Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 04/14/2024
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Weekly Notes From Colorado Wealth Management Fund
Positions: No trades for me over the last week.
Commentary: Some higher inflation data drove bond prices higher. We saw some pressure on most share prices Friday. I’ve got a piece in progress on inflation. I’ll plan to have the Portfolio Update out soon as well. Current inflation data is still being propped up by lagged data. As I was forecasting previously, we’ve seen the growth in market prices for goods and services fall significantly.
Looking at the long-term picture, I think inflation will pick up again in a few years. There’s simply an abundance of dollars as deficits run in the trillions. Since the amount of dollars will increase faster than the amount of goods and services, we’ve got an inflationary picture. Artificial Intelligence can be extremely deflationary since it can increase the amount people are capable of producing. But doing so would involve putting many people out of jobs. That’s pretty unpopular.
Remember when there was a huge protest about the idea that screenwriters might be replaced by AI? I’m not saying AI is great at writing plots, but you’ll have to agree that AI could’ve done some things much better:
Game of Thrones Season 8
The Witcher Season 3
Wheel of Time Season 1
For better or worse, those were big productions backed by some of the largest streaming services and given large budgets. Yet they produced scripts as bad as you might expect from a handful of college kids who didn’t know the source material. The best case scenario is one where AI enhances productivity so that the same job can be done with fewer hours. Could society handle that?
Weekly Notes From Scott Kennedy
Positions: No new or sold positions this week. In general, I am continuing to be patient regarding selectively deploying capital in attractively-valued stocks. Patience is key.
BDC Weekly Change: A recent consistent trend, spreads were relatively unchanged/very slightly widened.
BDC Other comments (Current Week): Similar to the prior several months, muted volatility in high yield/speculative-grade debt this week. Regarding weekly recommendation changes (mainly due to stock price and projected NAV changes), 1 upgrade and 0 downgrades occurred. With the market sell-off, CSWC moved from NOTABLY OVERVALUED/STRONG SELL to OVERVALUED/SELL strictly based on valuation.
Finalized calendar Q1 2024 earnings projections for all 15 BDC covered peers were provided on 4/7/2024. Overall, expectations are relatively unchanged - very minor decreases to most BDC’s quarterly earnings/net investment income (“NII”).
I will continue to monitor the recent developments in the mid-East (including all escalations/responses to a larger regional war) and broader macroeconomic impacts in the United States regarding private debt/credit markets.
Calendar Q4 2023 Earnings Season + Quarter-End Percentage Recommendation Range Upgrades (Downgrades) (Running Tally):
MFIC: 2.5% Upgrade (Week of 3/31/2024)
OCSL: (2.5%) Downgrade (Week of 2/2/2024)
CSWC: 5% Upgrade (Week of 2/2/2024)
PSEC: (7.5%) Downgrade (Week of 2/9/2024)
GBDC: 5% Upgrade (Week of 2/9/2024)
FSK: (2%) Downgrade (Week of 3/1/2024)
TCPC: (2.5%) Downgrade (Week of 3/1/2024)
TPVG: (7.5%) Downgrade (Week of 3/8/2024)
Calendar Q4 2023 Earnings Season + Quarter-End Risk/Performance Rating Upgrades (Downgrades) (Running Tally):
PSEC: Downgrade from 4.5 to 5 (Week of 2/9/2024)
GBDC: Upgrade from 3.5 to 3 (Week of 2/9/2024)
FSK: Downgrade from 4 to 4.5 (Week of 3/1/2024)
TPVG: Downgrade from 3.5 to 4 (Week of 3/8/2024)
Underlying Portfolio Company Credit Changes Held by BDCs (Weekly): 2 downgrades, 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) Down (Large Investment*)
GBDC: (1) Down (Small Investment*)
OCSL: (1) Down (Medium Joint Venture Investment [Both JVs]*)
PSEC: (1) Down (Large Investment)
SLRC: (1) Down (Small Investment*)
* = Regarding ARCC’s, GBDC’s, OCSL’s, and SLRC’s credit downgrade, this pertains to a portfolio company in the retail sector who is seeking Chapter 11 Bankruptcy protection. That said, this portfolio company was already “troubled” over the past year or so and this filing was previously anticipated (just a matter of exact timing). Out of the 4 BDCs impacted, ARCC has the largest exposure to this portfolio company but already marked-down the fair market value (“FMV”) of the company’s non-accrual loan by a considerable amount. That said, some additional losses/remaining mark-downs will likely occur during the calendar first and/or second quarter of 2024 which was already considered in our recent CURRENT NAV projections.
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 (Medium Investment), (3) Down (Large Investment**, Medium Investment**, Small Investment)
FSK: (2) Down (Small Joint Venture Investment; Restructured, Small Joint Venture Investment)
GBDC: (1) Down (Very Small Investment [Solely Equity])
OBDC: 1 Up (Medium Investment), (3) Down (Very Large Investment, Small Joint Venture Investment, Very Large Investment)
OCSL: (5) Down (Medium Investment***, Small Joint Venture Investment, Small Joint Venture Investment, Small Joint Venture Investment, Large Investment)
PFLT: (2) Down (Very Small Investment [Solely Equity], Small Investment [Solely Equity as Well])
PSEC: (2) Down (Medium Investment, Large Investment)
TPVG: (1) Down (Large Investment [Declared Bankruptcy])
** = Regarding one of ARCC’s credit downgrades, this pertains to a portfolio company that is issuing debt (raising leverage) to pay out a one-time, special periodic dividend. That said, I would point out the underlying fundamentals of this portfolio company (and the sector they operate in) remains strong - very strong. This is the underlying reason for the special periodic dividend in the first place (strong operational performance). As such, this is a bit of an “outlier” regarding a credit downgrade by the rating agencies. This downgrade is strictly in relation to the near-term increase in leverage from the issuance of additional debt to pay a special, periodic dividend. However, I would point out this portfolio company received a credit upgrade during the summer of 2023. I believe this latest rating change/downgrade will be relatively “short-term” in nature (up to 1 year). Over time, as operating fundamentals remain strong/performance metrics remain solid, this portfolio company will receive a credit upgrade as leverage is gradually reduced as net equity grows/rebuilds. I continue to believe ARCC’s debt investment in this portfolio company is strong (very low risk of principal loss). In addition, I believe ARCC’s debt investment could actually be partially/fully repaid from this portfolio company’s new, large debt issuance (something I am monitoring).
*** = ARCC and OCSL have a debt investment in a portfolio company which received a credit downgrade. ARCC also has an equity investment in this portfolio company. However, ARCC already had this portfolio company on non-accrual status as of 9/30/2023. In addition, ARCC’s equity investment in this portfolio company already had a fair market value (“FMV”) of $0 as of 9/30/2023. As such, this credit downgrade will have minimal impacts to both ARCC’s NII and NAV. On the other hand, OCSL still had this portfolio company on accrual status as of 9/30/2023. As I previously correctly projected, OCSL placed this portfolio company on non-accrual status during the calendar fourth quarter of 2023.
BDC View (Same as last week): Continuing the June - March 2024 trend, the market remains “cautiously optimistic” on high yield debt/speculative-grade credit. Spreads 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 in late 2024 - 2025. This expectation is already factored into price-to-book targets. Spreads will likely begin widening during 2024. 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 2023 (and any new updates regarding this event).
With the continued market rally, valuations within the BDC sector are remaining “pricey” in some names. I believe the majority of sector earnings are near their peak (plateauing). The rapid net investment income (“NII”) growth during 2022 - 2023 will not occur during 2024. As the FOMC eventually begins to reduce the Federal Funds Rate later this year, sector earnings will GRADUALLY decrease over time. The severity of decreases will vary peer-to-peer (which I/we continuously project/model). This notion is already embedded in all price targets. Just something to consider at this point. That said, SLRC still has some value (however, to remain non-bias, not as good of a deal as most of 2023).
MREIT Weekly Change: Most agency mREIT BVs modestly decreased during the week (severity varied peer-to-peer; ARR having the largest projected decrease). This was mainly due to agency MBS spreads modestly widening versus underlying net (short) hedges. Most hybrid and commercial whole loan mREITs likely experienced a slightly - modestly decreasing BV while the originator + servicer mREITs likely experienced a relatively unchanged - minor BV increase.
MREIT Other comments (Current Week): Regarding weekly recommendation changes (mainly due to stock price and projected BV changes), 4 upgrades and 0 downgrades occurred. With the market sell-off, AGNC moved from NOTABLY OVERVALUED to OVERVALUED strictly based on valuation. ACRE, PMT, and TWO moved from APPROPRIATELY VALUED/HOLD to UNDERVALUED/BUY strictly based on valuation.
Regarding weekly agency mREIT BV movements, most agency MBS coupons experienced modest - notable price decreases (including all specified pools; mainly HARP and LLB loans). There was a wide range of price fluctuations based on underlying coupons. For the 2nd straight week, higher coupons experienced less severe price declines while lower coupons experienced more severe price declines (especially very low legacy coupons; 2.0% - 3.5%). This was mainly due to the hotter March 2024 Consumer Price Index (“CPI) read which only solidified the “higher-for-longer” mentality regarding mortgage interest rates/U.S. Treasury yields. Most (short) derivative instrument valuations modestly increased. Simply put, the vast majority of spread relationships I/we track (over 100 combinations) continued to slightly - modestly widen.
Finalized calendar Q1 2024 earnings projections for all 20 mREIT covered peers were provided on 4/7/2024. Overall, expectations are for minor increases in most agency mREIT quarterly core earnings/earnings available for distribution (“EAD”) while the hybrid, originator + servicer, and commercial whole loan mREIT sub-sector peers will experience relatively unchanged - minor decreases.
Regarding monetary policy, 3 25 basis point (“bp”) FOMC rate cuts are likely “off the table” during 2024. My previous projection of 2 - 3 rate cuts during 2024 will be revised down to 1 - 2 rate cuts. Subscribers need to remain patient regarding catalysts playing out in the hybrid and commercial whole loan mREIT sub-sectors (longer-term horizon/mind set).
Q4 2023 Earnings Season + Quarter-End Percentage Recommendation Range Upgrades (Downgrades) (Running Tally):
DX: 1.5% Upgrade (Week of 2/2/2024)
BXMT: (5%) Downgrade (Week of 2/16/2024), (5%) Downgrade (Week of 3/31/2024)
FBRT: (2.5%) Downgrade (Week of 2/16/2024), (2.5%) Downgrade (Week of 3/31/2024)
GPMT: (5%) Downgrade (Week of 2/16/2024), (2.5%) Downgrade (Week of 3/31/2024)
MFA: 2.5% Upgrade (Week of 2/23/2024)
ACRE: (12.5%) Downgrade (Week of 2/23/2024), (2.5%) Downgrade (Week of 3/31/2024)
EFC: (2.5%) Downgrade (Week of 3/1/2024)
RC: (2.5%) Downgrade (Week of 3/1/2024), (2.5%) Downgrade (Week of 3/31/2024)
Q4 2023 Earnings Season + Quarter-End Risk/Performance Rating Upgrades (Downgrades) (Running Tally):
DX: Upgrade from 4 to 3.5 (Week of 2/2/2024)
BXMT: Downgrade from 3.5 to 4 (Week of 2/16/2024), Downgrade from 4 to 4.5 (Week of 3/31/2024)
FBRT: Downgrade from 3.5 to 4 (Week of 2/16/2024)
MFA: Upgrade from 4.5 to 4 (Week of 2/23/2024)
ACRE: Downgrade from 4 to 5 (Week of 2/23/2024)
RC: Downgrade from 4 to 4.5 (Week of 3/31/2024)
MREIT View (Same as last week): 1) Agency mREIT Sub-Sector Trends: Agency MBS spreads have moved a good ways below the October 2023 highs (a positive catalyst/trend). As pointed out for some time, I correctly anticipated the severity of widening during late Q3 2023 - early Q4 2023 would be a relatively short-term event. I (or really anyone) just could not “pinpoint”, to the exact week, when the November 2023 reversal would begin to occur. This net reversal continued through March 2024 but has partially reversed course during the 1st 2 weeks of April 2024. Higher risk tolerant investors may want to take “a stab” at initiating positions in the agency mREITs on any pullback in price (ONLY UNDERVALUED/BUY or NOTABLY UNDERVALUED/STRONG BUY recommendations). However, valuations, as a whole, remain unattractive in most agency mREITs. As such, patience is key. Some market participants thought agency mREIT valuations were attractive during the summer of 2023. 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 about beforehand via our weekly newsletter (regarding this sub-sector being overvalued prior to this prior sell-off; in particular AGNC).
Most agency mREITs remain 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). CHMI “bucked” this trend this past quarter (raised a proportionately large amount of capital at a notable discount to CURRENT BV) and suffered notable BV losses as a result. MSR valuations were recently at their peak but remain elevated versus historical trends. I/We do not anticipate a notable drop in MSR valuations over the foreseeable future (especially within lower coupons). That said, to remain unbiased, I correctly projected MSR valuations would decrease during Q4 2023. Prepayments, across the mortgage landscape, have remained relatively subdued (even with the fairly recent quick drop in rates/yields) but technically have “ticked higher”. MSR valuations should slightly increase during Q1 2024 but one also has to consider quarterly amortization which always negatively impacts overall MSR valuations (realization of cash flows). Repo financing rates have likely peaked in late 2023. Agency net interest spreads (excluding current period hedging income) remain slightly - modestly negative. However, dependent on the utilization of interest rate payer swaps, adjusted net interest spreads remain acceptable for most peers (though slightly - modestly decreased during the second half of 2023). Net interest spreads have likely “bottomed out” during Q4 2023 or will bottom out during Q1 2024. Then, a very slow, gradual increase will likely begin during the first half of 2024. Future decreases in hedging income regarding most agency mREITs should be mitigated by increases in MBS coupons/weighted average coupons, more attractive cost basis of investments when compared to legacy investments, and changes in derivative instrument strategies.
2) Commercial Whole Loan Sub-Sector Trends: There will continue to be pressure in commercial whole loan pricing/valuations, especially in office and some isolated pockets of multifamily loans during 2024 - 2025. ACRE, BXMT, FBRT, and GPMT were a perfect example of this during Q3-Q4 2023 (new non-accrual and/or “watch list” 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 and February 2024 of all 4 sub-sector peer’s peak non-accrual rate this credit cycle (above the high end of my/our previous range). This negatively impacted per share recommendation ranges a bit back in late June 2023 and more so during February 2024. ACRE, BXMT, FBRT, and GPMT will continue to have heightened monitoring regarding asset/loan resolution within the office (and more recently multi-family) sub-sector and all other troubled loans. As the risk ratings indicate, BXMT and FBRT should come out of this credit cycle the least harmed out of the 4 covered sub-sector peers (though will not be “unscathed”). This should be followed by ACRE and GPMT. While GPMT should be trading at a notable 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).
I also wanted to quickly highlight a recent discussion that took place in the chat feature of this service. A question was asked on where I believe we are currently at in the commercial mREIT/real estate credit cycle (indirectly tied to GPMT’s price targets). I provided the following reply in chat in late December 2023:
“...I’ll discuss a couple broader points. Remember, the market is ‘forward thinking’. So, pricing will be a bit ahead of itself versus the actual credit cycle. I believe we’ve seen this over the past couple of months via this market/sub-sector rally. I would continue to utilize the price targets set for GPMT to understand where we are in the credit/economic cycle. To use a baseball analogy, we’re still in the ‘early innings’ of the game. I would say the 3rd inning. There’s going to be more defaults. There’s going to be additional non-accruals. I’d pay attention to GPMT’s maturity schedule (including extensions). GPMT is actively managing the portfolio and achieving solutions over time. When compared to other mREIT sectors, it’s a longer-term process (more akin to the BDC sector). That is a good thing (gives time to come up with solutions over time). GPMT just has to properly navigate the ‘ripples in the water’/credit issues as they come. This cycle first started back in late 2022 and will very likely continue through 2026 (projected peak in late 2024 – early 2025). That said, as noted above, the market is forward thinking (usually by approximately 1 year but it varies)…So, I’ll continue to monitor GPMT/the entire sub-sector and check actual developments versus both short- and long-term modeling…I continue to believe GPMT is notably undervalued and the recommendation ranges continue to reflect that. However, as ALWAYS pointed out, especially for GPMT, it’s going to take time for the stock price to rise closer to the targets. Personally, I’m fine with holding my existing position and remaining patient. I could add to my position on any notable pullback(s) in price but remember GPMT’s assigned risk/performance rating of 5…”
I also wanted to quickly highlight a recent discussion that took place in the chat feature of this service. A question was asked regarding where I currently believe we are at (and will be over the foreseeable future) in the Federal Funds Rate cycle and recent developments in commercial real estate. I provided the following reply in chat and personal messages in early February 2024:
“...Yes, the commercial mREITs (and CSWC) got hit today. Likely due to what New York Community Bancorp reported today. That said, not a 100% parallel comparison but yes a partial relationship there. That said, I/we have already projected continued CECL reserve increases for all 4 (5 if you include RC) sub-sector peers for Q4 2023. That's reflected in the projected BVs. Also, the "delay" in the Fed Funds Rate cut didn't help with markets. That said, as continuously stated, I never believed there would be a cut in March. I continue to believe the 1st cut will be in May/June. During 2024, I continue to believe there will be 2-3 cuts. At one point, the market had 6-7 cuts during 2024 which was/is nuts in my professional opinion. Let the market digest the information/data from today…Also knew multifamily cracks/stress would begin to appear regarding credit risk. That said, multifamily will continue to perform better than the office sub-sector through this commercial real estate cycle. This is already embedded in the modeling and was part of the sub-sector downgrades back in the summer/fall of 2023. Simply put, just have to be patient for this cycle to play out…”
During the week of 3/31/2024, I decided to perform a minor percentage recommendation range downgrade to ACRE, FBRT, GPMT, and RC out of caution. A modest downgrade was performed on BXMT. As noted in each company’s individual earnings assessment articles, peak non-accrual rates were recently adjusted to account for a quicker/more severe spike in credit risk (versus previous expectations). I now believe it was only prudent to perform another sub-sector downgrade as a “tweak” to my/our modeling was needed as quarter-end data was compiled (mainly impacting late 2024 - 2025). This also factors in a higher probability of a “higher for longer” mentality regarding interest rates/yields. Company specific details on this sub-sector downgrade are provided in the above section.
3) RITM’s Likely Proposed Spin-Off: I am still awaiting RITM SEC filings regarding the company’s “organizational changes” in relation to its proposed spin-off of its mortgage origination business (NewRez and affiliated subsidiaries) that could occur during 2024. Subscribers need to remain patient on this potential future event (regarding all financial reporting impacts). While I continue to "run" 2 sets of RITM BVs on the potential/future spin-off, it is still too early to publicly provide both sets of BVs since I/we do not know which exact subsidiaries are being spun-off. Remember, RITM has 10+ underlying investment sub-portfolios. As such, the final organization chart could be tens of combinations. While, yes, RITM’s BV per share will change if/when a spin-off eventually occurs, I would continue to point out current RITM shareholders will not be "losing anything" as RITM’s BV decrease will merely transfer to the spun-off entity (which shareholders would own as well). There continues to be the strong likelihood some “value creation” will be unlocked as NewRez (and all affiliated entities) is spun-off. On a related note, as I have stated from the start, dependent upon the "final makeup" of RITM after the potential spin-off, the REIT Forum will continue to cover the "mortgage operations" of the company. In other words, the REIT Forum will cover the mREIT operations of the company. That will very likely be the spun-off company and might not include the parent (for instance if the parent/RITM merely becomes an asset manager). Again, I currently cannot provide the specifics/breakdown of this ENTIRE spin-off because RITM has not provided ALL details but I will be on the continued lookout to do so.
As a reminder for subscribers, mREIT/BDC earnings assessment articles take a deeper dive into each company's operational performance metrics and future catalysts/trends. Refer to those articles for company-specific details.
Public Disclosures
Our positions related to the sector:
CWMF is long: RITM-D, GPMT-A, DX-C, EFC-A, RITM-C, EFC-B, PMT-C, CIM-D, RITM-B, MFAN, RCB, RITM, SLRC, GPMT, RC.
Scott Kennedy is long: RITM, RC, SLRC, GPMT, MITT, ARCC, RITM-D, MITT-B, MITT-C, MFAN, ECCC..
Note: The paid version shows the sizing of each position (further down in the article).
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.
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The mREITs: