By Bill Alpert

While interest rates have eased in the past few months, real estate lending still has pain to work through. Ready Capital is a case in point.

The mortgage lender cut its dividend in September, after Barron's examined its shrinking cash flows . Despite its diminished dividend, the yield on Ready Capital's shares has reached 16%, given the stock's near-30% decline this year.

Anyone shopping for high yields should consider the real estate investment trust's financial challenges -- and the acquisition it announced last week of another REIT, whose managers went to federal prison two years ago for what prosecutors called "a classic Ponzi-like scheme."

Cash flows from continuing operations worsened in Ready Capital's September quarter, with over 60% of what the REIT calls its "distributable earnings" received as IOUs instead of cash interest payments. That was up from 40% in the June quarter.

Talking to investors after September's results, the REIT's management said they expected most of those interest IOUs to be paid off this quarter. The next dividend declaration from the REIT will be Friday, Dec. 13.

To turn around its fortunes, Ready Capital announced a deal last week to acquire another mortgage REIT called United Development Funding IV, or UDF IV. "The UDF IV transaction will allow us to scale our portfolio and expand our core business, unlocking exciting growth and value creation opportunities," said Ready Capital's CEO Thomas Capasse in the Dec. 2 announcement.

In exchange for $95 million worth of its own shares, Ready Capital will get a portfolio of 22 loans secured by properties that are mostly near Dallas and Fort Worth. The company says they are "paper lots" -- meaning they can't yet be developed because they lack roads or utilities.

It's hard to know if that is a good price because shares of UDF IV aren't publicly traded. Nasdaq delisted them in 2017, for lack of audited financials, and in 2020 the U.S. Securities and Exchange Commission revoked their registration.

Something else that might give investors pause: UDF's involvement in a criminal scheme that Ready Capital didn't mention anywhere in its announcement and slide deck on the acquisition.

In 2018, a federal district judge in Dallas enjoined UDF IV and five top managers against committing securities fraud, after those defendants settled, without admitting, SEC charges that they had diverted $67 million from UDF IV to help another UDF REIT maintain dividends when its borrowers were behind in their payments.

The REIT's managers blamed their troubles on an activist short campaign led by Dallas hedge fund manager Kyle Bass. Outside lawyers and forensic accountants hired by the REIT concluded that there was no evidence of fraud or other misconduct.

That conclusion became doubtful when a 2021 federal indictment charged the CEO and three executives at UDF's manager with defrauding the REIT's investors, auditors, and bankers -- and manipulating UDF cash flow statements to mask its loan problems.

"This is a Ponzi-like scheme," lead prosecutor Tiffany Eggers told jurors during closing arguments of the 2022 trial. "They were taking money from later investors so they could pay distributions to earlier investors. They can sugarcoat it all they want, but that is what it is."

Jurors convicted the CEO and his three colleagues on all charges. Those convictions, and the ensuing jail sentences that ranged from three to seven years, were upheld on appeal. Since those defendants went to prison, management of the REIT has continued under colleagues who worked alongside them for the better part of a decade.

Barron's asked current UDF management if they had ever noticed any wrongdoing.

"We have navigated extraordinary challenges to safeguard the Trust's assets," said a UDF spokesperson. "The Ready Capital transaction is our latest step to advance shareholders' interests. The transaction will maximize value for shareholders by providing them with liquidity and significant value in the form of cash distributions from UDF IV and ownership in a scaled, diversified and publicly traded industry leader."

Barron's asked Ready Capital why its publicity about the UDF deal doesn't disclose the crimes surrounding the portfolio.

"[W]e were aware of the legal issue surrounding UDF IV's external manager and certain employees at the external manager," said a Ready Capital spokesman. "Through our diligence of the merger, we view any remaining legal risk to be acceptable and the financial structure of the merger to provide sufficient protection to our shareholders."

For Ready Capital investors, what matters about UDF's history is what it implies about UDF's loan portfolio and its expected cash flow. The most recent available financial statement from UDF is from December 2023, when half of its loans were delinquent and operating cash flow was just $2 million.

Ready Capital's presentation on the deal says it should add 15% to distributable earnings in 2025 and 11% in 2026. "The portfolio was underwritten and priced to account for various items including current market yields, loan performance, trends in UDF IV's core markets and credit history," said the spokesman.

Another comfort, says Ready Capital, is that it has done $110 million worth of business with the UDF trusts since 2014, making loans and buying properties from the Texas trusts.

"Each asset has performed to its contractual terms without issue," said Ready Capital's spokesman.

If the acquisition goes through, UDF's long-stranded shareholders will get 13 million shares of Ready Capital. Let's see if they're impressed enough by their new managers to stick around.

Write to Bill Alpert at william.alpert@barrons.com

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(END) Dow Jones Newswires

December 09, 2024 11:51 ET (16:51 GMT)

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