Bet Your Retirement Income On The USA

Co-produced with Treading Softly.

It’s been said that the United States has been the single greatest incubator of wealth in the history of mankind. The United States’ economic output and growth have been exceptional in a global and historical context.

A key driver of this has been what is tied up in the American Dream – the belief that any individual can better their situation and circumstances through diligence and hard work.

While the government has slowly taken more of a role and influence in the overall market and economy, a hallmark of the United States has been the belief and support of an open market where anyone can participate.

Greed is a powerful motivator and force. The desire to better one’s situation is a powerful driving force, and when an economic structure is designed to help support and flourish this driving force, the economy will benefit.

So when it comes to my retirement, I don’t bet against the United States – I bet on it. The stock market has become an increasingly accessible option for those with capital to invest in the US economy. This is where I choose to invest the bulk of my net worth.

Often investors think of the mega-cap companies that dominate the investment news cycle, like Tesla, Inc. (TSLA), Microsoft Corporation (MSFT), or even Starbucks Corporation (SBUX). Yet the bulk of the economy is supported by much smaller companies.

I like to invest in companies and funds that actively enable economic activity by supporting the middle market of the economy. This section of the economy is the largest but most disregarded area in the market. I do this by being a lender to a wide array of companies and individuals, and in return, I get interest and dividends paid back to me.

Let’s look at two ways you can do that with me.

Pick #1: BRSP – Yield 11.1%

BrightSpire Capital, Inc. (BRSP) is a commercial mortgage real estate investment trust (“REIT”) which invests primarily in floating-rate senior mortgages. With the Federal Reserve hiking rates more frequently than a college student orders pizza, an investor might think that would be a great tailwind for BRSP’s earnings.

That thought would be right, and here is a look at BRSP’s interest rate sensitivity:

Note that since September 30th, 1-month LIBOR is up to 4.4%, so for the purposes of this table, rates are up roughly 1.2%. So interest rate movements alone should be contributing a $0.08-$0.09 positive tailwind to BRSP’s annual earnings.

Despite that tailwind, BRSP has seen its share price decline. BRSP is currently trading at nearly a 50% discount to book value. It is trading at its lowest price since 2020, when it wasn’t paying a dividend at all.

In our opinion, this valuation is completely unjustified. However, there are some legitimate headwinds that some investors might be worried about. Let’s look at what might be concerning investors:

Loan originations are slowing down: In Q3, BRSP originated only $91 million. This is a sharp decline from $896 million in the first half. Management suggested origination will remain low in Q4 and maybe even the first half of 2023. This is a headwind to earnings because, as loans repay, the size of the loan portfolio will decline. A smaller loan portfolio means less interest is collected. All things being equal, this is a headwind to earnings.

Management was upfront with the risks they see in the Fed going too far and causing a recession. As a result, BRSP is taking a more conservative approach than some peers. They’re choosing to build up liquidity, instead of making loans in what might turn out an unfavorable environment. In the earnings call, CEO Mike Mazzei said:

Finally, that will undoubtedly be great lending opportunities that will arise from this market dislocation. But to be clear, over these past few quarters and in the very immediate future, all things equal, our bias is that liquidity will generally take precedent over new loan originations and stock buybacks.

Offsetting the decline in originations is a decline in repayments. In the earnings call, BRSP also noted an increase in loan modifications and extensions increasing the duration of the loans in their portfolio. BRSP collects additional fees for making these modifications, and also will collect more interest for longer.

The price of all debt is declining: Commercial mREITs measure the value of their loans by par value minus CECL (current expected credit loss). These loans are not publicly traded, and therefore are not “marked to market” like the debt held by bond funds or other types of mREITs like agency mREITs. This can make a material difference in book value.

Consider Annaly Capital Management, Inc. (NLY). It has $67.3 billion in par value of agency MBS that is reflected in book value at its fair value of $62.7 billion because these assets are mark-to-market and there is a public market where they are currently trading at a discount to par.

If these assets were carried at par value minus CECL – which is $0 since these MBS have no credit risk – that would increase NLY’s book value by $4.59 billion. NLY’s book value would have reported $10.67/share higher in Q3 if agency MBS was accounted for using the same method that commercial mREITs use for their mortgages.

So, when we discuss the premium/discount to book value for commercial mREITs, we should keep in mind that the book value only reflects credit risk as calculated by CECL. It does not reflect the market changes in the price of debt in general, which in 2022 has been significant. U.S. Treasuries, agency MBS, leverage loans, and bonds of all stripes have seen prices decline in 2022. So, it makes sense that these loans are trading at lower prices when investors are buying the companies because the market for mREIT shares is the only open market where these mortgages trade.

When we look at some of the largest, most established mREITs in the commercial sector like Blackstone Mortgage Trust (BXMT) or Starwood Property Trust (STWD), they are trading at 15-20% discounts to book value. So that is the amount we would chalk up as a reasonable discount due to the changes in loan valuations.

Default concerns: Last quarter, BRSP did recognize an impairment on two loans of $57 million ($0.44/share). Only one of the loans defaulted, but both are to the same borrower and BRSP thought it prudent to assume both would default. The amount written off reflects the difference between the size of the loans and an appraisal of the liquidation value of the property. With a significant write-off last quarter, some investors might be concerned about the credit quality of BRSP’s portfolio.

We aren’t. Why? These loans originated in 2019, long before the current management took over. They were also rated “4” (underperforming) on BRSP’s rating scale since 2020, so the risk of these particular loans was known and telegraphed by management. Credit defaults happen, that is a reality of investing. Currently, all of BRSP’s holdings that are rated 4 originated prior to 2020 under prior management. BRSP has managed to roll over most of its portfolio with a modest impact on its book value. The loans originated over the past two years reflect the much more conservative approach of current management compared to the prior regime. The remaining legacy holdings might justify some discount to book value, but the current valuation is excessive.

Valuation: As noted above, we do see some reasons why BRSP should be trading at a discount to book value. Slowing originations will be a headwind to earnings, though it should be offset by the benefit of rising rates. BRSP’s dividend is very conservative at $0.20/quarter compared to $0.25/share in distributable earnings. This coverage ensures the dividend should be secure even if the headwinds outweigh the tailwinds.

The price of debt is declining, and this likely should contribute to a 15-20% discount simply due to the macro-environment where other debt investment options are available for lower prices.

Finally, the write-offs last quarter served as a reminder to investors that defaults happen. Some of the weaker legacy loans in BRSP’s portfolio could experience a similar fate.

So BRSP should trade at a discount to book value, but how much? Here is a look at how BRSP’s book value is currently calculated.

$2.31 is cash and net assets, and $2.36 is its net lease properties and associated depreciation (which implies a 7% cap rate on the $64 million annualized NOI). That is $4.67/share in NAV before you even talk about the loan portfolio. If we assume that BRSP’s loans should trade at about a 20% discount, that would imply the loan portfolio is worth approximately $5.64/share in today’s environment. This implies that BRSP’s “fair value” should be approximately $10.31.

Today’s share price allows for a huge margin of safety for defaults. Additionally, BRSP’s current dividend is among the best covered in the sector, with 125% coverage last quarter. It appears that the market is still pricing in the “Colony” penalty, penalizing the share price for the sins of prior management. However, management has changed, and the style is very different. Where Colony reached for yield and loaded up the portfolio with mezzanine and shaky construction loans, BRSP’s management has been relentlessly focused on high-quality senior mortgages.

When the market environment turned unfavorable, BRSP didn’t keep accelerating. It took the conservative route, backing off and building up liquidity – ensuring that it has a strong and liquid financial position to deal with any headwinds.

BRSP is a very different company from its predecessor. Management is much more conservative and the portfolio is much higher quality. The market hasn’t realized it yet, and we are happy to collect our 11% yield while we wait.

Pick #2: ECC – Yield 15.8%

Eagle Point Credit Company Inc. (ECC) is a closed-end fund (“CEF”) that invests in the specialized sector of CLOs or Collateralized Loan Obligations. Specifically, ECC has most of its investment in the “equity” tranche.

CLOs invest in Senior Secured Loans. These are the most senior loans in a company’s capital structure and have a secured first lien interest. This puts the CLO at the very top of the capital structure of the borrowers.

What seems to confuse many is that the CLO has its own capital structure. The CLO itself borrows money, using the loans as collateral. These borrowings are called “debt tranches,” and the CLO agrees to pay out the proceeds to the debt tranches in priority order. It looks something like this. Source.

Note there are two distinct capital structures. On the left, you have the borrower that typically has senior secured loans, maybe some unsecured bonds or subordinated debt, and equity (preferred and common).

On the right, you have the CLO. The CLO invests in the highest level of the capital structure of the corporation but has its own capital structure which consists of multiple tranches from AAA to BB. Just like any other company, the CLO is required to pay all the debt it owes before the equity investors collect their profits. ECC primarily buys the equity tranches of CLOs.

These are equity positions in a portfolio of senior secured loans. Kind of like when you invest in a business development company’s (“BDC’s”) common stock, the BDC has a portfolio of loans that your equity is buying, but the BDC itself has debt that has to be repaid.

These equity positions are not publicly traded. As a result, they are illiquid investments that are best held until maturity. CLOs have a predetermined lifespan, typically 7-10 years. After raising capital, a CLO will have a “reinvestment period” where any principal repayments from the borrowers are reinvested into new loans. Then at the end of the CLO’s life, the CLO will have an “amortization period” where all principal repayments/prepayments are used to pay down the debt in order of seniority and once all the debt is repaid, the equity investors get the balance.

Note that during the reinvestment period, the CLO is being paid back with par dollars. If a company decides to refinance or deleverage by paying off a loan, the CLO receives par and then reinvests in loans at the current market price. So when loans are trading below par, it is very advantageous for CLOs that are in their reinvestment period.

These are the kinds of CLOs that ECC has been focused on. ECC has intentionally increased the average remaining CLO reinvestment period in its portfolio to 3.2 years. Source.

Additionally, the underlying loans that the CLOs hold have very few maturities in the next two years.

This is a benefit because defaults tend to be most frequent when loans mature. With the economy likely to weaken in 2023, ECC has very little exposure to companies that will be forced to refinance when there are dual headwinds of high-interest rates and a weakening economy. If there is a recession in 2023, it’s best not to hold a lot of loans that are maturing mid-recession.

It is this kind of proactiveness from ECC’s management that gives us the confidence to continue holding and collecting the massive +15% yield.

Conclusion

With BRSP and ECC, we can not only be actively engaged in the United States economy, but we can also be key players in helping it be strong and healthy.

A recession is coming, as a recession is always coming. It is a question of “when,” not “if.” This doesn’t mean you should pull out of the market or economy and wait for better times to come. It’s a time when the level-headed can remain invested and unlock massive rewards. ECC and BRSP have positioned themselves to benefit from the current interest rate environment and created portfolios structured to weather any recessionary storms to come.

I love the United States of America. No country is perfect. No country has ever been without error or fault. Likewise, no person is perfect or without fault. Nevertheless, I am betting my retirement on the ability of the United States economy to continue to produce wealth for its people and allow those who strive to better themselves to achieve those goals.

It’s never easy to achieve success, but it remains possible. I like to think that I can help enable that for others, all while receiving excellent income for myself.

That’s the beauty of the Income Method. That’s the beauty of income investing.