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I've written about Sachem Capital (NYSE:SACH) a number of times in the past but I had held off from establishing a sizable position until I saw significant progress in their earnings. I own shares in competitor Broadmark Realty Capital (BRMK) based on an attractive valuation at the time of purchase (~$9.15 in late November 2021), as the stock had sold off in the wake of the broader market's risk-off behavior surrounding the latest COVID resurgence.
Past year's performance of BRMK and SACH with strong divergence over the past few months. Sourced from portfoliovisualizer.com
However, going forwards into 2022 I believe that Sachem has a better chance to offer superior returns based on their multi-faceted approach to earnings per share growth. Below, I will briefly touch on the five most important reasons that Sachem should have an excellent year.
Background
Before I get started though, I want to quickly remind readers of the business model of Sachem Capital. The company makes hard-money loans primarily for construction and renovation (fix and flip) of residential and commercial properties. The company is primarily active in the Northeast but has also recently expanded their presence in Florida and Texas. For those that want a more in-depth look at operations, I encourage you to check out Brad Thomas' recent article here.
When I first researched Sachem Capital a few years ago, I assumed that the high degree of safety when it comes to principal protection in the case of default was just from the fact that their loans are senior (first to get paid) and secured (collateralized by the underlying property). What I failed to give them credit for was their ability to cross-collateralize with additional properties and/or rent payments from the debtor's other cash-flowing assets. Had I known this rarely discussed feature, I would have bought shares hand-over-fist when they dropped $2 a share in the wake of the COVID pandemic in 2020.
In addition to their ability to negotiate possible defaults with increased collateral from their debtors, the sheer amount of money being pumped into the economy in 2020 and 2021 has caused default rates for many loans to decrease drastically. According to Fitch Ratings, the institutional leveraged loan default rate was 0.6% in 2021, which was the lowest in a decade. Granted, the size of loans that Sachem is making are tiny in comparison and are not being lent to large institutions, but I think that it represents a good proxy, nonetheless. Many of the defaults on the sector's balance sheets are legacy loans from early 2020, not new defaults. With every settlement of these old loans, tied-up capital is returned to the companies to be reinvested.
5 Reasons that Sachem Will Thrive in 2022
1. Churchill Repurchase Agreement
Sachem obtained a new, superior method of financing in July 2021 with Churchill Real Estate. Up until recently, this had yet to be used in a meaningful way, but this will be a huge boon to the company going forwards. I actually like the agreement as a potential investor for two big reasons.
First and foremost, the rate is very low. Churchill will charge a 4.25% cost of capital but will lower the rate as more capital is drawn on the agreement. This could cause effective rates of around 3.5% as it is further utilized towards the $200 million limit.
Secondly, I trust management, but I do also like the concept that another large institutional lending and credit entity, Churchill Finance, is also confirming the credit quality of the loans they review within their agreements with Sachem. This is, in essence, another set of eyes on Sachem's lending package.
2. New Bond Issuance and Debt Refinance
Sachem recently issued $45 million of unsecured bonds about two weeks ago, plus a $6.75 million over-allotment for total proceeds of just under $50 million. The notes carried a coupon of 6.0% and are due 2026. This is the lowest rate that Sachem has ever been able to obtain through bonds or preferred shares, and while Broadmark was able to fetch 5.0% a month earlier, it still represents a great move by management.
Outside of the Wells Fargo margin line, here is what the debt situation looks like:
$23,663,000 x 7.125% = $1.686 million
$34,500,000 x 6.875% = $2.372 million
$56,363,750 x 7.75% = $4.368 million
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~$8.426 million per year interest
New notes of ~$50,000,000 at 6.0% is $3 million
This money could theoretically be used to eliminate most of the 2024 debt, resulting in the following (without taking into account any fees or penalties:
$7,500,000 x 6.875% = $0.516 million
$56,363,750 x 7.75% = $4.368 million
$50,000,000 x 6.0% = $3 million
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~$7.884 million per year interest after theoretical refinance
$542,000 of annual interest expense savings on approximately 29 million shares is 1.9 cents per share, or .5 cents per quarter. This would not take any special skill to do, would extend the company's debt maturity profile, and would create some extra wiggle room with the dividend payout ratio (last quarter's earnings and dividend were both 12 cents per share), assuaging some fears and possibly causing an increase in public investment.
Smaller, growing companies like SACH rarely choose to go this route, however, so I could also see them utilizing the proceeds to invest at ~12% and achieve a spread of roughly 6%. Back of the napkin math would suggest that this might generate around $300,000 per quarter in net income, or about $0.01 per share.
3. Pending SPAC Formation
Last July, SACH filed the paperwork to IPO a SPAC that they had just formed as a subsidiary. I expect that this offering will go through soon, since it has been quite a while. Sachem intends to retain shares of the company after the IPO, which could value the company at about $57.5 million assuming over-allotment. This is essentially a public fund raise for an investment vehicle which will turn a modest initial investment from SACH into a decently sized operating company. This has the ability to meaningfully contribute to SACH's consolidated financials for years to come. I am optimistic about this course of action despite Broadmark's liquidation of their private investment vehicle because of the relative size of each one. Upon liquidation, Broadmark's private REIT was $42 million in size compared to a market cap of about $1.35 billion of the parent. Sachem's SPAC stake could be worth more relative to their market cap at about $172 million. This has the ability to move the needle for the latter company only.
4. Despite Competitive Pressure, Portfolio Yield Remains High
One of the main concerns around the secured bridge loan investment space is the increase in competition. Broadmark and Sachem are just two of the companies making these loans. Over the last year or so, other companies that I am familiar with are making forays into the same or similar investments. New Residential (NRZ), one of my largest positions, just completed the acquisition of Genesis Capital, which provides development loans to residential real estate. iStar (STAR), has launched its own special version of development financing with Ground Lease Plus, which provides the bridge loan financing for a property from groundbreaking to stabilization. This then feeds into their normal ground lease loan portfolio.
While these aren't always directly competing with Sachem per se, there is enough competition for Broadmark to caution investors that their expected portfolio yield will continue to decline:
As of September 30th, our portfolio yield was 15% down from 16.6% a year ago. And over the coming quarters, we expect the portfolio yield to stabilize in a range of 11% to 12% - Jeff Pyatt, Broadmark CEO
However, Sachem has been able to keep their portfolio yield high and does still earn origination fees to help cushion any declines in base rate. They also have made a shift to larger principal loans, which will help offset lower rates with slightly higher margins on the expense side of things.
5. Duration Risk Is Very Low Due To Short-Term Loans
The same short-term positive effect of plentiful, cheap money on default rates can have negative long-term effects on fixed-rate loans if interest rates rise to combat inflation. However, duration risk is only really a problem for longer-duration investments (obviously) such as 10+ year bonds. The typical length of loans in this industry is about 12 months (Sachem's average is 11 months), which means that should interest rates rise, loan proceeds will be quickly reinvested at these higher rates. The vast majority of Sachem's financing is fixed-rate debt, which also protects the company's balance sheet from an increase in interest costs.
Summary
I am bullish on this investing space and the highly fragmented market associated with it. There's no reason that lenders such as SACH, BRMK, NRZ, etc. can't continue to be highly profitable. The biggest reason that these companies haven't been able to live up to their immense potential has to do with the COVID-related challenges in moving quickly on foreclosure proceedings and being able to redeploy capital in a timely manner. Going forwards this should be less of an issue, and the five aforementioned reasons listed in the article should result in Sachem Capital having a fantastic future ahead of it.
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