CIM & ACRE Q3 2023 Updates By Scott Kennedy

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Disclosures

Related to the stocks in this article:

CWMF is long: RITM-D, GPMT-A, DX-C, EFC-A, MFA-C, RITM-C, EFC-B, PMT-C, PMT-B, CIM-B, AGNCP, CIM-D, RITM, SLRC, MFA, GPMT, RC.

Scott Kennedy is long: RITM, RC, SLRC, GPMT, ARCC, TSLX, FSK, MFA, RITM-D, MITT-B, MITT-C, GAINL, RCB, ECCC, ECCW.

The rest of this post is from Scott Kennedy.

Summary

• This 13th earnings assessment article reviews CIM’s and ACRE’s BV and core earnings/adjusted core earnings performance during Q3 2023. This article is mainly for subscribers who do not utilize chat.

• CIM’s BV was a very minor-minor outperformance while its core earnings matched my/our expectations. ACRE’s BV and adjusted core earnings were a minor outperformance.

• However, CIM surprisingly notably reduced the company's quarterly dividend to just $0.11 per common share.  This is troubling and needs to be factored into modeling future earnings expectations.

• Directly due to a cumulative (52%) dividend decrease within only 3 quarters, CIM recently received a (6.5%) recommendation range “downgrade”.  No change in CIM's or ACRE's risk rating though.

• Even with this percentage recommendation range downgrade, CIM is currently deemed slightly undervalued (BUY) (ONLY for short-term valuation plays though). ACRE is currently deemed appropriately valued (HOLD).

Introduction:

Hi subscribers. For new members, my name is Scott Kennedy and currently I fully cover 20 mortgage real estate investment trust (mREIT) and 15 business development company (“BDC”) common stocks within this Investing Group regarding research/data, subscriber questions, weekly projected book values/net asset values (BV/NAV), and common stock recommendation ranges. Colorado (“CO”) Wealth Management handles the mREIT preferred stocks and he and his team handles all other applicable REIT sectors outside the mREIT sector. CO also provides some mREIT common stock and BDC articles from time-to-time which are more of an “overview/introduction” discussion; typically based either on my or our combined research/data. This also includes some macroeconomic trends and data. My name is always attached to all Investing Group articles I personally wrote so there is no confusion for subscribers.

This REIT Forum article is part of a series of articles over a span of 6-7 weeks which will analyze my previously projected BV/NAV and core earnings (or core earnings equivalent)/net investment income (“NII”) figures and compare these metrics to each mREIT’s and BDC’s actual reported results, respectively. For readers who are familiar with my public mREIT and/or BDC articles, these types of articles are beneficial to readers who desire to pursue a more active investing strategy and/or want more “real time” thoughts/analysis.

I hope my services/contributions ultimately help enhance a subscriber’s total investment returns or minimize their total investment losses within the mREIT and BDC sectors. At the very least, I hope subscribers will gain more insight into the mREIT and BDC sectors by reading my/our exclusive REIT Forum articles.

1) CIM’s BV and Core Earnings Q3 2023 Performance (Projected Versus Actual Results):

On 11/2/2023, Chimera Investment Corp. (CIM) reported the company’s earnings results for the third quarter of 2023. Table 1 below provides CIM’s BV and earnings summary.

Table 1 – CIM Q3 2023 BV and Earnings Summary

Source: Taken Directly from the REIT Forum’s © Analytical Spreadsheets/Data

Hi subscribers. I was able to review CIM's Q3 2023 earnings results in more depth. CIM reported a BV as of 9/30/2023 of $6.90 per common share (5.4% decrease) versus my prior projection of $6.80 per common share (6.7% decrease). I consider this a very minor - minor (greater than a 1.0% but less than a 2.5%) outperformance and was well within my $6.45 - $7.15 per common share range. Still, let us reconcile CIM’s quarterly BV fluctuation when compared to my expectations.

First, when reviewing CIM’s investment portfolio, management was pretty “dormant” across all sub-portfolios during the third quarter of 2023. CIM basically continued to “roll-off”/call some agency commercial mortgage-backed securities (“CMBS”) during the quarter. On the agency CMBS, similar to the prior several quarters, call volumes were more subdued when compared to 2021. This was generally correctly projected/anticipated on my end during the third quarter of 2023. CIM also rolled-off the company’s agency interest-only (“IO”) and non-agency residential MBS (“RMBS”) during the third quarter of 2023.

In addition, unlike the first quarter of 2023, CIM continued to take “the foot off the accelerator” regarding the company’s residential whole loans sub-portfolio. The severity of the quarterly decrease within this sub-portfolio was slightly greater when compared to my expectations (which actually helped BV a bit). In particular, CIM reduced the company’s residential whole loans by ($0.5) billion during the third quarter of 2023. In comparison, I projected a decrease of ($0.2) billion. In addition, CIM has recently continued to refinance some legacy debt securitizations (liabilities) via creating new collateralized debt/loan obligations (CDO/CLO). All debt securitizations are non-recourse in nature and have no “mark-to-market” call provisions. However, with the notable, quick move higher in mortgage interest rates/U.S. Treasury yields, CIM’s growing refinancings have started to “take a toll” which has resulted in a notable increase to CIM’s borrowing rate. This will be further discussed later in reference to CIM’s announced notable dividend reduction.

Regarding valuation fluctuations within CIM’s entire investment portfolio, the company recorded a total investment portfolio net realized and unrealized valuation loss of ($74) million during the third quarter of 2023 (the majority of this loss was within residential whole loans [netted against securitized debt]). In comparison, I projected CIM’s entire investment portfolio (including agency and non-agency RMBS/CMBS valuation fluctuations) would have a net valuation loss of ($100) million. Again, this was mainly due to CIM’s lower total investment portfolio size when compared to my expectations (thus resulting in lower valuation losses). When calculated, this $26 million variance directly led to a BV outperformance of $0.11 per common share when compared to my expectations.

Second, I correctly projected CIM would maintain the company’s derivative instruments/hedges during the third quarter of 2023. As I have noted in previous earnings chat notes, derivative instruments/hedges are not solely meant/used for agency mortgage-related investments. This is something CIM “learnt the hard way” during 2022 which was at least partially linked to the fairly recent termination of a C-suite executive (lack of derivative instruments heading into 2022). CIM was simply “too late to the party” regarding properly managing interest rate risk during 2022.

I would point out CIM’s interest rate payer swaps have a very short tenor/maturity which actually negatively impacted valuation fluctuations during the third quarter of 2023 (and October 2023). This was also correctly projected. CIM reported a derivatives net valuation gain (excluding current period hedging income which is a part of core earnings/earnings available for distribution (“EAD”)) of only less than $1 million during the third quarter of 2023. In comparison, I projected a derivatives net valuation gain of $2.5 million. When calculated, this ($2.5) million variance directly led to a BV underperformance of ($0.01) per common share when compared to my expectations.

When both variances noted above are combined, along with correctly assuming no common or preferred stock repurchases during the quarter and a core earnings/EAD underperformance of ($0.003) per common share (which will be discussed next), this fully reconciles to CIM’s BV outperformance of $0.10 per common share when compared to my expectations.

Moving on, CIM reported core earnings/EAD of $0.127 per common share for the third quarter of 2023. In comparison, I projected CIM would report core earnings/EAD of $0.130 per common share. CIM’s core earnings/EAD was $0.122 per common share for the second quarter of 2023. As such, I projected a core earnings/EAD increase of $0.008 per common share. In actuality, CIM reported a core earnings/EAD increase of $0.005 per common share. The institutional analysts’ consensus average was core earnings/EAD of $0.169 per common share.

First, I would point out this figure includes all discount accretion/prepayment fees that are “trued-up” when a non-agency RMBS/agency CMBS is called by CIM. This is analogous to a business development company’s (“BDC”) original issue discount (“OID”) true-up and/or prepayment fees when a loan is prepaid. Simply put, once a particular loan/securitization is called, all unaccounted-for discount accretion and/or prepayment fees have to be accounted for in the period of occurrence. As such, it accelerates GAAP income/core earnings/EAD. CIM reported $9.0 million of discount accretion/prepayment fees during the third quarter of 2023. In comparison, I projected CIM would report $10.0 million of discount accretion/prepayment fees during the quarter. When calculated, this ($1.0) million variance directly led to a core earnings/EAD underperformance of ($0.004) per common share when compared to my expectations. As such, a pretty accurate projection again this quarter.

Second, with CIM’s recent continued efforts to “shore up” the liability side of the balance sheet, via continuing to “replace/transfer” some recourse debt to non-recourse debt through loan securitizations, this did result in higher interest expense during the third quarter of 2023 when compared to my expectations. Borrowing costs, as a whole, increased to a greater degree when compared to my expectations (especially moving into next quarter). Furthermore, CIM’s investment portfolio size decreased (4%) during the third quarter of 2023 (based on FMV). In comparison, I projected a mean decrease of (2.5%). This was partially mitigated by a slight increase in overall portfolio yields (lower prepayments). CIM reported quarterly net interest income of $63.4 million during the third quarter of 2023. In comparison, I projected net interest income of $65.0 million. When calculated, this ($1.6) million variance directly led to a core earnings/EAD underperformance of ($0.008) per common share when compared to my expectations.

Third, CIM reported lower operational expenses during the third quarter of 2023 when compared to my expectations. This was mainly within CIM’s general and administrative (G&A) expenses. Remember, transaction expenses (mainly due to the securitization activity) is already reversed out of core earnings/EAD. CIM reported total operational expenses of $20.8 million during the third quarter of 2023. In comparison, I projected total operational expenses of $22.5 million. When calculated, this $1.7 million variance directly led to a core earnings/EAD underperformance of $0.009 per common share when compared to my expectations.

When the 3 variances noted above are combined,this fully reconciles back to CIM’s core earnings/EAD underperformance of ($0.003) per common share when compared to my expectations for the third quarter of 2023.

So, all-in-all, a very minor – minor outperformance on CIM’s BV (variance of 1.3%) and basically an exact match on the company’s core earnings/EAD (variance of only $0.003 per common share). So, basically an “as expected” quarter on BV and earnings performance. However, along with reporting earnings, CIM declared a notable dividend decrease from $0.18 per common share during the third quarter of 2023 to $0.11 per common share during the fourth quarter of 2023. The following quote from management within CIM’s press release for the third quarter of 2023 makes this declaration a bit “bewildering”:

‘Credit performance and income generation of our assets have continued to meet or exceed our initial investment expectations...’

What adds to this notable dividend reduction surprise, the 2^nd in only 3 quarters, is the following quote from management during CIM’s earnings conference call for the second quarter of 2023 (just last quarter):

‘…Right now,…the board feels comfortable paying that dividend…’ (referring to the previous dividend of $0.18 per common share).

Simply put, 2 recently contradicting statements made by management in my professional opinion. Regarding the first statement, if CIM’s investment portfolio is generating yields better than expected, along with continued subdued credit risk, then why was there a need for the 2^nd notable dividend reduction during 2023? This now calculates to a cumulative dividend decrease of (52%) over just 3 quarters. Regarding the second statement, obviously there was a quick, notable change in sentiment by the Board of Directors (“BoD”) in the matter of just 1 quarter (or management simply misspoke last quarter). I believe both points are troubling on CIM’s future outlook (even if management states otherwise). My interpretation is CIM has now “moved away” from the notion of being able to increase core earnings/EAD back to the previously declared $0.18 per common share dividend level and have now guided they will be pleased with keeping this core earnings/EAD above the newly reduced $0.11 per commons share dividend level. This is a notable negative catalyst/trend.

Why the notable implied change? I believe it all comes back to the liability side of the balance sheet. As noted earlier, borrowing costs. For example, at the end of second quarter of 2023, CIM had a secured financing agreements weighted average borrowing rate of 7.26%. However, by the end of the third quarter of 2023, this increased to 7.99%. When calculated, this was a quarterly increase of 0.73% which will have a “trickle effect” moving into the fourth quarter of 2023. This was a quick, rapid increase and will very likely outpace most (if not all) sector peers. The same generalized movements have recently been/will be felt by CIM’s securitization vehicles (more so than my models previously projected). The recent “higher for longer” mentality probably “sealed the deal” on the much more cautious CIM outlook/common stock dividend per share rate.

Therefore, when taking CIM’s recent and projected performance into consideration, along with macroeconomic trends/events (mainly Fed monetary policy, the general projected movement of rates/yields, and projected economic performance over the foreseeable future), I/we are “downgrading” our CIM percentage recommendation ranges (relative to CURRENT NAV) by (6.5%). This change is already reflected in the subscriber spreadsheets (since last night). However, no change to CIM’s risk rating (remains at a 4.5; moves closer to a 5 though). Over the past 8 quarters, CIM has just not been a company that has been outperforming its hybrid mREIT sub-sector peers. The (52%) cumulative dividend reduction within just 3 quarters, along with the implication of reduced guidance regarding core earnings/EAD generation, simply needs to reflect this point. Again, I believe CIM is now not trying to get back to the $0.18 per common share core earnings/EAD level but simply trying to stay above the $0.11 per common share core earnings/EAD level.

With that being said, most of this “negative news” is already priced into CIM’s stock. At a closing price as of 11/3/2023 of $4.88 per share, CIM is deemed to be slightly UNDERVALUED/a BUY recommendation (price target of $5.80 per share). Currently, CIM is not the most undervalued mREIT stock that I/we cover but, in my opinion, is not one of the most overvalued either. However, I/we continue to believe an investment in CIM’s common stock is a “speculative” play. Simply put, high - very high risk but the potential for higher rewards, via stock price appreciation OVER TIME, is a possibility. Again, CIM has a risk rating of 4.5. Simply put, not a great “fit” for your very cautious - cautious investor. CIM should probably ONLY be considered a short-term “swing”/speculative trade based on value at this point.

2) ACRE’s BV and Adjusted Core Earnings Q3 2023 Performance (Projected Versus Actual Results):