expected from the borrower, the obligations to the loan-sharing partner and reasonability of being repaid on maturity. This analysis of the fair value of the mortgage resulted in an additional fair value loss provision of $1,800,000”

    https://sedar.com/GetFile.do?lang=EN&docClass=5&issuerNo=00033792&issuerType=03&projectNo=03039266&docId=4693931

    1. dt

      I think management’s claims that the larger loan (the one which was in default previously) is performing are not really correct. Additional provision also clearly shows that. The scheduled interest payments on this loan are not received in cash but simply added to the loan balance. However, as this loan is secured by the property, even in the worst case scenario (borrower defaults) the recovery will be well above zero. TZS shares now trade as if there is only 15% recovery on this loan, which I think is a bit too punitive (but in light of over-all market sell-off and other discounts, might be correct).

  9. Ilja

    As of Q2 BV stands at $3.03/share. $0.34/share special dividend is expected to be paid out on the 20th of August. The borrower of the large loan has asked and has been granted for 3 months deferral on the scheduled C$0.5m semi-annual repayment. Provision on the loan has not been changed.

    “During Q2 the borrower requested a three month deferral of mortgage payments, due to the inability of tenants to pay rent as a result of the Covid-19 economic and health crisis and the deferral was granted. Due to continued risk and the challenged nature of the loan, the Manager has a fair vale reduction of $4.75 million against the mortgage. “

    https://sedar.com/GetFile.do?lang=EN&docClass=7&issuerNo=00033792&issuerType=03&projectNo=03094174&docId=4776014

    Additionally, TZS has announced a normal course issuer bid and in time will buy up to 6% of total outstanding shares (10% of public float) in the open market.
    https://sedar.com/GetFile.do?lang=EN&docClass=8&issuerNo=00033792&issuerType=03&projectNo=03094688&docId=4776444

  10. Maple Fun

    It seems that TZS’s mortgage is in Fort McMurray (as mentioned above re wild fire). Real estate is in deep distress in that area (local RE board provides good data). More importantly, there is another tranche senior to TZS’s mortgage. So the risk is extremely high imo. If the mortgage was in another place of Alberta, I would be far less worried.

  11. dt

    Shares of TZS.TO spiked upwards by 15% over the last month and now trade close to the book value of C$2.7/share (adjusted for August dividend payout). I have closed my position at these levels as book value was my target. I am also removing TZS from active ideas with 23% return in two years.

    This one has taken a while to play out and to be fair I am puzzled why the shares started trading at around book value specifically now. Aside from the dividend payout (will trade ex-dividend today) I have not seen any other info that could warrant such a move. Investors buying at current levels are betting on the provision reversal for the problematic loans – C$4.75m in provision could potentially result in C$0.66/share in incremental book value.

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