Magnifi Communities

Last week a real estate investment trust (REIT) – which was not financially stressed – voluntarily “turned in the keys” for one of its properties, defaulting on a $725 million loan. The ramifications of this decision depend on a lot of factors.

Let’s talk about what it means for you.

On June 5, Park Hotels and Resorts (PK) announced it would stop payments on a $725 million, non-recourse CMBS loan secured by two of its San Francisco hotels. The hotels are the 1,921-room Hilton San Francisco Union Square and the 1,024-room Parc 55 San Francisco.

The press release made these comments:

After much thought and consideration, we believe it is in the best interest for Park’s stockholders to materially reduce our current exposure to the San Francisco market. Now more than ever, we believe San Francisco’s path to recovery remains clouded and elongated by major challenges—both old and new: record high office vacancy; concerns over street conditions; lower return to office than peer cities; and a weaker than expected citywide convention calendar through 2027 that will negatively impact business and leisure demand and will likely significantly reduce compression in the city for the foreseeable future. Unfortunately, the continued burden on our operating results and balance sheet is too significant to warrant continuing to subsidize and own these assets.

There is a lot here to unpack.

A non-recourse loan means that Park Hotels can literally “turn in the keys” and not have any further loan obligations. The company said it would work with the loan servicers to determine the most effective solution.

The loan was part of a commercial mortgage-backed securities (CMBS) pool. This structure means any investors in the CMBS will be negatively affected.

For the REIT, stopping payments on the debt will reduce the debt-to-EBITDA ratio from 6.0 to 5.1. The company expects to save $30 million of annual interest expenses and $200 million of maintenance CapEx over the next five years.

The cash savings will let the company pay a special dividend once the hotels are fully out of the portfolio.

For the larger picture, investors need to know where REIT properties are located. There is a mass business exodus out of San Francisco, so REITs with heavy exposure to that city or others with challenged business environments should be sold or avoided. This chart uses cellphone activity to show which downtowns have recovered the least from work-from-home policies.

Commercial mortgage investors are at significant risk. Banks, CMBS, and finance REITs own these loans. CMBS are typically by large institutional investors such as insurance companies and pension plans. Stay away from riskier finance REITs. There will be companies that can take advantage of financially stressed situations. Starwood Property Trust (STWD) has a long history of finding special opportunities in commercial finance.

Finally, this decision makes Park Hotels & Resorts a more attractive investment. I will keep a close eye on this lodging REIT.

Citigroup (C) is the third-largest lender in the U.S. and the least-loved major bank by investors—and for good reason…

The bank has been a chronic poor performer seemingly forever. Its low return on equity, poor stock market underperformance, and low valuation made the point for quite a while that Citigroup’s business model did not work and needed changing.

But changes at this disliked bank are now creating some great opportunities for investors.

Jane Fraser: the Broom Cleaning Up Citi

Changes began to happen after Jane Fraser became CEO in March 2021: she set about divesting Citi of much of its global consumer banking franchise, which had no synergies with its best businesses: transaction banking, credit cards, and fixed-income markets.

The changes she made are already starting to bear fruit.

On April 14, Citigroup reported a profit of $4.6 billion in the first quarter, up 7% from a year earlier and well ahead of the expectations of Wall Street analysts. Revenue jumped 12%. Citi’s loan book was roughly unchanged, and deposits fell 3% from the previous quarter, though credit card lending was up 7% from a year earlier.

However, UBS analysts said Citigroup still had “more wood to chop”—and the bank has proceeded to do so.

On May 24, Citi said it will spin off its Mexican retail bank (Banamex) through an initial public offering, abandoning a plan hatched early last year to sell the unit to another bank instead.

Banamex is one of the largest consumer banking franchises in Mexico. Citi said an IPO of the unit was likely by the end of 2025. Despite the spin-off, Citi does plan to retain much of its corporate and institutional business in Mexico.

At the time of this announcement, the babk also said it would resume stock buybacks by the end of June—at least six months sooner than analysts expected.

Mike Mayo, a highly respected bank analyst at Wells Fargo, said: “Citi is becoming a simpler firm. Jane Fraser is feeding the winners and starving the losers, as she should.”

In other words, Fraser is doing all the right things to turn Citi around. Yet, neither she nor Citigroup shareholders have yet been rewarded for doing the right things.

Citi Remains Cheap

Citigroup stock has continued to underperform the other big diversified U.S. banks, and its valuation remains largely unchanged. In fact, Citi’s price to tangible book value ratio is still edging down—to $0.54—as of June 2, 2023.

What is most surprising to me is that its valuation even trails some regional banks, with characteristics that scare investors, like lots of uninsured deposits and a large securities portfolio of commercial real estate loans.

So, what is the problem?

Despite all she has done, Fraser still has a lot to do. The numbers don’t lie…

Citi’s return on tangible common equity (8.9% in 2022) is lower than it was in 2019. And the gap with its big banking peers is still in the mid-teens, and has not narrowed. None of the divestments or other reforms so far have moved the needle.

The Financial Times’ Robert Armstrong reports that the valuation wizard, Aswath Damodaran of New York University, has made a strong case for owning Citi. Here is the link to what Damodaran wrote: good-bad-banks-and-good-bad-investments.

Damodaran wrote that Citi had ample regulatory capital and has been growing assets slowly, but steadily. He believes this means net income will grow over time. In order to assess the riskiness of Citi, he looked at net interest margin, regulatory capital ratios, dividend yield, return on equity, deposit growth, and securities portfolio accounting at the 25 largest U.S. banks.

In his analysis, Citi actually scored above the median on the first three of these six measures—meaning it had the best performance among banks that trade at a price/book discount. Damodaran added that Citi’s weakest link remains its return on equity (ROE). However, he also believes the discount on Citi is too much. He says that its banking business, while slow-growing, remains lucrative.

Finally, Damodaran said: “I will be adding Citi to my portfolio…It is a slow-growth, stodgy bank that seems to be priced on the presumption that it will…never earn an ROE even close to its cost of equity, and that makes it a good investment.”

I agree with Damodaran’s assessment: Citi is moving in the right direction. Jane Fraser is streamlining the bank, especially the planned exit of consumer banking in Mexico and the ongoing sales of its Asian retail banking units. These actions will release equity capital that can be redeployed to the company’s leading position in corporate treasury services, financial technology platforms, and expanding global wealth management business that has new leadership.

Dividend-wise, Citi has made a lot of progress. Its annual dividend in 2015 was just $0.16 per share; now, the annual dividend is $2.04 per share (a 4.42% yield)…although that has not changed for three years. I do expect dividend increases to resume in 2024.

Citigroup remains a deep value turnaround play, with a multiyear time horizon. Even so, investors have been more than adequately compensated to bear these risks. That’s thanks to the material upside to the stock’s current price of around $46 per share and a nice dividend—all without the deposit outflow risk of regional banks.

C is a buy anywhere in the mid-$40s per share.
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