2023-03-21 17:26:04 ET
Summary
- Big discounts to book value are delivering large dividend yields.
- The plunge in the market since early February created far more opportunities.
- For lower risk, there are some preferred share alternatives to consider also.
Get ready for charts, images, and tables because they're better than words. Well, not this time. Those things are all missing this time. The ratings and outlooks we highlight here come after Scott Kennedy's weekly updates in the REIT Forum. Your continued feedback is greatly appreciated, so please leave a comment with suggestions.
The latest dip in the market is creating far more opportunities. We're seeing them in equity REITs, mortgage REITs, preferred shares, and BDCs. Annaly Capital Management ( NLY ) plunged 20% (as of last close) relative to Feb. 8, 2023. That's been a harsh reaction since the Q4 2022 earnings release. The dividend cut was probably a significant factor in the underperformance.
I want to talk about a few opportunities in the sector today.
Dynex Capital ( DX ) is one of the agency mortgage REITs. By our estimate, they're trading at about a 17% discount to the current estimated book value. Shares carry a 13.3% dividend yield. The payout ratio will scare some investors, but it represents a flaw with the system used to establish "Core EPS." Note: Dynex Capital is using EAD (Earnings Available for Distribution). However, the calculations are fundamentally the same so I'm going to simply call it core EPS.
Analysts create their estimates (which drive payout ratios) for these non-GAAP metrics. While you certainly do want non-GAAP metrics as a significant part of the package for analyzing mortgage REITs , the method used to establish core EPS for mortgage REITs has a few flaws. These flaws are mainly related to how different derivatives (used for hedging) are recognized and how the historical price and amortization flow through the yield on assets.
When interest rate volatility was lower, the flaws in core EPS were not particularly important. They had a minimal impact. However, we're seeing a huge gap in the projected core EPS per dollar of book value between DX, AGNC Investment Corp. ( AGNC ), and Invesco Mortgage Capital Inc. ( IVR ). The huge gap in projected core EPS per dollar of book value does not mean DX is being less efficient. It simply reflects differences from the way the portfolio is structured and the way costs and income are wrapped into that equation.
Moving on to the originators, we continue to see significant value in Rithm Capital Corp. ( RITM ) and Ready Capital ( RC ). We think these REITs should trade materially closer to book value. Ready Capital announced a buyout, and the market thoroughly punished shares. There are positives and negatives to the transaction, but the magnitude of the decline puts RC at an unusually large discount to book value (estimated discount of around 34%). It's hard to argue against RC at such a large discount to book.
Looking at Rithm Capital, they've only made a few bad decisions:
- They had too much credit-sensitive exposure going into the pandemic, which triggered some cheap asset sales.
- They bought another company in the origination/servicing space at the wrong time. However, the price wasn't too bad, so it's not a bad deal.
- They changed their name and ticker to the single worst name in the sector. Seriously, they had to misspell rhythm? Why? They went from a ticker everyone knew to RITM. That ticker is a misspelling of their own misspelled name. Seriously, that's a really bad name and ticker combination. At least with "New Residential" you knew it was related to something residential.
Here are some New Residential stats (don't make me call them Rithm):
- 12/31/2021 book value per share: $11.44
- 12/31/2022 book value per share: $12.00
- Dividends paid during 2022: $1.00
- Internalized management with the costs recognized during the year
There are your stats. Book value wasn't pumped up by pushing the internalization costs into Goodwill. So that's a real boost of $.56 in book value per share during 2022.
We see Q1 2023 as a pretty rough period. We're forecasting a dip in book value per share down to somewhere closer to $11.50. However, interest rates have been pretty wild so that estimate certainly could move again before the quarter ends. Based on $11.50, RITM would be at a 30% discount to book value.
Going on to commercial mortgage REITs, we see value in both Blackstone Mortgage Trust ( BXMT ) and Granite Point Mortgage Trust ( GPMT ). In BXMT, you get dramatically superior management. BXMT is externally managed, which is generally a negative factor. However, Blackstone has done a solid job managing the REIT for shareholders. It's one of the few external managers that doesn't deserve to be called out for weak performance. Granite Point Mortgage Trust is internally managed, but I'd still trade their internal management for being externally managed by BXMT. GPMT tends to produce weaker earnings and weaker total economic returns (change in BV + dividends), so why would anyone ever want it?
Because shares trade at about 36% of book value (64% discount) and leverage has been declining. Even if you assume GPMT's assets need a material write-down on average, the resulting book value would still be far above the current share price. I'd be happy to see BXMT looking to create a buyout here. While BXMT is at a very material discount to book value (estimated 28% discount), it's still much smaller than GPMT's discount. BXMT could operate the portfolio more efficiently and finance it more effectively, so an acquisition could be immediately accretive to BXMT's book value per share and earnings per share. Looking at the earnings multiples, you wouldn't think an acquisition could be accretive to earnings for BXMT, but the improvement in operating costs and financing costs could be significant. I'm not predicting that a buyout will happen, but I think shareholders in both REITs would benefit. Remember, Broadmark Realty ( BRMK ) was able to get a buyout from RC and BRMK was trading at a significantly higher price-to-book ratio than GPMT.
Therefore, we have five bullish ratings. Those shares, along with their dividend yields, are listed below:
- DX: 13.2%
- RITM: 12.4%
- RC: 16.2%
- BXMT: 13.4%
- GPMT: 15.6%
Note: GPMT's weaker earnings are a material factor that weighs on that dividend and creates increased risk. However, there's almost always a significant risk in double-digit dividend yields.
Preferred Shares
Investors looking to reduce the risk a bit may want to check out the preferred shares. NLY-F ((NLY.PF)) is already floating and has a stripped yield of 10.2% with shares at $24.04. Due to the floating rate, we may see the dividends increase a bit further. However, when the Federal Reserve eventually cuts rates (probably late this year or sometime in 2024), the floating feature becomes less attractive. For a big fixed-rate dividend, see FBRT-E ((FBRT.PE)) at $19.17. The stripped yield of 10% is offering an attractive return. Shares go ex-dividend near the end of the month. That's factored into the stripped yield. Without the dividend accrual, the yield would "only" be 9.78%.
I think NLY-F and FBRT-E are each good choices here. I'm inclined to favor FBRT-E a bit due to the larger discount to call value and the premise that I think rates will dip by the end of 2024 if not sooner. There also are a few AGNC preferred shares that offer a better valuation, though those shares are not floating yet.
Things You Used to See
If you're familiar with our series, you're used to seeing a table breaking down each stock by sector followed by several charts that provide comparisons for book value, dividend yield, and earnings yield. You also would expect to find preferred share charts providing the current prices, stripped dividend yields, and what the yield would be if the floating rate kicked in today. However, Seeking Alpha has determined that being able to compare price-to-book ratios, dividend yields, and earnings yields throughout the sector is not relevant to analyzing the underlying companies. This decision was based on negative feedback from a very small number of readers out of more than 3 million.
If you find comparing these values between stocks in the same sector to be relevant to your investing discussion, please add a comment to this article to tell Seeking Alpha that charts comparing investments within the same sector are relevant to your investment process. I'll make sure your comments reach management. Thank you.
Strategy
Our goal is to maximize total returns. We achieve those most effectively by including "trading" strategies. We regularly trade positions in the mortgage REIT common shares and BDCs because:
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Prices are inefficient.
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Long term, share prices generally revolve around book value.
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Short term, price-to-book ratios can deviate materially.
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Book value isn't the only step in the analysis, but it's the cornerstone.
We also allocate to preferred shares and equity REITs. We encourage buy-and-hold investors to consider using more preferred shares and equity REITs.
Performance
We compare our performance against 4 ETFs that investors might use for exposure to our sectors:
The four ETFs we use for comparison are:
Ticker | Exposure |
One of the largest mortgage REIT ETFs | |
One of the largest preferred share ETFs | |
Largest equity REIT ETF | |
The high-yield equity REIT ETF. Yes, it has been dreadful. |
When investors think it isn't possible to earn solid returns in preferred shares or mortgage REITs, we politely disagree. The sector has plenty of opportunities, but investors still need to be wary of the risks. We can't simply reach for yield and hope for the best. When it comes to common shares, we need to be even more vigilant to protect our principal by regularly watching prices and updating estimates for book value and price targets.
Ratings: Bullish on common shares DX, RC, RITM, BXMT, GPMT
Bullish on preferred shares: NLY-F, FBRT-E
For further details see:
12% To 16% Dividend Yields At 17% To 64% Below Book Value