2023-08-14 16:24:21 ET
Summary
- TPG RE Finance Trust offers a very attractive dividend yield of nearly 14%.
- However, the expansion of the percentage of its portfolio classified as higher risk merits close attention.
- Despite the elevated risk, TPG RE Finance trades at an undemanding valuation, suggesting that the elevated risks have already been priced in to the stock.
TPG RE Finance Trust ( TRTX ) offers an attractive dividend yield of nearly 14%. However, the mortgage real estate investment trust (mREIT) has experienced an uptick in the percentage of its portfolio classified in the higher risk category. Investors would need to monitor these upticks in its portfolio closely, particularly as increased loan loss provisioning poses a material risk to continued earnings growth and potentially to the dividend in the longer term.
TPG RE Finance Trust’s Portfolio
In the second quarter of 2023 TPG RE Finance Trust reported a significant increase in the percentage of its portfolio classified in the highest risk category, category 5. The overall percentage of its portfolio classified in the highest risk category is now at 11.32% compared to just under 5% in the first quarter of 2023. Management defines loans in risk category 5 as loans with “a very high risk of realizing a principal loss or [which] has otherwise incurred a principal loss.”
The $129.2 million increase in non-accrual loans was indeed driven by one of these category 5 mortgages which had gone on non-accrual status during the second quarter of 2023. The mREIT also reported just over $33 million in realized losses from the resolution of two other loans in category 5 where the debtor had defaulted. This then also contributed to management reporting a $55.9 million net increase in current expected credit losses (( CECL )) reserves.
The increase in CECL reserves was the primary driver of the net loss reported by the mREIT in the quarter. Management has also acknowledged that resolving the credit challenged portion of the portfolio would be more important to its earning potential in the short term than even interest rates. In its earnings call management noted in this respect that
…rates are clearly important to us and companies like us. But in terms of our ability to rebuild earnings power, rates are actually a secondary issue. The biggest issue is clearly for us to move quickly through the credit challenge loans, resolving like the best value as possible. We had, at quarter end, $555 million of nonperforming loans. All of those are financed. So we’re paying interest on the funding costs and we’re not collecting interest. The foregone interest there on an annualized basis, by our estimates, is $0.15, $0.16 a year in a quarter.
Therefore, investors would need to monitor credit quality in the upcoming quarters closely. In my view, the credit quality issues are likely to persist for a few more quarters and this could see much greater fluctuations in the mREITs distributable income which may, in turn, have an impact on the dividend. However, promisingly, there were no new loans migrating from category 3 to category 4 in the second quarter of 2023. Category 4 can be looked at as an early warning sign to investors of challenges to come, with most category 5 loans having migrated from category 4 at some point. The lack of new loans migrating from category 3 to category 4 can accordingly be seen as a more positive development, notwithstanding other concerns over portfolio quality.
How Safe Is The Dividend?
TPG RE Finance Trust offers an attractive forward dividend yield of around 13.64% which is the third highest of the mREITs included in the peer comp charts below. However, in the second quarter of 2023 the dividend was not covered by distributable earnings on the back of the loss arising from increased CECL provisioning cost. Excluding the CECL provisioning cost, the dividend would have been fully covered by distributable earnings of $0.25 per share.
Nevertheless, if credit challenges persist, there is a real risk that the dividend may not be covered by distributable earnings for multiple consecutive quarters. This seems unlikely at the moment, but should be closely monitored by income investors concerned with the safety of the dividend. It is noteworthy that the $0.24 per share quarterly dividend had not been fully covered by distributable earnings per share for 3 out of the past 6 quarters. This raises important concerns surrounding the dividend's sustainability.
Nevertheless, when excluding the most recent loss resulting from increased CECL provisioning, the mREIT has a one-year average distributable earnings coverage ratio of around 107%. This indicates that the dividend has mostly been covered by distributable earnings, with some quarters seeing distributable earnings comfortably above the dividend while others have not fully covered the dividend.
In my view, TPG RE Finance will likely try to retain the $0.24 quarterly dividend for the time being. However, persistent declines in distributable earnings per share could see management revisiting this, with the most recent earnings call noting that
Our view is that dividend level for a company and our company in particular ought to be set at a level that matches its sustainable earnings power. There is also a consideration about distributable earnings, which to say is a pretty close, but not perfect proxy for taxable income and distributing at least 90% of taxable income is a REIT rules based driver dividend levels as well, but let's focus on the first point. We just articulated that NIM currently exceeds our dividend level. Doug described that volatility of distributable earnings is likely to continue as we work to resolve these loans.….So all of those are variables in the equation, and we use that to formulate recommendations to our Board
These comments suggest that management will not only be looking at distributable earnings coverage in isolation when determining the dividend, especially when considering other factors such as considerable cash on hand. Nevertheless, the declining dividend coverage is something that income investors should monitor quite closely going forward.
Valuation
TPG RE Finance Trust is currently trading at an undemanding price to book value of around 0.45 which is the lowest of the mREITs considered in the peer comp charts below. This is also well-below TRTX’s 5-year average price to book value of around 0.7.
The lower valuation level on a historic basis suggests that the market may have factored in most of the elevated risks discussed in this article. This discount brought about by the elevated risk suggests that the stock might be fairly valued given its current risk profile. However, should credit quality improve meaningfully in the near future, a re-rating would be justified.
Conclusion
TPG RE Finance Trust continues to offer an attractive dividend yield. However, one cannot simply overlook the significant increase in the percentage of its portfolio classified as high risk, particularly category 5 loans. This raises concerns about the potential impact on the company's earnings and longer-term dividend stability.
Nevertheless, TPG RE Finance Trust's undemanding valuation in terms of price-to-book value seemingly reflects the market's awareness of the elevated risks the mREIT faces. This suggests that the current valuation might reasonably account for the challenges in its risk profile. This then leads me to consider TPG RE Finance a hold with heightened scrutiny over the next few quarters on the dividend coverage front.
For further details see:
TPG RE Finance: Attractive Yield, Elevated Risk