Fitch Affirms Ladder Capital's IDR at 'BB'; Outlook Stable
KEY RATING DRIVERS
The affirmations incorporate Ladder's growing commercial real estate (CRE) investment platform that enables flexibility to invest across products, a conservative underwriting culture, and access to multiple sources of capital. Ladder varies its leverage depending on the risk profiles of and allocation levels to the various CRE asset classes in which it invests. As a result of an increased allocation to 'AAA' and other investment grade rated CMBS securities over the last two years, the overall corporate debt to equity ratio increased to 2.7x as of June 30, 2015, at the higher end of the company's articulated target of 2.0x-3.0x and up from the 1.5x-2.0x range from 2011-2013.
Ladder's credit strengths include growing core earnings through periods of market volatility, recently reduced reliance on gain on sale income -- though this has yet to be sustained over an extended period -- and adequate liquidity. Rating constraints include the company's less diversified business model focused on the commercial real estate sector, high proportion of secured funding, weak unencumbered asset coverage of unsecured debt following the August 2014 bond offering, reduced capital retention stemming from the parent Ladder Capital Corp's (LADR) REIT tax election effective Jan. 1, 2015, the absence of a track record as a standalone entity through a full credit cycle and key man risk.
Symbiotic Business Lines
Fitch has a favorable view of Ladder's track record of originating conduit and balance sheet mortgage loans, purchasing investment grade CMBS, U.S. Agency and other securities, and acquiring net lease and other equity real estate as market conditions warrant. Net lease equity real estate and highly rated securities balance Ladder's gain on sale for conduit loans and higher risk balance sheet loans given that they are on properties undergoing transition. The balance sheet continues to grow, with total assets increasing to $5.7 billion as of June 30, 2015 from $3.4 billion as of Dec. 31, 2013.
As noted in Fitch's commentary 'Commercial mREITs Eye Growth as Banks Keep CRE in Check,' dated July 6, 2015, commercial mortgage REITs (mREITs) like LADR are becoming more prominent in the commercial real estate lending market. There is a possibility that commercial mREITs will fill a void left by large U.S. banks, which have pulled back from the more volatile segments of CRE lending, such as construction, acquisition and land development while growing overall CRE lending volumes post-crisis. Ladder has significant floating-rate loan holdings (60% of total loans as of June 30, 2015), including higher risk CRE loans on transitional properties, thereby potentially benefitting from a rising interest rate environment.
Conservative Underwriting Culture
Ladder was founded during the financial crisis in October 2008 and has operated during multiple periods of market volatility without incurring credit losses since inception. Ladder's average loan-to-value is lower and debt service coverage and debt yield levels are higher than commercial real estate finance peers, including other commercial mREITs, banks, and other real estate investment and asset management firms, a credit positive. Ladder's average loan balance was $19 million as of June 30, 2015, limiting individual loss exposures, and the weighted average loan-to-value on balance sheet first mortgage loans was approximately 64% as of June 30, 2015, down from approximately 70% year-over-year.
Access to Multiple Sources of Capital; FHLB Remains a Low-Cost Alternative
Ladder remains reliant on wholesale funding sources, although there is growing diversity amongst Ladder's sources of capital. As of June 30, 2015, the company had five repurchase facilities, two secured credit facilities and a corporate credit facility from numerous lending institutions, mortgage loan borrowings, borrowings from the Federal Home Loan Bank (FHLB), and access to unsecured notes and public equity.
In June 2015, Ladder's captive insurer subsidiary, Tuebor Captive Insurance Company LLC (Tuebor), increased its FHLB advance limit to the lesser of $2.9 billion, 40% of Ladder's total assets or 150% of Ladder's total equity ($325 million increase). This came almost a year after the FHLBs' regulator, the Federal Housing Finance Agency, proposed rules to revise the requirements for financial institutions to apply for and retain membership in one of the 12 FHLBs. Among the proposed rules was that existing captive insurers would sunset over five years. Ladder has continued to take advantage of the low-cost funding afforded to FHLB borrowers. Interest rates on Tuebor's FHLB borrowings ranged from 0.25% to 2.74% as of June 30, 2015, which is among the lowest borrowing rates for any of Ladder's borrowings. Therefore, Fitch expects Ladder to continue accessing this capital source when financing certain first mortgage loans, mezzanine loans and investment grade CRE securities.
Fitch believes that Ladder's potential loss of access to FHLB funding would be manageable, considering Ladder finances high quality conduit loans and CMBS securities with the FHLB. These investments can be replaced with other sources of funding including term debt and repurchase facilities. However, this shift in funding would increase Ladder's cost of borrowing impacting its profitability metrics, and if replaced with shorter-term repurchase facilities, further reduce Ladder's liquidity profile and financial flexibility. Fitch will monitor the regulatory developments and continues to view access to more unsecured and longer-term funding sources positively.
Increase in Leverage
Ladder levers its assets based on their liquidity and volatility characteristics, with highly rated securities levered the highest, followed by net lease and other real estate equity, conduit loans, and balance sheet loans. The company matches its assets and liabilities well from a funding duration standpoint. Low leverage has been a key credit strength for Ladder but increased to 2.7x as of June 30, 2015, at the upper end of the company's articulated target of 2.0x-3.0x, from 1.9x as of Dec. 31, 2014 and 1.4x as of Dec. 31, 2013. Should the company fully utilize its recently authorized up to $50 million share repurchase program, leverage would increase slightly to 2.8x, which would still be appropriate for the 'BB' rating.
Growing Core Earnings and Lower Reliance on Gain-on-Sale Income
Core earnings totalled $100.1 million during the first half of 2015, down year-over-year due in part to adjustments related to the timing of the recognition of hedge results and the realization of gains/losses related to the sale of hedged assets. The overall earnings trajectory has remained strong at $219.3 million in 2014, up from $200.3 million in 2013 and $177.5 million in 2012. This comes despite several periods of volatility in the commercial real estate debt markets during the past several years. Core earnings to average equity was 13.3% in 1H2015, down slightly from 16.3% in 2014 and 17.5% in 2013; the decline was partially driven by a reduction in loan sale proceeds, including securitization profits.
Notably, the quality of Ladder's earnings has improved from a credit standpoint as gain on sale income (loan sales and gain on securities), net of hedges related to securitized loans, represented 30.9% of net revenues in 1H2015, down from 51.0% in 2014 and 53.3% in 2013. Greater revenue diversity with reduced reliance on gain on sale income over a longer term period would be viewed favorably by Fitch.
Predominantly Secured Borrower
Ladder's secured debt represented 83.2% of total debt and 59.5% of total assets as of June 30, 2015, which limits financial flexibility. In addition, unencumbered asset coverage of unsecured notes has weakened over the past year due to the company's August 2014 bond offering. Unencumbered assets and unrestricted cash totaled $835.2 million as of June 30, 2015, which covered unsecured debt by 1.2x. This ratio is down from 2.2x as of June 30, 2014.
Nevertheless, Ladder's liquidity position remains adequate with sources (unrestricted cash, projected retained cash flows from operating activities) covering uses (debt maturities assuming a 90% refinance rate on secured debt, operating lease expense, securities commitments remaining to be funded and unfunded commitments on mortgage loan receivables) by 1.0x through Dec. 31, 2016. As of June 30, 2015, Ladder had $957.6 million of excess committed capacity under its committed secured repurchase funding facilities and other repurchase facilities, $38 million under its secured credit agreement, and $507.8 million of undrawn committed term financing from FHLB, for a combined $1.5 billion available to fund future growth in its business.
Key Man Risk
Key man risk is not unusual for mortgage REITs or similar finance companies. In Fitch's view, key man risk continues to reside with the Chief Executive Officer of Ladder. However, the company has a deep bench, and the six executive officers of the company average 26 years of commercial real estate finance experience. In August 2015, Ladder's Chief Investment Officer resigned to assume the Chief Executive Officer role at a competing commercial real estate investment platform. Fitch views Ladder as having sufficient remaining management depth to absorb this departure.
As of June 30, 2015, Ladder's management team and directors held interests in the company comprising 12.3% of the company's total equity, aligning interests of management and shareholders.
REIT Tax Election Credit Neutral; Higher Dividend Payout Ratio
LADR's REIT tax election effective Jan. 1, 2015 had no impact on Ladder's 'BB' long-term IDR or Stable Outlook. This was because of Ladder's intention to maintain a consistent operating strategy and pay a portion of the dividend in common stock rather than an all-cash dividend, which offset the limited capital retention flexibility that comes with REIT election. The REIT conversion negatively impacts Ladder's ability to retain capital for growth and/or opportunistic activity, driven primarily by the requirement that REITs distribute at least 90% of taxable income to shareholders.
As a result of the REIT tax election, Ladder is expected to retain approximately 45% of its core earnings going forward, compared to approximately 60% prior to the REIT conversion. All else being equal, the REIT conversion increased after-tax core earnings because of a lower effective tax rate as a REIT, but this was somewhat offset by an increase in the company's cash dividend to $1.10 per share from $0 per share previously.
RATING SENSITIVITIES
IDRS AND SENIOR DEBT
The Stable Outlook reflects Fitch's expectation that the company will continue to prudently grow its business, maintain conservative underwriting standards, and continue to moderate reliance on gain on sale income. This is offset by Ladder's increase in leverage and growing access to FHLB financing, which is economical but nevertheless constrains further growth in the unencumbered pool and the ratio of unencumbered asset coverage of unsecured debt.
The following factors may have a positive impact on Ladder's ratings and/or Outlook:
--Greater revenue diversity with a sustained reduction in reliance on gain on sale income;
--Sustained profitability and asset quality performance through multiple market environments, while maintaining conservative leverage at the lower end of the 2.0x-3.0x target and strong liquidity levels;
--Increased economic access to long-term unsecured debt funding.
The following factors may have a negative impact on Ladder's ratings and/or Outlook:
--Regulatory risks that immediately impede access to FHLB borrowings without an offsetting increase in long-term economic sources of funding;
--Material increase in exposure to more aggressively underwritten balance sheet loans or real estate equity investments without adequate reserves and commensurate decrease in leverage;
--An increase in leverage beyond the company's articulated target;
--Sustained reduction in liquidity levels and/or unencumbered assets relative to outstanding unsecured debt;
--Sustained operating losses or material weakening of asset quality.
Fitch has affirmed the following ratings of Ladder Capital Finance Holdings LLLP and Ladder Capital Finance Corporation:
--IDRs at 'BB';
--Senior unsecured notes at 'BB'.
The Rating Outlook is Stable.
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