I've been asked by one of my followers to take a look at Resource Capital Corp. (RSO), which is a real estate investment trust. About 65% of the company's revenues come in the field of commercial real estate mortgages, which puts them roughly in the same category as some of the residential mortgage REITs that are the center of attention right now because of their high dividend yields. For this article, we will compare RSO to American Capital Mortgage (MTGE) which is engaged in mainly residential but also some commercial mortgages. MTGE is also relatively small compared to the giants in this business, American Capital Agency (AGNC) and Annaly Capital Management (NLY)
Here are some of the vital statistics, per Yahoo Finance:
|Current Price $/share||5.85||25.24|
|Forward Dividend Yield||13.70%||14.40%|
|Shares Outstanding (M)||88||36|
Here is a recent stock chart: Notwithstanding the bad day on September 6, the performance of the two has been about the same for the last month:
The main predictor of success in this industry is the spread, which is the difference between the mortgage coupon value and the net borrowing cost. This information is reported on the quarterly reports, the latest of which for RSO is here, and for MTGE is here.
|Average Asset Yield||4.63%||2.94%|
|Average Borrowing Cost||1.36%||0.82%|
The bulk of RSO's portfolio is commercial mortgages, which because they are not backed up by a government entity, are considered riskier. The higher coupon value above reflects the risk premium. RSO's borrowing costs are also higher, this is more of an artifact of that company's hedging program, which in the case of MTGE reduces net borrowing costs.
Leverage is the extent to which these companies inflate themselves by using borrowing and/or hedging instruments as they turn their stockholders' equity into a portfolio. The higher the leverage, the higher the risk, and it is pretty typical for the residential mortgage REITs to be higher (around 7 or maybe higher) because of the perceived lower risk of their portfolios. RSO's relatively lower leverage balances out its relatively riskier portfolio.
Hedging activities are an important factor in this business, and are typically detailed on the company's income statements.
|$ Millions||$ Millions|
|Net Income ($M)||25.3||30.3|
|Operating Expense ($M)||11.2||0.4|
|Net Operating Income ($M)||14.1||29.9|
|Realized Gain on AFS Securities ($M)||1.4|
|Net Realized and Unrealized Gain on Investment Securities Trading||1.4|
|Provision for Loan Losses ($M)||-4.3|
|Gain on Extinguishment of Debt ($M)||5.6|
|Other Expenses ($M)||-1.7|
|Net "Other Income" $M|
|Realized Gain on Agency Securities||17.1|
|Realized Loss on Periodic Settlement of Swaps||-3.8|
|Realized Loss on Derivatives||-17.4|
|Unrealized Gain on AFS Securities||65.5|
|Unrealized Loss on Agency Securities||-1.7|
|Unrealized Loss on Other Derivatives||-54.4|
|Net "Other Income" $M||2.4||5.3|
You might notice that even though MTGE is three times larger in terms of "enterprise value", above, the two companies have pretty similar revenues (the top line) which reflects the higher interest coupon for RSO.
How, you might ask, can MTGE get by with having essentially zero operating expense? The answer is that this quarter, it had "negative interest expense," which is "interest income" due to its financing activities. MTGE had about $6.5M of "negative interest expense" for the first six months of 2012 so the company was better at this in the second quarter than it was in the first.
The more conservative RSO actually has operating expense, as indicated above, and it mainly consists of management expense for its portfolio of actual commercial real estate that it owns and operates, management fees of various types, and a little depreciation. RSO's "interest expense" was actually about $9M and this number is included in the "net income" number above.
The hedging activity: I suppose you could make the statement that for MTGE this activity takes up a lot more of the management time and energy, relative to RSO. The two companies' revenues are within the same order of magnitude, but the realized gains and losses on security trading for MTGE were about three times the revenues, and netted out to only about $5M.
So, what are we to make of all of this?
Keeping in mind that the goal of all of this is to make money and reduce risk, you have to say on the surface that RSO is looking pretty attractive, provided you are not worried about the difference between agency-backed RMBS and the commercial sector, in which RSO is participating. RSO is in a higher-yielding marketplace, actually retains and manages some assets, and is within 1% of the dividend yield of the apparently much riskier MTGE, which is 90% invested in agency-backed mortgages, but does much more in the derivatives markets.
There is one more thing: On September 6th, RSO announced a secondary offering, and the market did not take it well, as indicated by the above chart. Here is the detail of the announcement:
|Total Shares Issued||8,500,000|
|Offering Price $/Share||5.9|
|Potential Portfolio Increase||185,555,000|
|Weighted Average Borrowing Rate||1.36%|
|Weighted Average Coupon||4.63%|
|Potential Income Increase $||6,067,649|
|Current Dividend/$ Share||0.2|
|Annualized Dividend/ $ Share||0.8|
|Dividend Payout at Current Rate||6,800,000|
The "back of the envelope" calculation above is this: By doing the secondary offering, the company will raise about $50M in the marketplace, and using the current leverage rate of 3.7:1, will turn that money into about $185M of portfolio. At the current average spread of 3.27% per year, RSO can expect to gain about $6M in income. At the current dividend rate, the money will cost RSO about $6.8M/year in extra dividends, so unless the management has a project in mind which can yield higher than the average portfolio, the company will be bigger, but not really make that much more money. Perhaps that is why the market did not take the news well.
Prediction: The next attempt at financing by RSO will be the issuance of some more preferred stock, at a lower rate. This strategy is now being used by many of these mortgage REITs for the above reason: These companies need to tap into lower cost funds.
So, with the usual caveat that the world is chaotic, and there are no guarantees on anything, I would have to say that RSO as an investment has a lot of merit. The dividend yield is high, it is in a high interest rate spread environment, and if you are not worried about the fact that the portfolio is not backed up by any government sponsored entity, the difference in yield between RSO and MTGE may very well not justify the additional risk of a bad quarter by MTGE's hedging program.
Do with this information what you will. Keep in mind that with this week's announcement by Mr. Bernanke, the current environment of low and shrinking interest rate spreads is likely to continue, all the more reason to think about being in a marketplace where spreads are higher.
Additional disclosure: I am still thinking about how or whether to exit IVR