BRSP - BrightSpire Capital: Will Benefit From Higher Average Interest Rate

2023-11-27 10:37:41 ET

Summary

• BrightSpire Capital offers a dividend yield of around 12% and has solid financials, despite its stock trading downward due to concerns about office market exposure.
• The company's strategy of holding floating-rate loans within multifamily, office, and hotel properties is advantageous in a high-interest rate environment.
• As interest rates have risen over time, so has BRSP's net interest income.
• Management has maneuvered well throughout a rough economic cycle and has been building a strong cash position.

Overview

BrightSpire Capital ( BRSP ) is a mortgage real estate investment trust (mREIT) with a dividend yield of around 12%, making it an appealing investment for income focused investors. A 12% yield is too fat to ignore and the company has posted solid financials over the last quarter. However, it's stock has been consistently trading downward, mainly because of concerns about its exposure to the office market. Similarly to other REITs, the exposure to office properties really impacted the price and presents an opportunity.

The company maintains a well-diversified portfolio primarily composed of senior loans and net lease assets. Notably, the loan portfolio comprises 92 total loans, each with an average size of $34 million. BRSP cut their dividend in 2020 to preserve capital and has since reinstated the dividend and grown the payouts above pre-pandemic levels. I like the price down here at these levels and think this makes an attractive entry point to capture superior income potential and great returns going forward as a higher interest rate becomes the new norm compared to the more recent near-zero rates.

Strategy

BRSP has benefitted from their loan portfolio structure during this high interest rate environment. BRSP's strategy consists of holding 98% floating rate loans within multifamily, office, and hotel properties. Having exposure to floating interest rates is advantageous when interest rates are rising because mortgage REITs can increase the rates on their portfolios, leading to higher revenue.

Although the Fed has slowed their rate of interest rate increases, I do believe a higher interest rate environment will become the new norm. Howard Marks seconds this exact sentiment because he believes we are actually sitting in an interest rate environment that more closely aligns with what is "normal". Going forward, a higher average interest rate would likely help BRSP grow profits over time.

In terms of liquidity, BRSP exhibits a strong position with total liquidity amounting to $348 million, supported by $183 million in unrestricted cash (equivalent to $1.41 per share). The company's prudent financial management is reflected in a favorable debt-to-equity ratio of 1.9x, highlighting a balanced capital structure.

Portfolio

As we can see, the majority of BRSP's portfolio consists of multifamily properties, closely followed by office properties. The office properties has been a major contributor to the price decline. We've seen a similar price drop across other REITs with office exposure as well. These price drops can make for a great buying opportunity to take advantage of an above average yield and superior total returns going into the future. I believed that this was the case with Realty Income ( O ) in my prior analysis , and I believe this is the case with BRSP.

The property type exposure by region is quite interesting. The south west region of the USA is where they hold the majority of their multifamily loans. The Northeast is the only location where they have mixed-use properties and the West is the only region they hold industrial properties. As previously mentioned, a contributing factor the falling share price is their exposure to office properties and we as can see, they have office exposure throughout all regions. Office properties were seen as a major threat to REITs because of the implied lowering of demand. Employers are embracing more and more of their employees to work from home and there isn't as much demand as once upon a time. I believe these dramatic price reactions were overblown as many REITs have found ways to mitigate this risk and maintain profitability. BRSP's latest earnings report certainly enforces this.

During the third quarter, BRSP reported positive financial results. The company disclosed a GAAP net income of $12.4 million, equivalent to $0.09 per share, along with distributable earnings of $31 million ($0.24 per share) and adjusted distributable earnings totaling $35.8 million ($0.28 per share). Most importantly for me, the dividend coverage for the quarter reached 1.4x which provides me with reassurance that the dividend is sustainable and has opportunity to grow.

BRSP's current liquidity position is robust, amounting to approximately $348 million, composed of $183 million in cash and $165 million available under their credit facility. For the quarter, BRSP maintained an overall leverage of 1.9 times, consistent with the second quarter. Quarter-over-quarter, the undepreciated book value experienced a slight increase of $0.02, reaching $11.55.

Dividend

As of the latest declared dividend of $0.20/share, the dividend yield currently sits over 12%. Typically, I like to hold companies that have a strong history of increases over time. BRSP did slightly pause dividend payments in 2020 to preserve cash over the pandemic. Since then, they have been slowing growing the dividend and the current payout per share sits higher than pre-pandemic levels. The 3 year CAGR of the dividend is 7.44% which is extremely attractive for a company that already has a yield in the double digits.

One thing to emphasis here is that I think entry here is specifically attractive because of the trending downward price action. The price really suffered in an interest rate environment that was near zero. Since inception, from a price perspective you'd be down over 65% from your initial investment. Even taking distributions into account, you'd still be down over 43%. As a higher interest rate becomes more normalized, I believe we will see a more stable price movement in the future. As a result, we are more likely to see better total returns forward looking. We can see this exact story play out by observing their change in net interest income in relation to rate changes.

In terms of earnings and dividend safety, BRSP's dividend appears sustainable, supported by adjusted distributable earnings. The undepreciated book balance value per share stands at $11.55, showcasing the company's asset value. Additionally, BRSP maintains a robust liquidity position with a fully undrawn $165 million revolver and an availability of $805 million in master repurchase facilities. The company continues to demonstrate financial strength, evident in its ability to declare a quarterly dividend per share of $0.20 in Q3'23, with earnings and dividend coverage indicated at $0.28.

Risk Profile

The average risk rating for loans at BRSP is 3.2, with only two loans rated 5 and ten rated 4. Like other companies in the industry, BRSP has significantly increased its CECL (Current Expected Credit Loss) reserve in anticipation of potential defaults. As of Q1 2023, the reserve is $146 million ($1.13 per share). This includes a specific reserve covering 100% of 5-rated loans and a general reserve covering an additional 1% for all loans. The higher CECL reserves have led to a decrease in book value per share to $11.74, which is still double the current share price.

CECL is a great metric because it shifts the credit loss recognition model from incurred losses to a forward-looking approach. The metric is helpful here because it helps forecast expected credit losses at origination. This offers benefits such as timelier recognition of credit losses and increased transparency. So BRSP making an effort to increase their cash reserves reinforces that management is well aware and prepared to cover any short comings that the future may hold.

Takeaway

BrightSpire Capital emerges as an intriguing investment opportunity for income-focused investors, offering a substantial dividend yield of around 12%. Despite a recent downward trend in its stock, largely influenced by concerns over office market exposure, BRSP has maintained a well-diversified portfolio, primarily composed of senior loans and net lease assets.

The company's strategic decision to hold 98% floating-rate loans within multifamily, office, and hotel properties aligns well with the current high-interest rate environment. While the exposure to office properties has impacted the stock price, presenting a buying opportunity, BRSP has demonstrated resilience and adaptability in mitigating risks, as seen in their latest earnings report. The robust financials, positive earnings in Q3, sustainable dividend coverage, and attractive 3-year dividend growth rate of 7.44% contribute to the appeal of BRSP as an income-generating investment.

Moreover, the company's proactive measures, such as increased CECL reserves, reflect a prudent approach to potential defaults. With a strong liquidity position, undepreciated book value growth, and a promising entry point due to the recent price decline, BRSP positions itself for potential superior total returns in a changing interest rate environment.

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