Atlantic Real Estate Finance in Chicago: A cannabis lender stuck between a rock and a hard place

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investment thesis

Chicago Atlantistic Real Estate Finance (NASDAQ: Nasdaq: REFI) It is a mortgage fund that lends to state-licensed operators in the cannabis industry. On the basis of valuation, REFI is trading at 1.1x P/B and yielding 9%, which is Not terribly attractive. On a more troubling note, the legal environment does not provide any margin of safety for cannabis investors, as REFI is not allowed to take ownership of the underlying real estate while it is being used to conduct cannabis-related activities. Such a legal ban would not allow REFI to realize the full value of the “estimated” value. Additionally, if cannabis is eventually legalized, such an event would be detrimental to REFI as larger, more traditional and established players would be able to move into space.

background

REFI is a mortgage fund that completed its IPO in December 2021. It focuses on creating large loans (and sometimes mezz’s) for state-licensed operators in the cannabis industry. It is externally managed by the Chicago Atlantic REIT Manager and seeks loans of between $5-200 million, generally with terms of 1 to 5 years and amortization when terms exceed 3 years. They usually act as lenders involved in such transactions and intend to hold up to $30 million of the total loan amount.

The loans are secured by real estate (when lending to owners and operators) and other collateral (equipment, receivables, licenses, etc.). Some statistics on its current loan portfolio:

  • 23 loans totaling $286 million, consisting primarily of first mortgages for cannabis operators or landlords from multiple countries or one country

  • Weighted average yield to maturity (YTM) 17.3%

  • 55.9% consisted of floating rate loans, and 44.1% fixed interest loans

  • All loans had prepayment penalties

REFI CURRENT LOAN PORTFOLIO

REFI CURRENT LOAN PORTFOLIO (2022 10K)

The stock is currently trading at $17. With 17.7 million diluted shares outstanding, the market cap/value of the venture (no debt and minimum cash of about $6 million) is ~$300 million.

Risks

  • real estate investment trusts: mREITs are generally considered to be more dangerous and prone to fluctuations; mREITs are usually taken advantage of but that doesn’t seem to be the case here

  • externally managed: There are two potential downsides to outside management and they are (1) less likelihood of economies of scale (management fees/incentives grow as fast as assets under managed + majority payout as dividends) and (2) potential conflicts with shareholders (eg, may issue stock less than the intrinsic value for growth). There is also not enough historical data to know how REFI management will operate in the future.

  • Assets/Binary Combination Cannabis: REFI’s assets are primarily in the cannabis space, which doesn’t offer much diversity in terms of asset class; In other words, you are betting on the success of the cannabis space. Keep in mind that cannabis is still a Schedule I controlled substance and is not yet legal in the federal state. All kinds of cases stem from the fact that cannabis is still illegal: difficult access to bankruptcy courts, loans to government cannabis companies, etc. may be confiscated.

  • Doubtful warranties: Some key points caught my attention:

    • REFI is not allowed to take ownership of real estate while it is being used to conduct cannabis-related activities due to legal prohibitions and exchange listing criteria. In the event of a default and if REFI decides to take over the property, they must first evict the borrower from the property, and then engage a third party to remove all cannabis from the property before acquiring it.

    • Of course, REFI can follow other paths in the event of a default, such as forcing the sale of property to another cannabis operator, pursuing a judicial foreclosure through the mayor’s sale (without taking the title deed), or using the property for non-cannabis-related operations.

    • Unfortunately, all of the above points are value-destroying for basic real estate appraisals. As stated in 10-K, “Therefore, the values ​​of valuation-based real estate collateral shown in the table below may not equal the value of such real estate if it were to be sold to a third party in the event of foreclosure or similar action.”

    • In addition, the estimated values ​​were based on two approaches: income and replacement cost of a similar facility. If you take away all the “value added” related to cannabis, the replacement cost component becomes meaningless. Which begs the question, “What is the value of the property actually appraised?”
REFI real estate guarantees coverage

REFI real estate guarantees coverage (2022 10K)

  • High interest rates: We are currently in a high rate environment. In such an environment, the profits of the investing real estate investment companies generally decline due to the increase in the cost of the money they borrow to finance their operations, which puts pressure on profits. This is mitigated here since REFI does not appear to have borrowed money. However, the value of the loan will decrease if interest rates continue to rise.

  • inflation: In an inflationary environment, you want to take on debt (a borrower) and not make a debt (a lender). why? Because as a borrower, you will be paying off debts with less valuable money. mREITs, unfortunately, are from lenders.

evaluation

Using data from the latest 10-Q:

  • book value: $286 million in assets, $16.5 million in total liabilities → $269.5 million in book value (1.1x the book value multiple)

  • Dividend: $0.4 / shilling for the last quarter → $ 1.6 / shilling annually → 9% return

  • earnings per share (“EPS”): $0.44 Q4 → $1.76 an hour a year (9.65x earnings, although not a terribly useful metric because mREIT earnings do fluctuate already)

  • Real estate guarantee coverage: According to their deposits, the loans are secured by a real estate value of 1.8 times (on average) than the loans; This value is based on their underwriting and is “evaluated by a third party at least once a year, or as frequently as needed.” However, I have reservations about the true valuation of collateral (see my points under Risk- Doubtful Collateral). If you decide to charge a 50% hair reduction (which I usually do in case of uncertainty), you will get 0.9x mortgage coverage.

In short, REFI is trading just above book value (1.1x), producing returns of around 9% and its earnings are covered by its dividend. From an evaluation perspective, REFI isn’t terribly attractive; A quick look at BXMT shows that it is trading at 1.1x P/B and yielding 8% (roughly the same metrics but with very different risk profiles).

In addition, a major caveat is that the historical performance of the mREIT is an essential component of its evaluation (eg trends in P/B, payout ratio, etc.). However, since REFI just completed its initial public offering less than a year ago, historical benchmarks are not available. Any formulation of the value going forward would be entirely guesswork, providing a zero margin of safety.

triggers

  • Insiders buy. Two insiders bought in April/May 2022 for $15.50 and $17.95 ($377,000 total). Many insiders also participated in a private placement coinciding with the $16 hourly IPO in December 2022 (about $7.5 million in total). The shares have undergone a 180-day lock-down that will expire on June 5, 2022.

  • Federal legalization of cannabis: Legalizing cannabis at the federal level would greatly benefit REFI, but on the other hand, it would also lower the barrier to entry into the cannabis space, paving the way for larger and more established players (which makes REFI a mootable “advantage” of REFI)

away

REFI is an interesting company operating in a specialized corner of the cannabis industry. In theory, the work makes sense; Cannabis operators have limited access to traditional bank and non-bank financing, allowing companies like REFI to offer them attractive loans.

However, in addition to being an MREIT company operating in a single asset class, its historical performance limited to only 6 months does not allow for an analysis of operating performance. Additionally, REFI’s inability to hold cannabis assets as collateral was a “nail in the coffin” moment in my analysis. As a lender, if you are unable to obtain the underlying collateral, this begs the question – what exactly underpins your loans? The estimated value is calculated in part using the cost of replacing a cannabis facility, which becomes meaningless if you have to strip everything related to cannabis.

In short, the current legal environment offers no margin of safety for cannabis investors, especially lenders like REFI. Even if the legal environment changes (eg cannabis is legalized), such a measure would render the REFI “edge” useless, as traditional investors/lenders would be free to move quickly into space.

From a valuation perspective, the 1.1x P/B and the 9% return aren’t terribly attractive (on an absolute or relative basis). A quick look at similar mREITs shows that they trade similar to REFI but with very different (and possibly more attractive) risk and diversification profiles. In addition, the “estimated” value of the underlying real estate offered by REFI loans also does not have a margin of safety.

Based on the above analysis, I would not recommend a long position in JJSF (for general short/sell recommendations, like Edwin Dorsey at Bear Cave, I don’t hold trades in the stocks I mention and have no intention of starting a trade).

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