Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 02/11/2024
Hi subscribers.
We aim to retain the same layout from week to week.
Weekly Notes From CWMF
Positions: Picked up some shares of Ready Capital (RC) RC 0.00%↑ at $8.83 per share.
Commentary:
Prices dropped more than BVs. Overall, more upgrades than downgrades. Getting quite a few upgrades, though very few reached the “strong buy” range. Many more in the “buy” range than we had a few weeks prior. In total, there were 5 upgrades and 2 downgrades during the week as the price-to-book ratios changed.
There is a new section in Scott’s notes I think readers should check out.
I formatted the data in bullet points to make it stand out at a glance.
There’s a batch for BDCs and a batch for mREITs, though there’s only one mREIT mentioned in the batch. The new section highlights changes in the recommendation (target price-to-book ratios) and changes in the risk ratings. As a reminder, higher numbers for risk ratings are worse. Lower numbers are better.
Weekly Notes From Scott
Positions: As noted during the week, I increased my position in Golub Capital (GBDC) GBDC 0.00%↑ and RC. I basically doubled my position GBDC while RC was a minor - modest “add-on” position. I will continue to “layer into” my RC position when deemed very attractively valued (no rush). In general, I am continuing to be patient regarding selectively deploying capital.
BDC Weekly Change: Spreads slightly tightened. Most weekly NAVs slightly increased.
BDC Other Comments: 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), 2 upgrades and 2 downgrades occurred. ARCC and GBDC moved from APPROPRIATELY VALUED/HOLD to UNDERVALUED/BUY. PSEC moved from UNDERVALUED/BUY to APPROPRIATELY VALUED/HOLD. GAIN moved from APPROPRIATELY VALUED/HOLD to OVERVALUED/SELL.
Earnings season takes a mid-season “lull” this week on the BDC side. TSLX reports after the market close on Thursday. TSLX will have a “top-line” earnings chat note on Thursday night and a full earnings chat note/assessment article provided Friday or Saturday night.
Calendar Q4 2023 Earnings Season Percentage Recommendation Range Upgrades (Downgrades) (Running Tally):
OCSL: (2.5%) Downgrade
PSEC: (7.5%) Downgrade
GBDC: 5% Upgrade
CSWC: 5% Upgrade
Calendar Q4 2023 Earnings Season Risk/Performance Rating Upgrades (Downgrades) (Running Tally):
PSEC: Downgrade from 4.5 to 5
GBDC: Upgrade from 3.5 to 3
Underlying Portfolio Company Credit Changes Held by BDCs (Weekly): 1 downgrade, 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: (3) Down (Large Investment*, Medium Investment**, Small Investment)
FSK: (2) Down (Small Joint Venture Investment; Restructured, Small Joint Venture Investment)
OBDC: (2) Down (Very Large Investment, Small Joint Venture Investment)
OCSL: (2) Down (Medium Investment**, Small Joint Venture 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. That said, I have previously projected OCSL would be placing this portfolio company on non-accrual status during the calendar fourth quarter of 2023.
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 (Small Investment), (1) Down (Small Investment)
FSK: (1) Down (Medium Joint Venture Investment)
MFIC: (1) Down (Small Investment)
OBDC: (2) Down (Medium Joint Venture Investment, Small Joint Venture Investment)
OCSL: (2) Down (Small Joint Venture Investment, Large Investment)
PFLT: (2) Down (Small Investment [Restructuring], Small Joint Venture Investment)
PSEC: (2) Down (Medium Investment, Large Investment)
SLRC: (1) Down (Very Small Investment)
TCPC: (1) Down (Medium Investment)
BDC View: Same as last week. - Continuing the June - January 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. 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). I/We will continue to monitor the recent developments in the mid-East (including all escalations to more of a regional war) and broader macroeconomic impacts in the United States regarding private debt/credit markets.
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 to 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, a couple of names still have value.
MREIT Weekly Change: All agency mREIT BVs slightly - modestly increased during the week (variations peer-to-peer). This was mainly due to agency MBS spreads slightly - modestly tightening versus underlying net (short) hedges (especially swaps). Basically the exact opposite to what occurred last week. Most hybrid and commercial whole loan mREITs likely continued to experience a minor BV decrease while the originator + servicer mREITs likely experienced a minor BV increase.
Q4 2023 Earnings Season Percentage Recommendation Range Upgrades (Downgrades) (Running Tally):
DX: 1.5% Upgrade
Q4 2023 Earnings Season Risk/Performance Rating Upgrades (Downgrades) (Running Tally):
DX: Upgrade from 4 to 3.5
MREIT Other comments: Regarding weekly recommendation changes (mainly due to stock price and projected BV changes), 3 upgrades occurred. EFC and NYMT moved from APPROPRIATELY VALUED/HOLD to UNDERVALUED/BUY. ORC moved from OVERVALUED/SELL to APPROPRIATELY VALUED/HOLD. This was mainly due to weekly stock price decreases “trumping” projected BV fluctuations.
Regarding weekly agency mREIT BV movements, most agency MBS coupons experienced modest price decreases (including all specified pools; mainly HARP and LLB loans). Most (short) derivative instrument valuations modestly - notably increased. Simply put, the vast majority of spread relationships I/we track (over 100 combinations) slightly - modestly tightened. In particular, in direct contradiction to last week, swaps outperformed MBS coupons and U.S. Treasuries this week.
Earnings season remains busy next week. BXMT and CIM report pre-market open on Wednesday while GPMT and FBRT report after the market close. ACRE and ARR could be reporting next week but an official earnings date has yet to be provided. Out of the stocks listed above, BXMT and GPMT will likely have an earnings chat note/assessment article provided Wednesday night. CIM and FBRT will likely have an earnings chat note/assessment article provided Thursday night. Possibly ACRE and ARR will have an earnings chat note/assessment article provided Friday or Saturday night. The night of earnings, all stocks where a detailed earnings chat note/assessment article is not provided will have a very brief, “top-line” summary provided.
MREIT View: Same as last week. 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 into late January 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). 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). 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 am projecting MSR valuations decreased during Q4 2023 (just not “notable”). Prepayments, across the mortgage landscape, have remained relatively subdued (even with the recent quick drop in rates/yields) but technically have “ticked higher”. 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 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.
There will continue to be pressure in commercial whole loan pricing/valuations, especially in office and some isolated pockets of multifamily loans (BXMT was a perfect example of this during Q3 2023; 3 new non-accrual office loans), during late 2023 - early 2025. 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 and FBRT should come out of this credit cycle the least harmed out of the 4 covered sub-sector peers. This should be followed by ACRE and then 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). There really hasn’t been any recent notable deviations to the long-term modeling at this point in time (hence no GPMT percentage recommendation range/risk rating changes).
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…”
There was a recent discussion in chat regarding RITM’s projected BV decrease during Q4 2023. Yes, it is going to be an underperforming quarter for RITM on the BV (which was confirmed this past week). That said, I DON'T see another quarterly 100 basis points (“bps”) move lower in mortgage interest rates/long-term U.S. Treasury yields occurring anytime soon (like we saw during Q4 2023). If anything, a slight-modest move higher to counter the very quick move lower in rates/yields. So, more of a "one-off" for Q4 2023 on the BV (which shouldn't be a surprise; have continued to highlight/point out).
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 spin-off because RITM has not provided such details but I will be on the continued lookout to do so.
RC’s quarterly dividend decreased from $0.36 to $0.30 per common share during Q4 2023 which was disappointing. Along with this dividend reduction, management stated the company was continuing to experience a short-term earnings “swoon”; mainly in relation to the BRMK merger. Management continues to believe longer-term earnings will rebound. However, management provided the same exact reasoning (only a short-term earnings "swoon") on not notably cutting the dividend prior to the Q4 2023 dividend declaration. As such, there seems to be a change in management’s tone/expectations which is a bit disheartening. In addition, even if/when RC “outearns” the company’s new $0.30 per common share dividend in the future, management implied there would not be a future dividend raise in lieu of protecting book value and preserving capital. In light of these changes in tone/sentiment, RC received a (5%) recommendation range downgrade during mid-December 2023 to account for the severity of the dividend cut and dimmer prospects of a raise down-the-road (earnings model also moved a bit lower). This decreased RC’s recommendation ranges by approximately ($0.75) per common share. This also resulted in a risk/performance rating downgrade from 3.5 to 4. RC still has a nice "cushion" on valuation but, yes, it narrowed some as a result of this downgrade (I always remain unbiased).
NYMT’s quarterly dividend decreased from $0.30 to $0.20 per common share during Q4 2023 which was also disappointing. I projected a dividend per share range of $0.25 - $0.30 per common share for Q4 2023. When calculated, NYMT has now reduced the company’s dividend per share rate by (50%) within only 3 quarters. Simply put, this is a negative catalyst/factor. NYMT has been an underperforming sub-sector peer for a while now which only solidifies prior downgrades to make this mREIT the most discounted sub-sector peer (and 2nd most discounted out of the 20 covered peers). This 2nd, notable dividend cut within just 3 quarters is making me a bit "antsy" regarding NYMT’s joint venture (“JV”) equity positions. NYMT is in the process of monetizing a good deal of these investments which likely is not turning out to be going well. These positions are low on the credit hierarchy (not 1st lien positions; subordinated). Even with NYMT’s recent shift into more agency RMBS recently, I would point out the company did not have existing interest rate payer swaps in place so net spreads remain an issue. As such, NYMT received a (2.5%) recommendation range downgrade during mid-December 2023 to account for the severity of the dividend cut. This decreased NYMT’s recommendation ranges by approximately ($0.30) per common share. This also resulted in a risk/performance rating downgrade from 4.5 to 5.
MITT’s projected BV experienced a modest weekly decrease during the week of 1/19/2024 to account for a “true-down” adjustment in direct relation to the WMC merger. Previously, management implied a relatively unchanged BV impact from the company’s WMC merger (which I previously took into consideration when setting my prior weekly BV projections). However, mainly due to a change in the accounting methodology of WMC’s debt (change in measurement of liabilities from amortized cost basis to fair market value [FMV]), this directly resulted in a reduction in net equity/BV. Coupled with additional merger-related expenses being incurred during the fourth quarter of 2023 (more than management previously anticipated), this resulted in the weekly MITT BV true-down adjustment. As such, my projected MITT BV as of 12/31/2023 will almost certainly be an underperformance when compared to actual results (just a “heads up” for subscribers). As is always the case, once I set a BV/core earnings projection for a specified point in time, I/we do not go back and alter said prior projection(s). I simply make adjustments in the current week/moving forward. This does not alter my/our MITT valuation thesis (still a STRONG BUY recommendation but a very high risk/speculative play) but this lowered the company’s per share price targets by approximately ($0.40) per common share in mid-January 2024. This BV adjustment did not have an impact to MITT’s preferred stock price targets.
I also wanted to quickly highlight a recent discussion that took place in 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:
“...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...”
“...Definitely eyeing RC at this point. It's on the radar but I'll be patient + layer in…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…”
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, AGNCP, CIM-D, RITM-B, RITM, SLRC, GPMT, RC.
Scott Kennedy is long: RITM, RC, SLRC, GBDC, GPMT, ARCC, RITM-D, MITT-B, MITT-C, GAINL, 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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