Paragon: buy-to-let lender with big asset base

Britian's buy-to-let property market is not the first place you would think to go hunting for value stocks. When the financial crisis struck in 2007-08, the market came close to collapse. Lenders withdrew, mortgage costs rose sharply, and the price of City centre flats in places of chronic oversupply, such as Birmingham, Leicester, Nottingham and Cardiff, fell sharply. To make matters worse, rental values dropped as developers who were stuck with unsold apartment blocks offered them for rent instead. 

For Paragon Group of Companies, a specialist in buy-to-let finance, the crisis was almost termincal. Its business model relied on two principal sources of finance: bank loans provided through a so-called 'warehouse'  facility, which served as the initial source for the funding mortgage advances, and the mortgage-backed sercurities market. The latter involved parcelling up bundles of mortgages, putting them into special purpose vehicles, and then selling a securitised bond backed by the cash from the mortagage repayments, As the cash came back from the sale of the bonds, it was used to top up the warehouse facility and fund another round of mortagage lending.

Fortunately, when the crisis broke, the great bulk of Paragon's £10bn book of loans had been securitised and was match-funded to maturity. But any further securitisations were impossible as the debt capital markets seized up. Paragon's First Mortgages business stopped lending, other than where it could fund top-up loans to existing borrowers out of redemptions from other borrowers. Its smaller consumer finance side did the same and its unsecured loan book was closed.

The company's warehouse bank facility was closed to new business and, in accordance with its terms, converted into a £1.7bn term loan maturing in 2050. That left two other sources of finance. One was a corporate bond, not due to mature until 2017. The other was a £280m bank line, which was called for repayment in February 2008. Paragon did the only thing it could - launch a deep discounted rights issue. That raised £287m, which got the bankers off its back.

Throughout the past two-and-a-half years, Paragon has concentrated on keeping existing customers. The business has been profitable, has generated cash, and, since the rights issue, has paid rising dividends for shareholders. Because Paragon always restricted the amount it lent on purpose-built city centre developments, it avoided the worst of the downturn. Mortgage arrears have been consistently lower than the industry average while margins have been strong. The dearth of competitors has ensured redemptions have been low. The mortgage portfolio has been held at £9bn.

Most importantly from a value perspective, Paragon has managed to maintain its net asset base. In the last profits statement, shareholders' funds were shown at £665m, or around 225p per share. That compares very favourably with a current share price of 158p.

Paragon's management should also get plaudits for the way it has set up new businesses from scratch. These have been viewed as alternative sources of income while the company waited for conditions in its primary area of buy-to-let finance to recover. They include third-party loan servicing, credit management and other specialist services for landlords. The company has also bought a portfolio of second mortgage loans at a discount and hopes to find more. Taken together, these businesses contributed £2.4m to operating profit in the six months to end-March this year.

But the key to the share price is the reopening of First Mortgages to new customers. That requires three things: the return to health of the buy-to-let market, the availability of a new warehouse loan facility from the banks and a full recovery of confidence in themortgage-backed securities market - on which Paragon's business model depends for secure long-term finance.

The company has been making preparations for the time when it can put up the 'business as normal' sign for some months. The buy-to-let market has recovered strongly. With new mortgage availability limited, would-be buyers are renting instead. Tenant demand has grown sharply in the past year, while the supply of property to the private rented sector has fallen.

On the financing side, the company has been in talks with potential providers of warehouse facilities for some time. The securitisation market has steadily picked up this year and UK issuers have been able to sell mortgage-backed securities to US investors for the first time since 2007. Royal Bank of Scotland has just raised £4.7bn in securitised debt, the biggest deal since the financial crisis struck.

Last week the group announced it has secured a 4-year £200m warehouse facility from Macquarie Bank and is restarting new buy-to-let lending. This should get analysts looking ahead to a growing loan book and rising profits.

Even without this, Paragon is performing well. It looks as if it will lift underlying profits by about 45% this year. The shares are selling for a single-digit P/E and there is strong cash flow. At the last count, the business had £128m of free cash. Importantly, competitors remain thin on the ground. Short of another financial crisis, the downside looks limited while the upside is considerable.

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Peter Shearlock writes in The IRS Report regularly

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