SACH - Sachem Capital: High Yield Is Tempting But Try To Limit Your Position Size

2023-08-10 15:22:24 ET

Summary

• Sachem Capital offers a high dividend yield of 15% and has provided investors with total returns of 39% in the last five years.
• The company focuses on larger loans with short duration and plans to expand into new markets for future growth.
• The stock appears to be cheap based on traditional metrics as compared to its historical range.
• Concerns arise from the rising rate of foreclosures and the company's focus on higher-risk loans.

Sachem Capital ( SACH ) is a real estate finance company with a mouth-watering dividend yield of 15%. In this article I will cover this company and talk about its positives, negatives and possible risks. It's difficult for me to rate this company either as a buy or sell but I'd feel more comfortable suggesting you to obtain a small position in it, not much bigger than 1-2% of your portfolio after considering everything.

As a result of its high dividend yield, in the last five years the company's investors have enjoyed total returns of 39% even though the share price was down -19% but things could have been a lot better since investors were looking at total returns of almost 100% by January 2022 before the Fed started hiking rates and triggering a bear market for bonds and other debt instruments which still continues today.

The company operates and issues loans in 15 states and it is planning to expand to new markets over time which should fuel growth in the future. The company mostly focuses loans with average size of $1.03 million with 88% of its loans having a duration less than 1 year. This allows the company to reissue new loans in a quick fashion as its loans get repaid and risk of default is fairly low considering the low duration of most of these loans. Sachem covers different types of real estate including residential, commercial, land and mixed use. Roughly 45% of the company's real estate coverage is for residential loans and another 35% covers commercial loans.

Currently, a lot of people say that commercial real estate is in deep trouble because one sub-sector of it (more specifically the Office sub sector) is in trouble due to shifting work trends and rising popularity of remote work. People don't seem to realize that commercial real estate is much more than office space and it includes many types of buildings and sub-sectors such as malls, factories, warehouses, hospitals, healthcare centers, hotels, storage units and farmlands. Offices make a very small portion of total commercial real estate market but many analysts talk as if offices are the only commercial real estate category.

Over the years, Sachem's total assets kept growing at a rapid pace (56% annual compounded growth rate to be exact) but the number of active loans in its portfolio didn't grow much. Notice from the table below how the company had 438 active loans in 2019 and 444 by the end of 2022 which represents a growth of only 6 loans but also notice that the average loan size rose significantly from $215k to $1.04 million during this time. The company shifted its focus to higher and higher loans over time. Also it was helped greatly by the fact that real estate prices were rising rapidly during this time and many loans had to be bigger to accommodate higher prices.

Not only did the company put more focus on larger loans over time but it also focused more on loans with shorter durations with average duration dropping from 10 months to 6 months between 2019 and 2022. Another interesting thing to note is that the average weighted interest rate dropped from 12.4% to 10.7% in the last 4 years even with interest rates rising overall. It is very possible that this was caused by the company shifting its focus on higher quality loans which come with slightly lower rates.

One trend I find concerning in the table above is the rising rate of foreclosures in process. The company had only 9 foreclosures in 2019 which rose to 16 in 2020 and 2021 and further rose to 40 in 2022. Since the company holds about 440 loans in its portfolio, this represents a 10% foreclosure rate and I would keep a very close eye on this metric moving forward. If this is just a temporary trend driven by weaknesses in one particular sector (such as offices) it may not be a big deal but I would be concerned if it's more widespread than that.

As I mentioned above, the stock currently enjoys a dividend yield of 15% which is near its all-time high with the exception of a brief period in March 2020 where the yield jumped above 35% but it didn't last long as the markets quickly recovered from that particular crash. As much as Sachem's dividend history goes, the company has been hiking dividends at a slow but steady fashion since its inception. In its short history of 6 years as a public company, Sachem doubled its annual dividend payments from 26 cents per share to 52 cents per share.

You might be wondering how the company gets away with collecting loan yields of 10-12% with short term loans that have durations in months when most mortgage companies can only charge about 5-7% for a 30-year loan. This is because the company focuses on a very specific group of properties which can also explain why we are seeing a high number of foreclosures in its books right now. The company focuses on fix-and-flip loans (the type of loan where an investor buys a property that is in bad shape and need of repairs, fixes it up and quickly sells it for a profit within 12 months), foreclosure loans, bridge loans, new construction loans and commercial real estate development.

These types of loans typically come with higher risk even if their duration is measured in months instead of years. For example in the last 6-7 years American real estate market has been booming which helped investors who fix up and flip houses for a profit but this may quickly change if the real estate market gets in trouble. In early-to-mid 2000s, fixing up houses and flipping them was seen as an easy way to get rich but many investors ended up going bankrupt after 2008 when liquidity and home buying suddenly dried up. There were many real estate investors who ended up going bankrupt because they were very tight in liquidity and couldn't afford to hold onto their properties for longer than a few months. This made the whole real estate crash situation even worse because now everyone was dumping their properties into the market which increased supply substantially, causing a chain reaction which couldn't find a bottom until 2012.

By the way SACH enjoys a pretty cheap valuation right now with a price to book ratio of 0.65 (indicating a 35% discount on its book value) and a low P/E ratio of 7.4. Both valuations are on the lower end of this stock's historical range where its average historical price to book value was about 1 and its average historical P/E was about 10. This cheap valuation is most likely driven by an overall weakness we are seeing in both REITs and financial stocks right now.

After saying positives and risks, what's my final verdict on Sachem? I would consider this as a risky income play and perhaps I'd favor buying and holding a very small position in it. I wouldn't put a substantial size of my portfolio in this stock but maybe put 1-2% of a well-diversified portfolio. The stock is cheap from a valuation perspective but many could also argue that it's cheap for a good reason given the challenges faced by the financial industry right now and possible delayed effects of last year's rate hikes on the economy. This is why I support holding a small position of this stock but not making a large bet on it.

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