Resource Capital Corporation (NYSE:RSO) offers an exceptionally low yield for mortgage REITs, but my projected future dividend rates suggest a very high yield. As far as mREITs go, RSO trades at the largest discount to tangible book value investors will find. The sector started coming back into favor with investors and valuations moving significantly higher since the early part of 2016. So why does RSO trade at such a low price-to-book value? The answer comes in a few parts.
RSO slashed their dividend rate from a completely unsustainable $.42 down to $.05. This was a necessary change I warned investors about over the summer. I said I didn't believe in RSO's dividend, and then reinforced that view with more math on the unsustainable dividend yield. The new management team seemed to agree and chopped the dividend to avoid bleeding out book value, while they went to work on repairing the REIT.
I believe the optimal amount of leverage for an mREIT running a CRE portfolio is somewhere in the 2.7x to 4.0x range. Blackstone Mortgage Trust (NYSE:BXMT) runs leverage in this range. Check out my math comparing leverage for RSO and BXMT.
By my math, a CRE mREIT like RSO should be planning on creating a sustainable yield of about 9% on book value (8.5% to 10% is a fair range). I put together a longer article on finding the expected dividend rate for RSO. To get there, I had to find out how much book value should be left when the company transitions into a better structure.
I began with the total equity from the end for Q3 and began making adjustments to include paying off bonds at par value (they were trading at a discount to par) and buying back preferred shares at par value (they also trade at a material discount).
Trailing book value is $14.71 per common share, but if we make those adjustments and drop $11 million to $14 million for asset impairments (based on management's guidance from Q3 earnings call), we reach a range of $13.29 to $13.39 per share.
Using those values and the normal yields and cost of funds from other mortgage REITs, I was able to project out estimated annual interest income available to common shareholders. I started with gross interest income around $82.7 million, interest expenses at $30.3 million, and operating expenses based on lower equity and only having the CRE segment at $13.5 million. That left almost $39 million to be split by the common shareholders.
Since my math involved deducting the full call value on the preferred shares from equity, the scenario suggests that RSO reduces their total portfolio. By my projections, that turns into around $1.19 per share annually in income for the common shareholders and sets the stage for the dividend rate.
Based on my expectation that 8.5% to 10% is the reasonable range for income on book value, I would like to see Resource Capital Corporation buying back their preferred equity. From the perspective of the common shareholder, this reduces the cost of both preferred dividends and management fees levied on the "equity." This could be a real challenge for management because who wants to buy the external manager so they can reduce revenue?
Without the preferred shares being retired, the expectation would be for a larger company with higher total numbers in every category. I don't see bigger as being automatically better. Don't get me wrong, economies of scale favor having a larger company, but I still would love to see some opportunistic buys on the preferred shares.
The argument for buying back preferred shares, from the perspective of a common shareholder, is very strong. Even if RSO can earn 10% on total equity after all operating expenses (that would be the optimistic end of the scale), the cost of preferred equity yielding around 9% would be pushing up the expected return to common shareholders, but at a very unattractive level of risk. Imagine if $200 million in common equity was matched by $200 million in preferred equity yielding 9%. The common shareholders' expected return could move up from 10% to 11%, but their volatility in book value would be doubled since they would need to hold twice the asset portfolio to maintain the same leverage of total equity. From the view of the common shareholder, leverage would be doubled through a very high cost structure. Would you want to double the risk for an expected 1% extra return? I don't like that risk/reward profile.
Lessons From BXMT Valuation
BXMT trades at an exceptionally high price to book value ratio. They also have no preferred shares available. I don't think this is a coincidence. I think investors view the increase in risk relative to the increase in expected returns in a negative light. Closing out the preferred shares materially reduces risk to the common shareholders, and I don't think we see BXMT stuck in this trading range from $8 to $9 unless shareholders are very concerned about the risk.
I wouldn't expect RSO to trade at the same price to book value ratio as BXMT. Theoretically, if they made all these changes and came out to $13.29 in common book value, the price would need to be around $14.62 (BXMT can trade around 110% of trailing BV). That price assumes no growth in book value from any earnings.
Normally, you wouldn't expect a REIT to have any retained earnings, but remember that this scenario is already taking significant charges against equity. It is unreasonably bearish to assume that the REIT pays almost no dividends ($.05 per common share), takes the impairments, and simply throws away any net interest income accumulated during the period.
One of the biggest challenges facing valuation of RSO is the impact of excessive leverage from the viewpoint of the common shareholder. The REITs investing in CRE assets with a lower cost structure have achieved excellent valuations on their common stock, but it would be too optimistic to expect that same valuation level for RSO. However, the gains necessary to achieve the same valuation level are also vastly beyond what I'm projecting.
I see a more reasonable valuation range in the $9.50 to $11.00 range with expectations that we hit that range by summer 2017. If RSO follows this strategy of retiring their more expensive sources of funding and coming out with a dividend around $.30 per quarter, I would expect share prices to continue moving towards book value. If shares moved to trade within 1% to 2% of book value, I would expect RSO to look to issue equity rapidly to improve leveraged on fixed costs for shareholders and to increase management fees. That puts an effective cap on share prices around $13.00 to $13.60 based on my strategy.
Disclosure: I am/we are long RSO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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