Broadmark Realty: Excellent value for money; Expect a Dividend Cut (BRMK)
I initiate coverage on Broadmark Realty Trust (NYSE: BRMK) as it has been at an attractive valuation over the past few months, although it is not without risk.
BRMK exists since 2010 but is fairly new to the capital markets as it released its IPO in 2019. BRMK is an mREIT that I’m generally not a fan of as I think it takes incredible skills to manage interest rate risk to not not have material adverse changes in net asset value. BRMK is not an exception to this, but less exposed (this will be discussed later in this article). BRMK is considered a “hard money lender” to property developers in dire need of capital. The company is essentially a private equity lender versus a cash flow lender, as it focuses on collateral (what it can realize in the event of default) versus the corporate cash flow you see with a chartered bank. The size of the loans usually does not exceed $75 million and is short term as it does not exceed 18 months.
Because these loans are higher risk than traditional commercial real estate loans, interest rates are between 10-12% even before underwriting fees are factored in. As a result, BRMK’s weighted average overall return is often around 13%. Additionally, LTV on properties typically does not exceed 70% with Q2 2022 weighted average LTV at around 60%. The loans are also 100% secured senior.
BRMK is diversified across the United States with loans in 19 states, although the three largest states account for 56% of total loans outstanding, namely Washington, Texas and Colorado. Residential and multi-family dwellings represent 51% of the portfolio.
BRMK only produced $12 million in losses out of a total historical portfolio of $3.8 billion, or about 0.3%. In the second quarter of 2022, there were 37 loans in default, representing $248 million in total commitments. The weighted average LTV of these properties is 85%. Due to the stability of land prices, I do not expect to see significant losses on the principal of these loans. In fact, BRMK sold foreclosed property at $0.7 million above book value that was on its Sage Creek property.
We are all well aware of recent interest rate hikes by the Fed to fight inflation and will likely continue their hawkish attitude. This led to a dramatic reduction in the market capitalization of banks and mREITs. BRMK has the lowest leverage ratio of any mREIT at less than 10%, or $100 million of senior unsecured notes. Interest on the Notes accrues at a fixed rate of 5.0% per annum. In addition, the short-term funding model makes them less exposed to interest rate risk. As a result, BRMK is much less exposed to rising interest rates than its mREIT and bank counterparts.
Q2 2022 investor presentation slides make BRMK the biggest company since Apple (AAPL). The stock is not without risk, which is why it trades at a high dividend yield of 12% and a 10% discount to TBV, which is among the cheapest it has traded since its IPO.
Overall I would say they are a very capable management team who are good stewards of capital but for one major flaw that is their decisions when it comes to returning capital to shareholders through dividends. Don’t get me wrong, that’s why I invest, but like most investors, I get nervous when it’s just been recycled to me and it depletes the BV.
Distributable income is the preferred measure for assessing dividend coverage rather than basic net income, as it takes into account non-cash expenses such as stock-based compensation, provision for credit loss and impairment charges . Either way, BRMK failed to generate enough revenue on a quarterly basis to fully cover its $0.07/month dividend, with the payout ratio reaching its highest level of 131% in the second quarter. 2022.
My reflection on why management chose not to cut the dividend is threefold. The first, which is related to my second point, is that BRMK had a property management expense of $1.1 million in the second quarter of 2022, which was much higher than previous quarters. This expense resulted from the transfer of approximately $30 million of loans from mortgages to real estate owned (REO). Under GAAP accounting, once this occurs, R&M expenses can no longer be capitalized but must be expensed in the period. This expense was irregularly high and will be recovered when the property is sold and, in its absence, would add $0.01/share to quarterly revenue. This, however, would only bring the payout ratio down to 123%.
Second, due to stable real estate prices, BRMK likely expects to realize at least book value from REO properties as it did for its Sage Creek property. This assumption is probably reasonable and likely under the BV states, as these properties represent 7% of total assets. Third, the current liquidity of $171 million between cash, short-term investments and the line of credit could cover the payment of the dividend over more than a year. As a shareholder, I would prefer to see excess cash used to grow the loan portfolio and reap the benefits of the assets.
The question is not whether the dividend is cut but when. New loan originations have been down sharply since 2021 YE and in Q2 2022 barely covered portfolio runoff. This is the result of slowing US housing starts reaching their lowest point since July 2020, which looks like the start of the pain that rising interest rates will inflict on this market. It would seem that the only way to increase revenue is to increase rates or charge higher fees and there is some leeway to do that with contractual defaults at only 15% of the book total, but don’t forget that the highest level of the main has been moved. defaulted in the second quarter since the pandemic, so there is little room to paddle before the shore arrives. There is also no guarantee that they will be able to continue to realize the book value of these properties if the housing market begins to crack.
BRMK’s core markets have some of the highest growth rates in the United States, as all three being Washington, Texas and Colorado have experienced greater economic growth than the country as a whole in recent years, which should at least keep origination growth high enough to at least meet runoff. However, it would seem that the growth of the loan portfolio will slow down considerably in the coming quarters and therefore make the payment of the dividend unsustainable.
The Q2 2022 earnings report paints a pretty good picture of what to expect over the next few quarters in terms of earnings, with the loan book stagnating at $16 million. $0.17/share of quarterly earnings ($0.68/annualized) will be insufficient to cover $0.84/share of quarterly dividends and will continue to drain cash of $21 million per year. A monthly dividend cut of 24% would be needed to stop the decline in BV following the dividend. A drop to $0.05/share seems inevitable, but the payout rate would drop to around 88%. This would still generate an attractive yield of around 9% at the current price of $6.90/share, which is nothing to complain about and appears to be priced in at the current market price as the yield is typically between 7.5 and 9%.
Despite the likelihood of a dividend cut, I still think this stock represents huge value at a 10% discount to TBV, which is likely undervalued due to REO properties. It’s unclear how the market will accept the dividend cut, so writing put options may be the best bet for those worried about short-term volatility. The low leverage position and shrewd management should guide this vessel through economic turmoil, making it a good long-term investment. I expect double digit returns over the long term as the market finally forgives management for being overpaid in dividends as the company has mostly traded at a premium to TBV during its short life on the public market. Investors can still enjoy a hefty yield while waiting for capital appreciation, whatever that may be.