Sitting in front of me is Prospect Capital's 2011 annual report. On page one, where it begins to describe its investment activities, it says:

We have made no investments to date in the real estate or mortgage industries, and we do not intend to currently focus on such investments. We are currently pursuing multiple investment opportunities, including purchases of portfolios from private and public companies.

It goes on and on, but these two sentences laid the language for Prospect Capital's new foray into its real estate investment business, APH Property Holdings. The newly formed company has become quite active, making up a bigger portion of Prospect Capital's portfolio.

Prospecting for rental yield
As of the last quarter, Prospect Capital valued its investment in APH Property Holdings at $154 million, or 3% of total assets.


Today, it announced an investment in APH Property Holdings that would nearly double its investment, putting another $144.5 million to work buying 19 multifamily residential properties.

To put this into context, real estate now makes up about 6% of Prospect Capital's assets.

What's the game plan?
Real estate was a cornerstone of the latest conference call. A back-and-forth exchange between Wells Fargo analyst Jonathon Bock and Prospect COO Grier Eliasek spelled out the company's strategy in earning yield with real estate investments.

The strategy is simple: buy properties at prices lower than the replacement cost, effectively insulating Prospect Capital's multifamily units from new competition. Then, with a modest additional investment, fix up the properties to grow rents over time. Elisak laid out one particular investment where the previous owner had invested incremental money into new fixtures like appliances, cabinets, and other improvements, and subsequently raised rents.

For an institutional buyer like Prospect Capital, real estate investments can be particularly lucrative. The company can secure low-interest financing backed by Fannie Mae and Freddie Mac to finance 70% of the purchase price.

The remaining funds are provided by Prospect, which makes additional debt and equity investments in APH Property Holdings to fund the 30% it can't borrow with low-rate mortgages.

How the portfolio is performing
Prospect Capital is quickly ramping up this new investment option, with the portfolio growing from just $48 million two quarters ago to more than $288 million today. With such a short history, and quick growth in the residential portfolio, it's too early to tell.

One concern is the change in how the company finances its investment real estate. In the filing for the quarter ending March 31, Prospect Capital loaned APH Properties $40 million at 10.5%, plus 2% paid in kind. As of the latest filing, it had amended the terms, and expanded its new investment. The company changed the terms so that APH Properties would pay Prospect Capital 6%, plus 5.5% paid in kind.

Paid-in-kind loans can be troublesome. A paid-in-kind (PIK) interest payment can be paid without the exchange of cash. Instead, the lender just increases the loan balance appropriately. So far, Prospect Capital's COO, Grier Elisak, says that all interest payments have been paid in cash, but implied that, because the business can be seasonal, the company wanted the option for PIK payments.

What this means for shareholders
As real estate becomes a larger portion of the Prospect portfolio, investors will need to watch carefully. Historically, Prospect Capital avoided real estate; but the company has not only changed its tone, it's investing aggressively in new multi-family properties. You can bet the real estate portfolio will be the topic of conversation for years to come, particularly in reference to whether or not its APH Property Holdings is capable of paying interest in cash.

Real estate, especially highly levered real estate, is a double-edged sword. When it performs well, it can easily produce double-digit, tax-free returns for investors. When it performs poorly, it's a money sink -- and a possible cash flow risk when favorable interest-only loans begin amortizing, and funds are diverted to paying down principal.

For now, we'll have to wait it out and see. From the conference call, it appears Prospect Capital is banking on a combination of higher real estate prices and growing rental yields to drive double-digit returns to investors. Only time will tell if this new strategy can pay off for shareholders. 

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The article Prospect Capital Wants to Be Your Landlord originally appeared on Fool.com.

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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