BRSP - Earn Up To +13% Yields: 2 Bargain Picks

2023-05-24 07:35:00 ET

Summary

• Today we'll get one tax free and one taxable investment.
• Both offer great income today and bright outlooks for tomorrow.
• One of these picks is perfect for your taxable account, because it is federal tax free.

Co-authored with Treading Softly

In the summers of my college years, I used to work various jobs, doing whatever I could find for those few months so that I can earn money towards paying for my next year of college.

One year, I spent the entire summer working 12-hour shifts at a company that manufactured handles for appliances – there is a chance that some of you reading this have grabbed a refrigerator door handle, or an oven handle, or a handle for another appliance that I personally attached.

What I found interesting when I worked there was how everyone got paid. The people who worked on the factory floor got weekly paychecks, while office staff were paid once a month. It was a running joke on the factory floor that the people in the office were just too lazy to go to the bank to cash their checks frequently so, they got paid once a month. While, the office workers used to joke that the workers who worked on the floor were not good enough at budgeting and that if they only got paid once a month, they'd be broke for three weeks out of the month.

When it comes to the market, there is a wide variety of payment schedules. Some investors are perfectly happy never receiving a paycheck until they decide to exit a position – you would call them growth investors. Some investors will buy investments that pay them once a year, four times a year, or 12 times a year. There are even some investors who want 52 individual dividend payments! Believe it or not, there are investments that offer that!

I enjoy having a variety of payment schedules in my portfolio. The High Dividend Opportunities Model Portfolio holds investments that pay us monthly, quarterly, or even semi-annually. At the end of the day, I simply want to be paid on a regular, reliable basis and to be paid handsomely for the money that I've invested. With a diverse portfolio of stocks on different payment schedules, I need to use my Dividend Tracker tool to keep track of all my paydays!

Today, I want to look at two investments to add to your collection of dividend payers.

Let's dive in!

Pick #1: BRSP - Yield 13.6%

BrightSpire Capital ( BRSP ) is a commercial mortgage REIT that recently reported earnings very similar to peers. Distributable earnings were high at $0.27, easily covering its $0.20 dividend by 135%. This coverage is despite leverage declining to 2.0x equity. Management started getting defensive late last year, and that continued into Q1. It is also something we can expect to continue. CEO Mazzei was blunt about BRSP's priorities in the earnings call :

"Okay, so I would say that in this type of market, the management team of a company's first duty is absolutely unequivocally to defend the balance sheet. I don't think anyone has seen market conditions quite like this, where we've had bank failures, foreign and domestic and other banks who are trading very poorly, and a debt ceiling coming up in June, which is more frightening than the debt ceilings that we've had in the past. There's a tremendous amount of uncertainty. So I think in this market, any management team’s number one priority, I would say number one through number five priorities are defending the balance sheet."

As we've seen in several mortgage REITs, they are starting to see a few credit issues. BRSP has started the foreclosure process of a Washington, D.C. office property, and in the earnings call suggested they were preparing to start the foreclosure process on another office property in New York. Together, these two properties account for three of the four loans that BRSP has a risk rating of 5 on last quarter.

The fourth loan was a mixed-use mezzanine loan in Los Angeles that BRSP had written down to $0 last year and recovered $9 million last quarter. This is a reminder that just because a reserve is taken on a loan, it's not the same as a realized loss.

BRSP is being punished for being in the commercial real estate market and having exposure to office loans. If BRSP was leveraged to the hilt, this would be a huge concern. But they aren't. What happens when a loan defaults? BRSP lent on the New York office property at a 58% loan-to-value. The Washington, D.C. property was financed at a 68% loan-to-value. So when BRSP forecloses on these properties, they are receiving real estate at a 30-40%+ discount to what it was worth when the loans originated. BRSP then has a wide range of options to pursue from operating the property themselves, selling the property, or holding it for a better market. This is why BRSP has built up $259 million in unrestricted cash on hand ($1.99/share), which provides them the flexibility to deleverage loans, instead of being forced to sell them or auction properties in a bad market.

Right now is a terrible time to be trying to sell an office building. Will it be terrible forever? Certainly not. BRSP is well-positioned to navigate this environment without being a distressed seller. As we've seen in past real estate slumps, those who are buying real estate are the long-term winners, those who are selling are realizing permanent losses. BRSP is getting real estate at $0.60-$0.70 on the dollar, and has the balance sheet to deleverage it. The hurdle for being cash-flow positive with no leverage is a lot lower than where the borrowers are trying to be cash-flow positive with a 60-70% floating rate LTV loan on the property.

Meanwhile, while we wait for the commercial real estate markets to stabilize, BRSP is paying out a $0.20/quarter dividend that is easily covered by cash flow. The largest risk for mREITs is that they overreach with leverage and are forced to deleverage. BRSP has been taking this risk very seriously, and maintaining a defensive balance sheet has been their number one priority.

Pick #2: DMB - Yield 4.5% (Equivalent to 7% Pre-Tax)

BNY Mellon Municipal Bond Infrastructure Fund ( DMB ) is a Closed-End Fund that invests in municipal bonds. Municipal bonds have two advantages over corporate bonds – their interest is tax-exempt, and defaults are more rare.

The primary driver of municipal bond prices is interest rates. As interest rates rise or fall, the price of existing bonds changes so that the yields are similar to newly issued bonds. If interest rates are higher, that means existing bond prices decline, so buyers are receiving higher yields.

As a result, municipal bonds have seen prices collapse as the Fed kept hiking interest rates. DMB holds a portfolio of bonds with an average maturity of over 18 years out. Source

"Duration" is a relevant metric for bond funds. Duration is a measure of how interest-rate-sensitive investors can expect a fund to be. It is a number that is expressed in "years", and the rule of thumb is that for each year of duration, investors can expect the NAV of the fund to change 1%, for every 1% change in interest rates. With a leveraged duration of 10.66 years, we would expect DMB's NAV to change by 10.66% for every 1% change in interest rates. If interest rates come down 1%, NAV should go up about 10.66%; if they go up 1%, NAV should go down 10.66% if DMB just held its current portfolio.

The prevailing wisdom in the market is that the Fed will pause rate hikes at the next meeting in June. Fed futures are projecting an 85% probability of a pause, with some predicting a cut as early as July.

DMB is currently trading at an 8% discount to NAV, making it a prime candidate to see a significant upside if the Fed stops the hiking cycle. DMB's NAV would benefit as interest rates declined, and its price would likely climb closer to NAV.

On the dividend side, DMB saw a significant cash flow contraction as borrowing costs rose. DMB uses about 35% leverage, which is borrowed at short-term interest rates. Rising short-term rates drove up that cost and put pressure on DMB's ability to pay a dividend without having to sell assets. As interest rates decline, the reverse would happen. The cost of borrowing would go down, freeing up more cash flow for dividends.

The bottom line is that DMB stands to be one of the biggest winners when the Fed pivots. We can't state for certain when that will happen, but we do know we want DMB in our portfolio when it does!

Note: DMB's dividends are Federal tax-free. A 4.5% yield is equivalent to a 7.1% pre-tax yield at a 37% tax bracket.

Conclusion

What I love about being an income investor is that I'm always getting paid. Frequently I am collecting dividends multiple times a week as some company is paying me for my ownership of their shares. I'll tell you, there's nothing that makes life easier in the midst of a bear market or volatile market like having consistent cash flowing into your bank account. I know that other income investors will personally reach out to me and attest to how much easier they find it to ride out a storm when they have the constant benefit of cash coming into their bank account, regardless of what their portfolio's value is doing.

With BRSP and DMB, we can enjoy a steady stream of income, both from a high-yield opportunity and a federal tax-free fund. This is the kind of mix and match that an income investor can enjoy while receiving great income month in and month out. You don't have to place all your eggs in one basket or bank all your hope on one sector here. BRSP will actually be hurt by declining interest rates, while DMB will benefit from them. This helps make your portfolio less interest rate sensitive overall. That's a win-win if you're looking for less stress in your retirement.

At the end of the day, your retirement should be a time of relaxation and enjoyment. If the market is effectively robbing you of that enjoyment because its prices are declining or moving up and down wildly, then you have probably invested in the wrong type of investments. If you're not able to enjoy a 12-day Alaskan cruise or climb Mount Kilimanjaro without having to whip out your cell phone to double-check that the market isn't destroying your portfolio or your future, you're probably invested in the wrong kind of investments. You need investments that will fund your lifestyle and make you comfortable at the same time. For most retirees, you need income investments.

That's the beauty of our income method. That's the beauty of income investing.

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