SCCF - Sachem Capital: 10.5% Baby Bond Bargain Is Safer Than You Think

2023-09-19 12:00:00 ET

Summary

• In this article, I make the case that Sachem baby bonds are very undervalued.
• Sachem Capital is an unusual mortgage REIT that has several baby bonds with yields up to 10.59%.
• However, its debt levels are much lower than those of other mREITs.
• What most investors seem unaware of is that SACH baby bond covenants require SACH to maintain 150% asset coverage in order to pay dividends providing a strong level of safety.

Sachem Capital

Sachem Capital ( SACH ) is a mortgage REIT (mREIT); however, its mortgages (loans) are quite short in duration; generally 1 to 3 years. Currently, 88% of their loans mature in 1 year or less which means that SACH is constantly receiving cash as mortgages come due, which helps maintain their liquidity position. Their loans generally go to customers who are fixing up a property in order to sell it at a profit. SACH originally only issued loans on residential property but has expanded, more recently, into making loans on multi-family and other commercial property as well.

Although these loans carry risk, SACH is very conservative in its underwriting. They will only loan up to 70% of the value of the property. Additionally, they require large upfront fees from their customers and earn double-digit yields on their mortgages. Additionally, when they feel it necessary, they require additional collateral in the form of personal guarantees from the borrower. This is a very profitable business model as long as there is no catastrophic crash in the residential and commercial real estate markets.

Here is from the second quarter conference call:

“Sachem has remained disciplined in our approach and our second quarter results were quite strong. We achieved record revenue growth of more than 31% to $16.5 million compared to the same quarter of 2022 and net income attributable to common shareholders of $4.8 million or $0.11 per share.”

Safety

On its conference call, SACH also talked about receiving a large number of mortgage applications which allows them to be selective and pick only the best/safest projects. They focus on customers with a proven track record and strong credit profiles. And as I mentioned above, they limit loans to 70% of the value of the real estate giving them strong collateral against defaults.

SACH did see a good number of defaults this year. Many of these were handled by loan modifications giving their customer more time to complete their projects and pay off their loans if SACH determines the borrower is making good progress. And SACH gets more fee income from the customer by giving them these loan modifications. Write-downs have been minimal as the company believes that the collateral that backs these defaulted loans is enough to cover the unpaid loan balance.

But what really gives SACH a good level of safety is its excellent balance sheet and a requirement to maintain 150% asset coverage in order to be able to pay out dividends . In other words, they cannot issue debt and preferred stock in an amount above 66.7% of the value of their assets if they want to pay dividends, and as a REIT they must pay dividends on 90% of their taxable earnings. So even if the management wanted to increase leverage, it would create large problems for them if they did so. And 66.7% leverage is extremely low leverage relative to other mREITs. And I should add that violation of this leverage limit also prohibits SACH from issuing any debt or from buying back stock. Here is from the SACH conference call:

“ Overall, our leverage level really not able to increase our leverage dramatically at this point. And there's really two reasons for that. One is finding affordable debt capital is very difficult and finding it in an amount that would be beneficial to us.

Second is the covenants on our short-term notes. So we are limited to a 1.5x asset coverage ratio”

In fact, after the close of the second quarter, SACH issued more common stock in order to provide a cushion against any baby bond covenant violations. Adjusting for the additional share issuance, currently, net debt makes up only 56% of assets. This is extremely low leverage and way lower than any other mREIT . And what is also interesting about its asset coverage rules is that it includes preferred stock. Since SACH has preferred stock outstanding, this makes the asset coverage requirement for the bonds even better. Here is from the prospectus regarding how asset coverage is computed.

“Asset Coverage Ratio” means the ratio (expressed as a percentage) of the value of our total assets bears to the aggregate amount of our indebtedness ( including the aggregate of the involuntary liquidation preference of redeemable preferred stock , if any)."

SACH Baby Bonds

SACH has 3 shorter term bonds not in this chart as what I am focusing on is SACH’s double-digit yielding bonds. I am primarily focused on symbols SCCD, SCCE, and SCCF, which have a yield-to-maturity ((YTM)) greater than SCCG as well as somewhat shorter maturity dates so a little less risk.

Additionally, these baby bonds have YTMs greater than the yield on SACH’s preferred stock and trade enough below par that they have room to rally higher in price over the coming months. And the yield on these baby bonds is quite high given the relatively short maturity of these baby bonds.

SACH Bonds Versus BDC Bonds

Although SACH is not a BDC (business development company), its leverage limit of 150% asset coverage is the same as that of BDCs; although the BDC leverage limit is more solid. And the current net leverage of SACH at 56% is also fairly similar to many BDCs. And one could argue that the collateral behind SACH’s loans is actually better than those of BDCs as SACH loans are all first-lien loans backed by tangible real estate assets. How much will a BDC get if one of their loans to a software company goes bad, or a loan to a restaurant chain that leases its properties goes bad? They will likely recover very little.

Some may have some disagreement with what I am saying here, but with BDC bonds going for around 8% YTM, and SACH baby bonds going for up to 10.59%, I consider the SACH baby bonds very attractive and undervalued. I don’t see that the difference between SACH baby bonds and BDC baby bonds as having such a large difference in safety to account for the huge differences in yield.

Summary/Conclusion

Sachem Capital has 3 baby bonds ([[SCCD]], [[SCCE]], [[SCCF]]) that look very undervalued and have juicy double-digit YTMs with SCCE at a 10.59% YTM. And these bonds carry YTMs that are higher than the SACH preferred stock.

SACH operates at extremely low net leverage (56%) relative to other mREITs. And the baby bonds not only have protection from common equity but SACH also has issued preferred stock which is lower in the capital stack than the baby bonds providing additional protection for their baby bonds.

Given that SACH generally limits their loans to 70% of the underlying value of the real estate in combination with very low leverage on their balance sheet makes these baby bonds much safer than you would normally find in baby bonds with double-digit yields and relatively short maturities.

The SACH baby bond covenants also restrict SACH from taking the combined debt plus preferred stock to over 67% of assets (150% asset coverage) in order to pay dividends, buy back common stock, or issue more debt and REITs must pay 90% of their taxable income in dividends. Thus, SACH is very careful to keep leverage low.

This is not exactly an apples-to-apples comparison, but I compare SACH baby bonds to BDC bonds which also limit leverage to 67% of assets and operate at similar leverage to SACH. And SACH bonds look like excellent values relative to the typical 8% YTM on BDC bonds of the same maturity.

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