2023-03-26 10:00:00 ET
Summary
- I review 4 mREITs that I believe offer a buying opportunity for income-oriented investors with a long-term horizon.
- Of the 4, I like Ready Capital the best due to the pending acquisition of Broadmark, which will increase net assets and help the company deleverage.
- Although REITs had a terrible year of underperformance in 2022, 2023 is shaping up to be a recovery year for REITs.
You may have been reading about REITs (Real Estate Investment Trusts) and wondering if they are a good investment in 2023. Most of the news around inflation and rising interest rates sounds like bad news if you are looking to invest your cash in anything related to real estate these days. With recent bank failures, increasing fears of a recession, or at least a "hard landing" when the Fed does eventually stop increasing the base rate, many investors are wondering if REITs will ever recover from a terrible 10-year period of underperformance and poor relative returns.
As an income-oriented investor who is looking to increase my future income stream in retirement by compounding dividends and reinvesting a portion of them to grow my future river of cash, I like REITs for the dividend income they offer. Those steady dividends are due to the necessity to pay out 90% of their taxable income each year to meet the IRS tax requirements for an REIT . Thus, well run, high quality REITs generally pay out generous dividends when they are earning strong income and are not too highly leveraged with debt.
What are REITs?
From the Nareit website, whose stated mission is to serve as an advocate for REIT investments in the global community (with a focus on US based real estate), REITs are companies that own and/or finance income-producing real estate across a range of property sectors. There are 4 primary types of REITs including mortgage (mREITs), equity based REITs, public non-listed REITs, and private REITs. In this article, I will be focusing primarily on mREITs in both the residential and commercial markets.
Over the past 1-year period the REIT sector as a whole significantly underperformed the broader stock indexes such as Russell 1000, bonds, and most other asset classes, however, over longer periods of time REITs offer competitive returns as illustrated in this chart from Nareit.
While 2022 was a very difficult year for many REITs across the board, 2023 is shaping up to be a good year for many of them to recover due to the low cost of leverage after years of near zero interest rates. Historically low leverage rates based on debt to market assets of less than 40% has been the norm since 2011 with an increasing weighted average term to maturity of more than 7 years (as of Q322) as shown in the chart below from Nareit.
One result of that lower leverage is that the industry is now experiencing lower interest expense as a percentage of NOI (net operating income). Back in 2009 the interest expense was approaching 37% of NOI and as of the end of 2022 was closer to 15% for residential REITs. And many of the better managed REITs have cleaned up their balance sheets and thus are well positioned in 2023 to compete against more highly leveraged market participants.
What mREITs are a Good Investment Now?
There are several factors to consider when evaluating the potential future returns for mREITs, and some of those include the current TTM P/E, YOY Revenue Growth, Net Income Margin, Dividend Yield, Payout Ratio, as well as the P/B (price to book value). A matrix that ranks several of those factors is presented in this recent article from fellow author, Thomas Prescott, where he attempts to highlight the highest risk investments in his "mREIT straw house matrix".
While he presents an interesting method for ranking the risk, I would consider his matrix as a starting point for consideration and not necessarily a complete quality assessment of each REIT. There is more to the story than simple statistics based on what has happened over the past year, although some of the numbers are indeed quite telling. Furthermore, everyone has different investment objectives and risk tolerance, so my assessment of the quality ranking may differ from his or yours based on my own risk tolerance (which is higher than most), and investment objective - which is to generate a high yield income stream plus potential capital appreciation for long-term (10 years+) total returns.
Arbor Realty is a Dividend Champion
With 9 years of consecutive dividend growth, Arbor Realty Trust ( ABR ) is on my radar as a potential Buy candidate, especially after the price dropped substantially after the issuance of a short report by a research outfit called Ningi Research. Based on a review of articles by other SA authors, including this one who dismisses the short report as one "nobody should read", ABR is highly respected and is rated a Buy or Strong Buy by multiple authors in the past 3 months alone, even as the price continues to drop.
On February 17, ABR reported Q422 earnings that beat consensus estimates with Q4 distributable EPS of $0.60 (versus consensus of $0.46) and NII of $133 million compared to $99 million in Q3 and $76 million in Q421. Although the Structured Business loan originations fell the yield improved and Agency Business loan originations increased. GAAP net income reported was $0.49 per share and a quarterly dividend of $0.40 was declared, in line with the previous quarter. The company reported a strong liquidity position with $685 million in cash and liquidity and $420 million in restricted cash.
Full year GAAP net income of $1.67 per diluted common share, and distributable earnings of $2.23 per share represents an increase of 11% compared to 2021. The company also raised $486 million in accretive growth capital through common and preferred share offerings and issued $438 million in debt offerings to primarily repay existing debt.
Since the Q4 report was issued, the company has also closed on a $95M notes placement, part of which will be used to redeem $70M in outstanding 8% senior notes due April 2023. In addition, the ABR Board approved a $50M share repurchase program on March 20.
ABR trades at a TTM P/E of 4.86 and P/B of 0.86 (roughly 14% discount to book value). The current dividend yield is nearly 15% (14.76%) and the payout ratio is a reasonable 94.5%. The YOY revenue growth is -1.12% but forward expected growth is 17.5%. The net income margin is a healthy 49.8%. Short interest is somewhat elevated (perhaps in part due to the short report) at 5.9%. Total debt to equity is a bit on the high side still at 442%.
Looking at the GAAP P/E over the past year, the price is approaching the lowest point it has seen in months, indicating that it may be a good value now for those investors willing to accept the risk that the price could still drop further.
Along with other SA authors and Wall St analysts, I also rate ABR a Buy at the current price, however the preferred shares may be of interest to those investors who want lower risk and are willing to accept a lower yield. The ABR.PD shares are trading at a price of $16.55 ($25 is par) and offer a current stripped yield of 9.48% based on a quarterly dividend of $.3906. Those shares are not callable until June 2026 and are based on a fixed coupon rate of 6.375%.
Rithm Capital is One to Watch When Rates Fall
Another mREIT that I like a lot at the current price is Rithm Capital (RITM). Formerly known as New Residential, RITM was formed in 2013 and now consists of a portfolio of operating companies as shown on this slide from the Q422 investor presentation.
RITM holds $6.9B in total equity and has a book value of $12 per share. At the market close on 3/24/23 the share price was $7.71, representing a nearly 40% discount (P/B = 0.63). The TTM GAAP P/E of 4.21 is one of the lowest in the sector. The current yield on common shares is about 13% based on the $0.25 quarterly dividend, most recently announced on March 20.
RITM is now internally managed after going through a transformation in 2022, rebranding as Rithm Capital, launching a private capital business, acquiring 50% of Green Barn Investment Group to pursue distressed debt and equity opportunities in commercial real estate, and "rightsizing" by reducing overall headcount.
With continued widening of credit spreads in early 2023, higher funding costs, liquidity needs, and a decreased lending appetite across the MBS sector offers opportunity for RITM. The opportunity to deploy capital at attractive risk-adjusted returns and a robust pipeline of investment opportunities along with expansion into private capital and distressed/opportunistic CRE investments mean that RITM is positioned to drive strong performance in 2023.
Although the mortgage origination business declined substantially in 2022 as fewer buyers were in the market due to rapidly rising mortgage rates, the servicing business increased considerably with RITM now the largest non-bank owner of MSRs. The GAAP pre-tax net income increased from $825M in FY21 to $1,573M in FY22 as annualized G&A expenses were nearly cut in half as shown on this slide from the Q4 and FY22 presentation.
In addition to MSRs and originations, RITM also manages a single family residential portfolio across most of the southwestern and southeastern US with 3,750 units across 20 markets in 13 states. The portfolio has stable financing with 85% term financing and 99% of it fixed rate, with 93% occupancy as of Q422. The weighted average maturity date of financing is September 2026.
Despite the slowdown in the servicing and origination business in 2022, net income increased from $1.51 per diluted share in FY21 to $1.80 in FY22, although earnings available for distribution per share decreased from $1.48 in FY21 to $1.33 in FY22 in part due to the higher share count at the end of 2022.
The company is not done growing with plans to expand into Europe and the UK, according to CEO and Chairman Michael Nierenberg as recorded on the Q4 earnings call :
When you look at the portfolio of operating companies, keep in mind, this business was started in 2013 to be an asset manager of excess MSRs. Today, if you look across the board, we have a number of different operating companies in financial services, whether it be on the residential side, the commercial side, making loans to builders, we have property preservation businesses. We have a single-family rental business, and we have title and appraisal. We are currently marketing a financial services fund and look forward to working with partners to take advantage of the wonderful opportunities we are seeing and expect to see in 2023 and beyond. We will also be opening Rithm Europe, very excited about this. This will enable us to take advantage of dislocations in the EU and U.K. This should happen in Q2, and I'm very excited about the what-ifs here.
Another positive for RITM is the opportunity opened up by Wells Fargo stepping back from the mortgage business. Fellow SA author, Dane Bowler, does a good job of outlining that opportunity in his article from January. In that article he also describes the 4 different preferred shares that are offered by RITM, all 4 of which convert to floating rate yields at different times. For a more detailed look at the RITM Preferred shares, check out this December 2022 article from Mark Tennenbaum.
Meanwhile, if you are not too concerned with the potential for further downside in the price of common shares, I believe that RITM is a Buy at the current discounted price that offers a 13% yield with potential for significant upside once rates settle down.
AGNC - Will Also Benefit from Falling Rates, Whenever that Happens
One of the largest mREITs that specializes in agency backed (think Fannie Mae and Freddie Mac) residential mortgages is AGNC Investment Corp. (AGNC). Founded in 2008, AGNC invests predominantly in RMBS securities on a leveraged basis financed through collateralized borrowings structured primarily as repurchase agreements. While AGNC has struggled to maintain profitability over the past year along with every other mREIT, they have been able to maintain the dividend on the common shares, most recently declaring the $0.12 monthly dividend on March 10, in line with previous and resulting in a forward yield of 14.7% at the current share price.
The current interest rate environment, with rapidly rising rates and increasing credit spreads, has posed serious challenges for fixed income investors but also offers an opportunity to leverage the transition whenever rates fall to work in AGNC's favor as discussed by President and CEO Peter Federico on the company's Q422 earnings call :
Throughout our 15-year history, we have noted that rapid and sizable interest rate changes are the most challenging environments for levered fixed income investors. Importantly, however, these transitions have generally preceded our most favorable investment environments. As I will discuss in greater detail, the investment opportunity ahead could be one of the most favorable and durable in AGNC's history.
Meanwhile, the dividend appears to be well covered with a payout ratio of only 46%. The TTM non-GAAP P/E of 3.13 is one of the lowest in the sector and the price to book value is 90%. Tangible book value increased by about 8% in Q4 and as of January 2023 book value was up about 10%. In February, the company estimated that book value increased by 11% to $10.80 - $10.90 per common share from $9.84 at the end of December.
Although the book value declined substantially in 2022 due to widening credit spreads, the current dividend yield on book value is well aligned with the economic return outlook as explained by CEO Federico in a presentation given at the Credit Suisse Financial Services forum :
We're not trying to target a particular dividend. But when I think about the dividend level, one of the, I think, the most critical inputs into that equation first is what is the economic return outlook on the existing portfolio today at today's prices, right? And our dividend yield on book value, not on our stock price, but dividend yield on book value and our economic return outlook are pretty well aligned. And I think that's the most critical element when you think about the sustainability of a dividend that's making those two things -- making sure those two things are aligned.
On March 8, J.P. Morgan analyst Richard Shane upgraded AGNC from Neutral to Overweight in anticipation of a rally in the stock price before interest rates peak.
AGNC Preferred Stock
As is the case with the other REITs that I have discussed, the preferred shares offer investors a lower risk, lower return option, and in the case of AGNC there are 5 to choose from as shown in this snippet from the Q422 investor presentation . Four of the five are fixed-to-floating rate.
I like AGNC common stock at the current discounted price with its well covered dividend and also rate it a Buy, but with the caveat that the price could move lower if the overall market continues to decline based on fears of continued economic malaise over the next few months.
Get Your Capital Ready for My Top REIT Pick for 2023
While ABR, RITM, and AGNC all look like solid buys at current prices and offer high yield dividend distributions for both the common and preferred shares, I view Ready Capital ( RC ) as being the most undervalued with strong financials and the greatest upside potential in terms of both share price and dividend growth in 2023.
When I first wrote about RC back in January 2022, I compared it to Orchid Island Capital (ORC) and determined that it was a much better buy for an mREIT at the time. And if you go back and look at the 3-year total returns, RC still way outperformed ORC. However, since I wrote that article the performance has been just about even between the two, with ORC actually beginning to take the lead just in the past 2 months.
The reason for that is more due to the underperformance of RC since January of this year, versus strong performance from ORC. In fact, YTD the total return of RC is -13% while ORC is essentially flat. So why would I recommend now to go with RC when ORC offers an 18% yield and appears to be showing some strength in its share price?
Well for one thing, RC is trading far below book value in March of 2023. The book value of RC on December 31, 2022 was reported at $15.20 per common share while the stock price closed at $9.92 on March 24. In fact, over the last year the stock price has swung from a slight premium to book value in early 2022 all the way to a -33% discount, and most of that decline occurred over the past month.
When RC reported Q422 results on February 27, 2023, the GAAP EPS was only $0.08, however, the distributable earnings per common share of $0.42 more than covers the $0.40 dividend that was just declared again, in line with last quarter, for Q123. At the current price the forward yield is just over 16%.
The stock price has declined by -21% since the Q4 report and was exacerbated by the announcement of a pending acquisition of Broadmark Realty ( BRMK ) in an all stock deal. A recent article from fellow author Pacifica Yield (who also covered RC in a February article ) suggests that the deal is a huge positive for Broadmark, essentially saving them from collapse, and should also help RC to deleverage. The downside of the deal for RC shareholders is that the addition of BRMK will require issuing 63 million new shares. But the upside of adding all the BRMK assets to the mix (mostly unlevered loans) will help to increase the net assets and bring down the leverage of the RC portfolio.
According to the press release from RC, the transaction is expected to close by the end of the June quarter and will result in an expected value at closing of $787 million. Once completed, the transaction will result in RC becoming the 4th largest commercial mREIT with a capital base of $2.8 billion.
Previous to this acquisition RC completed 6 mergers since 2016, most recently acquiring the assets of Mosaic Real Estate Credit in March 2022, demonstrating a positive track record in M&A transactions. This announcement further enhances the growth by acquisition model that has enabled RC to successfully grow despite adverse economic conditions over the past year plus, as explained by Ready Capital Chairman and CEO Thomas Capasse in the Q4 earnings press release,
"Against a shifting economic backdrop, we continue to deliver strong results for our shareholders. With the highly accretive acquisitions we have made over the past few years, along with our differentiated business model, Ready Capital continues to execute on our growth strategy, while remaining disciplined from a liquidity, leverage and credit perspective."
Ready Capital is a Differentiated Mortgage REIT
From their March 2023 investor presentation, RC outlines the reasons why they are differentiated from other mREITs, including the fact they are the largest non-bank lender for SBC properties.
With recent news of bank failures and some banks such as Wells Fargo retreating from the mortgage lending and servicing business, this potentially opens up even more opportunities for RC to capture new business from customers who might otherwise seek bank loans. RC primarily offers products and services across 3 broad segments including SBC Lending and Acquisitions, Small Business Lending, and Residential Mortgage Banking. This diversified investment strategy supports a diverse and reoccurring revenue stream. That diversification further plays out in spreading the risk as well as the income generation by investment type as illustrated in this slide from the March 2023 investor presentation .
On the Q4 earnings call, CEO Capasse further explained the detailed reasons why this diversified strategy has enabled them to grow successfully despite the challenging market conditions since the beginning of 2022:
Ready Capital's historic strategy of diversification in small balanced lending and defensive sector focus in multifamily, has resulted in significant outperformance over time, and continued in this quarter. First, in our originated CRE loan portfolio, comprising 84% of the total, 60-day plus delinquencies increased only two basis points to 1.9%, while high risk assets, those rated four to five on our one to five risk rating scale, were only 4.8% of the total. Furthermore, our focus on mid-market multifamily, which accounts for 81% of the current portfolio, is positioned to withstand the post-COVID and macroeconomic factors plaguing other sectors such as office, where we have a very modest 5% exposure in small ballots, average of 6.3 million loans. Second, in our acquired CRE in Mosaic loan portfolio comprising 10% of the total, much of which was distressed at purchase. 60-day plus delinquencies were only 10.1%, and high risk assets were 22%, mitigated by the remaining Mosaic contingency equity right reserve, and significant purchase discounts on non-performing loans or NPLs. Third, in our SBA portfolio, which comprises only 6% of the total exposure, 60-day delinquencies were a modest 1.4%, and high risk assets totaled 7%. Despite the small equity allocation to SBA, the segment generates returns well in excess of the CRE lending business, which is a significant differentiator for Ready Capital.
Financial Strength and Outlook for 2023
According to CFO Andrew Ahlborn on the Q4 earnings call, RC has ample liquidity with $164 million of total cash and another $1.1 billion in unencumbered assets. Mark to market debt decreased to 14% in the quarter. Since the end of Q3 the company also closed on 2 CLOs. The first was an $860 million transaction with an 84 advance rate and AAA pricing at 283 basis points over the curve, with the second a $590 million CRE CLO also with AAA spreads tightening to 253 basis points over the curve. Recourse leverage in the business declined to 1.5 times due to those CLO issuances.
And then with the Broadmark transaction the company expects to add approximately $900 million in equity, expected to be accretive to earnings within four to six quarters after closing. The Broadmark deal will allow RC to pursue additional multifamily transitional lending opportunities for smaller scale loans, on average of around $7 million balance versus the $15 million average they currently manage. And secondly, it will allow them to pursue an additional concentration in construction loans, potentially increasing new originations from 15% to as much as 20% of total CRE.
In addition, the transaction once completed will enable additional deleveraging to occur. The CFO explained how that is expected work:
Upon close of the transaction, we certainly expect to apply asset level financing on certain subsets of their portfolio. So, pulling out somewhere between $300 million and $500 million of liquidity pretty shortly after the close of the transaction. And as we look forward, as we continue to scale, the potential to bring down overall leverage from where we've been running historically and look to access a different rating and potentially different debt markets, is certainly something we're considering.
Looking at the balance sheet for Q4 and FY22, the total assets grew from about $9.5B in Q421 to $11.6B as of Q422. Book value remained relatively stable despite the difficult year, starting at $15.35 in Q421 and increasing to $15.40 in Q322 before dropping back to $15.20 at the end of Q4.
Quick Comparison
One final comparison between the 4 REITs discussed in this article further illustrates the Strong Buy opportunity that RC offers at the current share price. The one-year total return shows that ABR and RC had the worst performance and the more residential oriented RITM and AGNC fared slightly better. And again, most of that recent underperformance for both ABR and RC occurred just in the last month.
RC is not the cheapest in terms of valuation, but it does have the 2nd lowest price to book value at 0.65, while only AGNC has a lower Forward GAAP P/E.
In terms of revenue growth, RC has the best expected forward revenue growth as well as 5-year CAGR.
They also have the best 3-year Net Income growth and 3-year tangible book value growth is up there second only to ABR.
In terms of profitability, they are again second only to ABR in terms of net income margin and just behind RITM based on ROE.
RC also has the highest amount of institutional ownership at 52%. Short interest of 4.2% is higher than RITM but lower than both ABR and AGNC.
The balance sheet for the most recent quarter indicates that RC has the highest total debt to equity at nearly 500%, and also has the highest long term debt to total capital ratio at nearly 75%. This is one reason why the Broadmark acquisition is important to help with deleveraging.
Summing it All Up
My primary reasons for liking all these REITs is because they have been marked down in price below book value (in the case of RC and RITM, well below book value) due to irrational fears of ongoing inflation, widening credit spreads, and continuing concerns regarding increasing interest rates and recessionary forces impacting the broader economy in 2023. Meanwhile, all 4 have strong balance sheets, good prospects for increasing revenue and earnings growth by taking advantage of a pullback in bank lending, and well covered dividends that have the potential to grow once interest rates begin to fall.
Of the four that I reviewed, I like RC the most because of the pending acquisition of BRMK, which given the strong track record of M&A activity over the previous 7 years, bodes well for RC to increase book value and lower debt by deleveraging assets going forward. I also feel that the market has unfairly punished the share price to a discount that is far below book value and is likely to narrow that discount once the overall market comes to its senses. Meanwhile, the dividend yields 16% and is well covered and unlikely to be cut, unless the BRMK deal falls through for some reason.
If you have read all the way to this point, I thank you for sticking with me, and I wish you the best in your investing goals. Please provide any feedback that you feel is relevant to anyone interested in any of these REITs. I am not an expert on REITs by any means so please be kind if I stated anything incorrectly or provided inaccurate information.
For further details see:
Here Are 4 REITs To Watch In 2023 - My Favorite Is Ready Capital