Investors focused on dividend stocks for high yields will usually end up looking at mortgage real estate investment trusts (REITs) and business development companies (BDCs) because they offer extremely high yields.
Mortgage REIT dividends tend to go down over time — so the trick to succeeding in these sectors is not buying and holding indefinitely. There is nothing wrong with buying stocks as long-term investments, but it isn’t ideal for this type of equity. They’ll perform much better for investors willing to trade around the price-to-book ratios. In general, investors exploring mortgage REITs should aim to buy at lower price-to-book ratios and selling at high price-to-book ratios. Why is book value so important? One key reason is it represents the amount of equity available for the mortgage REIT to invest and leverage. Investors can’t control the change in book value, but the price-to-book ratio helps with understanding the risk/reward profile.
With BDCs, which invest in small- to medium-sized businesses, the price-to-net-asset-value (NAV) ratio can be similarly illuminating. BDCs take on some credit risk, but are generally much less sensitive to interest rates than mortgage REITs, which has been very favorable over the last few years as interest rates rallied. In this article, I will be covering two mortgage REITs and a BDC with yields over 10%.
MFA Financial (MFA)
MFA Financial (NYSE:MFA) has a portfolio of credit-sensitive loans. The loan values still have exposure to fluctuations in interest rates, but the primary exposure is credit. Investors have been concerned about real estate credit, which leads shares to trade at a discount to book value. As of March 31st, MFA had total leverage at 4.6x and recourse leverage of 1.8x. Those numbers are on the low end for mortgage REITs, which is appropriate given the credit exposure.
There are two factors impacting MFA’s current income statements.
First, MFA has assets (loans it owns) from prior years when interest rates were lower. Those loans have lower yields, which means less interest income for the REIT. As the loans mature, MFA will look to generate new loans at higher interest rates.
Second, MFA has interest rate swaps created in late 2021 and early 2022 at much lower interest rates. Those interest rate swaps are known as “hedges” and are designed to reduce the impact of interest rates rising. As the swaps mature, MFA will recognize a higher interest expense.
During Q1 2024, MFA completed another loan securitization. I like to see mortgage REITs with credit-sensitive assets using the “securitization” structure rather than relying on “repo” financing. This is because “repo” financing creates more risk with price fluctuations.
Chimera Investment (CIM)
Chimera Investment (NYSE:CIM) recently underwent a 1-for-3 reverse stock split. Reverse stock splits are generally a bad sign, coming after a series of disappointing results — but that’s more of a long-term issue. I am not listing CIM based on 10-year return projections. I’m including CIM here because of the huge discount-to-book value.
Before the reverse stock split, CIM reported book value at $7.11. Adjusted for the reverse split, that is $21.33. The discount-to-book value is now greater than 40%. For reference, that’s an unusually large discount; most mortgage REITs trade somewhere between 80% and 105% of book value.
Why are investors discounting these REITs so much?
They are concerned about the credit risk from lending on real estate. That’s reasonable. We’ve seen substantial declines in book value per share over the last few years. However, the current share price creates margin to deal with further declines in book value.
Another way to invest in double-digit yields from mortgage REITs is using preferred shares. These are far more stable than the common shares; the price fluctuates less and the common equity serves as a buffer for the preferred shareholder. They also have priority for dividends, so investors in the preferred shares are paid first.
Ares Capital (ARCC)
Ares Capital (NASDAQ:ARCC) is more appealing for investors who don’t want to be trading aggressively. This BDC has grown dividends significantly over the years. It’s harder to find a stock with a high yield and some dividend growth. BDCs have been a much better tool than mortgage REITs for handling higher interest rates. The economy held together through higher rates, so loans continued to perform. Meanwhile, the higher interest rates drove interest income higher. Since BDCs own loans with floating rates, they benefit from higher rates as long as those rates don’t cause a recession.
In Q1, ARCC reported an 11% yield on total investments at fair value and increased net asset value per share to $19.53 from $19.24 the prior quarter.
For reference, NAV per share was $17.21 for ARCC in Q1 2019. That is before the pandemic. As you may know, the pandemic was pretty rough for leveraged credit-sensitive investments. Despite that, ARCC recovered from tiny losses to net asset value during the pandemic and was able to resume growing the value.
Shares trade a bit above net asset value because the BDC was able to grow net asset value over many years.
On the date of publication, Michael VanLoon held a LONG position in MFAN, one of the baby bonds issued by MFA. The opinions expressed in this article are those of the writer, not subject to the InvestorPlace.com Publishing Guidelines.
On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.