Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 02/04/2024
We aim to retain the same layout from week to week.
Weekly Notes From CWMF
Took the gains on our positions in PMT-B (PMT.PB) (PMT.PR.B). Returns ranged from 12.86% to 22.35%. The weighted-average return was 19.165% as the majority of our shares were purchased pretty close to the bottom. I still believe PMT-B is required to float, but share prices over $24.00 resulted in far less upside than when we entered the original positions.
Book values dipped a bit. Share prices dipped quite a bit further. Some negative sentiment. The nonfarm employment report was interesting. I’m working on some note covering that release.
Weekly Notes From Scott
Positions: No purchased positions. As noted (in chat on SA and an article on Substack) during the week, I sold approximately 50% of my existing RITM position at a weighted average sales price of $11.014 per common share. As RITM has moved from last year’s NOTABLY UNDERVALUED/STRONG BUY recommendation range, along with the company’s stock price moving notably above my personal weighted average cost basis of $8.251 per common share (on my existing whole position) and my very heavy allocation within this specific mREIT peer, I wanted to “lock in” some notable RITM gains (vast majority in non-taxable accounts) and increase capital for future deployment. I am extremely satisfied with the ultimate outcome on this portion of my sold RITM investment. Even after this partial sale, RITM is my largest mREIT holding. I am continuing to wait for stock price pullbacks/declines (and where applicable earnings reports) to deploy capital.
BDC Weekly Change: Spreads slightly widened. Most weekly NAVs slightly decreased.
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), 5 upgrades occurred. CSWC, PFLT, and TPVG moved from NOTABLY OVERVALUED/STRONG SELL to OVERVALUED/SELL. GAIN and TSLX moved from OVERVALUED/SELL to APPROPRIATELY VALUED/HOLD. This was mainly due to weekly stock price decreases “trumping” projected changes in weekly NAV fluctuations in most covered stocks.
Earnings season remains busy next week. GBDC reports after the market close on Monday. GAIN reports after the market close on Tuesday. ARCC reports pre-market open on Wednesday while PFLT reports after the market close. As a reminder, since GBDC already provided preliminary earnings results (and we provided an earnings chat note/assessment article), we will not be providing additional commentary on that BDC on Monday (other than alerting subscribers to a potential percentage recommendation range upgrade [as previously noted]). PSEC could be reporting next week but an official earnings date has yet to be provided. Out of the stocks listed above, GAIN will have an earnings chat note/assessment article provided Tuesday night. ARCC will have an earnings chat note/assessment article provided Wednesday night. PFLT (and possibly PSEC) will have an earnings chat note/assessment article provided Thursday or Friday night.
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: (3) Down (Large Investment*, Medium Investment**, Small Investment)
FSK: (1) Down (Small Joint Venture Investment; Restructured)
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 names still have value.
I will very likely continue to hold my existing ARCC, GBDC, and SLRC positions.
MREIT Weekly Change: All agency mREIT BVs slightly - modestly decreased during the week (variations peer-to-peer). This was mainly due to agency MBS spreads slightly - modestly widening versus underlying net (short) hedges (especially swaps). Most hybrid, originator + servicer, and commercial whole loan mREITs likely experienced a minor decrease to BV.
MREIT Other comments: Regarding weekly recommendation changes (mainly due to stock price and projected BV changes), 7 upgrades occurred. BXMT moved from UNDERVALUED/BUY to NOTABLY UNDERVALUED/STRONG BUY. CHMI, RITM, PMT, and ACRE moved from APPROPRIATELY VALUED/HOLD to UNDERVALUED/BUY. DX and IVR moved from OVERVALUED/SELL to APPROPRIATELY VALUED/HOLD.
This was mainly due to weekly stock price decreases “trumping” projected BV decreases.
Regarding weekly agency mREIT BV movements, most agency MBS coupons experienced minor price increases (including a majority of specified pools; mainly HARP and LLB loans). Most (short) derivative instrument valuations modestly decreased. Simply put, the vast majority of spread relationships I/we track (over 100 combinations) slightly - modestly widened. In particular, swaps underperformed MBS coupons this week.
DX, TWO, PMT, and ORC provided earnings results for the fourth quarter of 2023 this past week. I will simply refer subscribers to my recent earnings chat notes/articles regarding results for this mREIT peer (linked later in the article).
Earnings season remains busy next week. RITM reports pre-market open on Wednesday while NLY reports after the market close. Out of the stocks listed above, RITM will have an earnings chat note/assessment article provided Wednesday night. NLY will have an earnings chat note/assessment article provided Thursday or Friday night.
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 June. During 2024, I continue to believe 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 of 2023. Simply put, just have to be patient for this cycle to play out…”
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…”
On 11/17/2023, Sculptor Capital Management (“SCU”) common shareholders (Class A + B) overwhelmingly voted FOR the RITM merger proposal (by nearly a 10:1 ratio). This ends a long, drawn-out/drama-filled process. Subscribers can simply use the chat search feature within this service to see the many, detailed conversations during the second half of 2023 in relation to the RITM/SCU merger (most important, the impact to RITM’s future operations). 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. 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.
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. 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 well below this amount). The long-awaited AAIC merger vote was held on 12/12/2023. As correctly anticipated, the EFC/AAIC merger was approved.
RC’s quarterly dividend decreased from $0.36 to $0.30 per common share 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 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.
Regarding our final decision on which new mREIT common stock to cover (FBRT vs. SACH), FBRT was determined to be the clear winner when based on both valuation and risk/performance assessment. Additional details/reasoning were provided to subscribers in a chat note/theREITforum.com article in late December 2023. As such, full coverage of FBRT started on 1/1/2024 (AAIC merged with EFC; as noted above).
Our positions related to the sector:
CWMF is long: RITM-D, GPMT-A, DX-C, EFC-A, RITM-C, EFC-B, PMT-C, PMT-B, AGNCP, CIM-D, RITM-B, RITM, SLRC, GPMT, RC.
Scott Kennedy is long: RITM, RC, SLRC, GPMT, ARCC, GBDC, RITM-D, MITT-B, MITT-C, GAINL, ECCC.
Note: The paid version shows the sizing of each position (further down in the article).
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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