The mortgage real estate investment trust (mREIT) sector has gone through significant turbulence since the COVID-19 pandemic hit. My previous article on Arbor Realty Trust (ABR) talks about mREITs as a whole in the current inflationary environment with rising interest rates. REITs can be instruments of portfolio diversification leading to risk mitigation and return maximization, but mREITs might be vulnerable to the interest rates hikes because of possible book value decline and strained interest income spread.
Ready Capital Corporation (NYSE:RC) operates as an mREIT, and therefore the same general rules apply to it. The company stock crashed in Q1 2020 and has been on the rise ever since, outperforming the S&P 1500 mREITs total return, trailing ABR. However, the company's performance has been relatively volatile compared to ABR, inclining me towards preferring ABR over RC.
RC has higher floating-rate loans, vulnerable to increasing interest expenses as short-term rates go up. These rising interest rates are a major headwind for RC due to the likelihood of lower origination volumes because of curbed incentives for borrowers to refinance loans. As RC finances the purchase of high-yielding Mortgage-Backed Securities (MBS) through low-cost financing, its spread and profitability are expected to be strained in the upcoming period.
Despite being a good passive income stock, I rate RC as a hold because of its volatile earnings exacerbated by the rising interest rate headwinds and the availability of better mREIT stocks in the market.
Ready Capital is a multi-strategy mREIT that originates, acquires, finances, and services Small Balance Commercial (SBC) loans (loans with original principal amounts of between $500,000 and $40 million), Small Business Administration (SBA) loans, residential mortgage loans, and to a lesser extent, MBS collateralized primarily by SBC loans, or other real estate-related investments. Its loans are used by businesses to purchase real estate used in their operations or by investors seeking to acquire multi-family, office, retail, mixed-use, or warehouse properties. Its 3 operating segments are:
The company has gone through 6 M&A transactions since 2016, with Mosaic Real Estate Credit being their latest transaction closed in the previous month.
The most recent 31% earnings estimate beat with an EPS of $0.67 marked the third consecutive quarter of the company's substantial earnings growth. However, since the company invests in SBC loans, SBC asset-backed securities (ABS), and other real estate-related investments, it is highly sensitive to rising interest rates because they generally reduce the demand for mortgage loans in the wake of higher borrowing costs. With the recent 25 basis point interest rate rise in March and expected hikes well into 2023, the yield curve has inverted, likely resulting in short-term-oriented interest expenses outpacing the long-term-oriented interest income.
The company's fixed-rate assets are reported under the fair value rules, subject to an impairment charge if the assets are assessed to generate lower returns than other benchmark rates such as swap and treasury rates. Consequently, the impairment will negatively affect the income statement, diminishing earnings. Further, the company's adjustable-rate mortgages (ARM) are subject to periodic and lifetime interest rate caps, but the firm's loans are uncapped. If the short-term rates exceed the ARM cap, the increase in interest expense will outpace the increase in interest income, leading to strained earnings.
In contrast, the company employs certain hedging instruments to protect itself from these interest rate hikes, particularly interest rate swaps that effectively fix the interest expense for a period close to the anticipated average life of the fixed-rate portion of the related assets, safeguarding the company from rising interest rates up to a certain extent. However, these hedging strategies are not designed to shield RC from the net book value (NBV) impairment, which may still hinder the company's net income.
As RC strives to manage risk and liquidity in the short term because of the highly volatile market, the earnings growth is expected to be unimpressive, leading to an underwhelming annual consensus EPS estimate.
Even though the price return plays an integral part in any investment, investors predominantly add mREITs to their portfolios as an income stock and highly value the yield and sustainability of their dividends. We previously established that ABR is a good bet because of its consistent and reliable dividend growth. Still, despite having approximately similar payout ratios, ABR has historically lagged RC in its dividend yield and the absolute dividend payment amount.
The company recently announced a quarterly dividend of $0.42 per share, representing a $1.68 annualized dividend, a dividend yield of about 11%, and an annualized dividend payout ratio of around 75%. RC's yield is higher than the FTSE Nareit US Real Estate Index's 9.67%, and the company is sufficiently liquid, with almost $250 million in liquid assets to cover its dividend distributions.
Comparatively, both stocks offer a good long-term opportunity to diversify investment portfolios, with RC offering a higher yield but ABR offering greater consistency.
However, when it comes to growth, ABR completely outmatches RC through its 9 years of consecutive years of dividend growth with a 3-year CAGR of almost 11% and a 5-year CAGR of 17.28%, compared to RC's 3-year and 5-year CAGR of 2.28% and 1.62%, respectively.
Investors should also know that most REIT dividends are taxed as ordinary income up to the maximum rate of 37% (39.6% in 2026), plus a separate 3.8% surtax on investment income. Considering a general 20% deduction, the highest effective tax rate on Qualified REIT Dividends is typically 29.6%. In addition, the maximum 20% capital gains rate (plus the 3.8% surtax) generally applies to the sale of REIT stock. Non-U.S investors should look at the U.S. Withholding Tax Rates on Ordinary REIT Dividends.
In terms of price growth, the stock has a consensus target price of around $17, but the stock has historically always lagged its target price. So it would be more relevant for investors to focus on the distributions than price growth.
This article exclusively focused on the two major concerns that a potential investor might have about RC stock in the current market. Firstly, what's the expected performance of RC stock in the rising interest rate environment? Second, what's the dividend distribution situation of the company?
To summarize, rising interest rates threaten the company's earnings because a larger portion of the company's loans is composed of float rate loans. The dividend distribution is high and sustainable but lacks consistent growth, as one may find in other similar stocks.
In essence, Ready Capital Corporation is a good income stock. Still, I rate it as a hold because of the strong headwinds and underwhelming expected financial performance that may result in a share price decline down the road in 2022.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. Business relationship disclosure: This article was researched and written by Waleed Tariq, reviewed, and submitted by myself.