Update: Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 11/12/2023

Update: In the initial release of the weekly update, the section containing Scott’s notes was out of date (from 11/5/2023). This version has the updated notes from 11/12/2023. There are no other changes.

Hi subscribers.

We aim to retain the same layout from week to week. The layout is carried over from last week.

Weekly Notes From CWMF

Positions: No changes last week.

Still looking at the fixed-to-floating shares. Cash position is pretty small. May swap out of Essex Property Trust (ESS) (apartment REIT) since it has a smaller discount to targets than many of the other shares.

Commentary: It was a pretty quiet week. No major events to report on aside from the change in Two Harbors preferred shares. Continuing to work on more of the equity REIT updates.

Weekly Notes From Scott

Positions: No purchased or no sold positions.

BDC Weekly Change: Most NAVs slightly increased. Spreads slightly tightened.

Other Comments: Similar to the prior 4 weeks, muted volatility in high yield/speculative-grade debt this week.  Earnings season for the BDC sector is less busy this week.  OCSL reports pre-market open on Tuesday while PFLT reports after the market close (both providing fiscal year-end results).  

Underlying Portfolio Company Credit Changes Held by BDCs (Weekly): 4 downgrades (ARCC, MFIC, PSEC, TCPC), 0 upgrades

Underlying Portfolio Company Credit Changes Held by BDCs (Current Quarter-to-Date):

This is a running tally of the credit upgrades and downgrades for companies held by each BDC.

ARCC: 1 Up (Small Investment), (1) Down (Small Investment)

FSK: (1) Down (Medium Joint Venture Investment)

MFIC: (1) Down (Small Investment)

PSEC: (2) Down (Medium Investment, Large Investment)

SLRC: (1) Down (Very Small Investment)

TCPC: (1) Down (Medium Investment)

Underlying Portfolio Company Credit Changes Held by BDCs (Prior Quarter):

This is a running tally of the credit upgrades and downgrades for companies held by each BDC.

ARCC: 1 Up, (2) Down

CSWC: (2) Down

FSK: 1 Up, (1) Down

MAIN: 1 Up, (2) Down

OCSL: (1) Down

PFLT: 1 Up (JV Portfolio Company), (1) Down (Includes JV Portfolio Company)

PSEC: 3 Up (Includes 1 Restructuring), (3) Down (Including 1 Bankruptcy)

GBDC: (1) Down

SLRC: (1) Down

TCPC: 1 Up

OBDC: 1 Up, (1) Down (JV Portfolio Company)

TPVG: (1) Down (Declared Bankruptcy)

View: Same as last week. - Continuing the June - October 2023 trend, the market remains “cautiously optimistic” on high yield debt/speculative-grade credit.  Spreads, for the most part, remain resilient as the market continues to “grapple” between plateauing short-term interest rates and economic uncertainty (typically impacting the longer-end of the yield curve).  Still expect an eventual mild recession to pressure NAVs into 2024. Already factored into price-to-book targets. Spreads will likely begin widening in late fall 2023. Still tight relative to history.  Continuing to watch the broader/macroeconomic impacts from the recent end of the 3-year student loan repayment pause (due to COVID-19) in October (and any new updates regarding this event).  Earlier this fall, I correctly assumed either a “last minute” government shutdown solution (albeit only 45 days) or a very short-lived government shutdown (under 1 week).  The 1st scenario previously prevailed and the next potential government shutdown in mid-November will be continually monitored.  I/We will continue to monitor the recent developments in the mid-East and broader macroeconomic impacts in the United States regarding private debt/credit markets.    

MREIT Weekly Change: Most agency mREIT BVs were relatively unchanged - slightly decreased during the week.  Agency MBS spreads were relatively unchanged - very slightly widened.  Most hybrid, originator + servicer, and commercial whole loan mREITs also experienced only minor BV fluctuations.  EFC and RC received a (3%) and (2.5%) recommendation range downgrade, respectively.  This slightly negatively impacted per share recommendation ranges (check the subscribers spreadsheets if desired).  This mainly occurred due to EFC’s and RC’s larger-than-anticipated decrease in quarterly core earnings/earnings available for distribution (“EAD”).  MITT received a 3% recommendation range upgrade.  This mainly occurred due to MITT’s continued positive progress of growing quarterly core earnings/EAD (while keeping BV declines “in check”; outside WMC merger-related costs).  Subscribers can read each company’s earnings assessment article for more details.  

Other comments:  Regarding weekly recommendation changes (mainly due to stock price and projected BV changes), a notably more quiet week.  Simply put, stock price fluctuations largely matched projected weekly BV changes.  ARR was downgraded to APPROPRIATELY VALUED/HOLD, ACRE was upgraded back to UNDERVALUED/BUY, and RITM was upgraded back to NOTABLY UNDERVALUED/STRONG BUY based on valuation.   

Regarding weekly agency mREIT BV movements, all agency MBS coupons experienced modest price decreases (including all specified pools; mainly HARP and LLB loans).  All (short) derivative instrument valuations modestly increased.  Simply put, the vast majority of spread relationships I/we track (over 100 combinations) remained relatively unchanged - very slightly widened.  Agency MBS spreads remain hovering around October 2022 levels (recently, a more positive catalyst/trend).  As pointed out for weeks now, I correctly anticipated the severity of widening to be a relatively short-term event.  I (or really anyone) just could not “pinpoint”, to the exact week, when the early November 2023 reversal would occur.  

View: Same as last week.  Agency mREIT spreads will likely remain volatile heading into 2024 (in both directions) so subscribers need to be patient for this to play out.  Before I personally consider an investment in this sub-sector based on valuation, I want to see some spread stabilization to occur that lasts more than a week - a couple weeks.  Just my personal choice within the agency mREIT sub-sector.  Repo financing was relatively unchanged during the week.  Higher risk tolerant investors may now want to take “a stab” at initiating positions in a couple of the agency mREITs on any pullback in price (ONLY undervalued or notably undervalued recommendations).  Some market participants thought agency mREIT valuations were attractive a few months ago.  Simply put, as continuously noted, the market was “ahead of itself” regarding agency mREIT valuations.  A perfect example of this was the notable sell-off during September - late October 2023 which we correctly warned subscribers beforehand (regarding this sub-sector being overvalued prior to this recent sell-off; in particular AGNC).  

Most agency mREITs were recently in common share issuance mode (rebuild capital as MBS pricing remains historically attractive).  However, some agency mREITs trading at notable discounts to estimated CURRENT BV will likely temporarily stop or notably reduce common stock issuance unless deemed necessary (due to greater BV dilution).  MSR valuations are likely near their peak and remain elevated versus historical trends.  However, I/We do not anticipate a notable drop in MSR valuations over the foreseeable future (especially within lower coupons).  The rate of financing cost acceleration has slowed over the past several months (which was previously correctly anticipated).  Repo financing rates should peak in late 2023.  Agency net interest spreads (excluding current period hedging income) are slightly - modestly negative.  However, dependent on the utilization of interest rate payer swaps, adjusted net interest spreads remain acceptable for most peers (though will continue to slightly - modestly decrease over the next quarter or 2).  Net interest spreads will continue moving lower during the second half of 2023 and will likely “bottom out” close to year-end.  Then, a slow, gradual increase will likely begin in the first half of 2024.  

There will continue to be pressure in commercial whole loan pricing/valuations, especially in office loans (BXMT was a perfect example of this during Q3 2023; 3 new non-accrual office loans). Simply put, continued credit/recession risk. However, there continues to be a bright spot for industrial loans (especially with the notion of a possible “soft landing” for the economy as a whole). Could even throw hospitality and retail loans in that mix (certainly better than the COVID-19 trends) but isolated credit events will occur in these sub-sector as well.  This included updated modeling in late June 2023 of all 3 sub-sector peer’s peak non-accrual rate this credit cycle towards the high end of my/our previous range.  This negatively impacted per share recommendation ranges a bit back in late June 2023.  ACRE, BXMT, and GPMT will continue to have heightened monitoring regarding asset/loan resolution within the office sub-sector and all other troubled loans.  As the risk ratings indicate, BXMT should come out of this credit cycle the least harmed out of the 3 covered sub-sector peers.  This notion was only solidified after fully analyzing BXMT’s Q2 2023 earnings results in late July 2023.  This should be followed by ACRE and then GPMT.  While GPMT should be trading at a discount to estimated CURRENT BV, I continue to believe the level of discount the market is pricing in is excessive (thus keeping GPMT very attractively valued).  Just know GPMT is assigned a risk rating of 5 (very high risk; potential for very high reward) and it will take time to see this valuation strategy play out (very likely 1+ year out).  

RITM’s BV was recently negatively impacted, to a very minor - minor extent, by the company’s revised proposed purchase price of Sculptor Capital Management (“SCU”) from $11.15 to $12.70 per Class A common share.  Simply something I am already factoring in.  Due to immateriality (again, consider the size of this potential merger when compared to RITM’s existing equity), this revised purchase price does not negatively impact RITM’s percentage recommendation ranges (relative to estimated CURRENT BV) or risk rating.  A very minor - minor CURRENT BV “true down” adjustment in October 2023 sufficed.  If SCU shareholders reject the merger proposal on 11/16/2023, RITM would receive an increased termination fee from $16.6 million to $20.3 million.  

EFC’s BV was negatively impacted in October 2023, to a minor extent, by the company’s termination of its previously announced merger with Great Ajax Corp. (AJX).  That said, a 9/30/2023 BV “true-up” recently occurred as EFC increased the company’s hedges to account for the upcoming termination.  So, more of a “timing event” on BV fluctuations.  Termination fee aside, I don't mind this development/decision. Out of EFC’s 2 previously announced mergers, AAIC is more important/appealing in my opinion. That said, I am not thrilled by the $16 million termination fee EFC is paying but probably the lesser of 2 evils down-the-road. If I had to take a guess, EFC backed out of the deal. EFC is receiving a minor position in AJX via part of the termination fee but at a price of $6.60 per common share which is bad (stock currently trades at $4.44 per common share). AJX’s stock price was previously“hit hard” from this news. This general downward movement makes sense as AJX’s stock price had recently held up much better versus basically all mREIT peers (merger price is now “off the table”).  I expect the AAIC/EFC merger to be finalized/cost during Q4 2023. AAIC basically fully hedged itself (asset-to-asset) leading up to the merger.

Weekly Recommendations

NOTE: This article is usually published Sunday evening or Monday morning. Sometimes it takes a bit longer.

The updates below were live in the spreadsheets by Sunday night, so the delay is just in preparing and posting this article.

The mREITs: