Lending Capital Stock: Headwinds from Rising Interest Rates (NYSE:RC)
The mortgage real estate investment trust (mREIT) industry has been through significant turbulence since the COVID-19 pandemic. My previous article on Arbor Realty Trust (ABR) talks about mREITs as all 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 could be vulnerable to increases in interest rates due to a possible decline in book value and tense distribution of interest income.
Loan Capital Corporation (NYSE: RC) operates like an mREIT and therefore the same general rules apply. The company’s stock crashed in the first quarter of 2020 and has been rising steadily since, outperforming the total return of the S&P 1500 mREIT, lagging the ABR. However, the company’s performance has been relatively volatile compared to ABR, which makes me prefer ABR to RC.
RC has higher variable rate loans that are vulnerable to increasing interest charges as short-term rates rise. This rise in interest rates is a major headwind for RC due to the likelihood of lower origination volumes due to reduced incentives for borrowers to refinance loans. As RC funds the purchase of high-yield mortgage-backed securities (MBS) through low-cost financing, its spread and profitability are expected to be strained in the period ahead.
While a good passive income stock, I consider RC a reserve due to its volatile earnings exacerbated by rising interest rates and the availability of better mREIT stocks in the market.
Ready Capital is a multi-strategy MREIT that originates, acquires, finances and manages Small Balance Commercial (SBC) loans (loans with an initial principal between $500,000 and $40 million), Small Business Administration (SBA) loans ), residential mortgages, and to a lesser extent, MBS secured primarily by SBC loans or other property-related investments. Its loans are used by companies to purchase real estate used in their operations or by investors seeking to acquire multi-family properties, offices, retail, mixed-use or warehouses. Its 3 operating segments are:
- SBC loans and acquisitions: This is the largest segment of the company that originates and services multi-family loans under the Federal Home Loan Mortgage Corporation (Freddie Mac) Small Balance Loan (SBL) program and also acquires SBC loans for the maximization of value. The acquisition of Red Stone is related to this segment. As of March 2022, SBC loans issued by the company had an outstanding principal balance (UPB) of $6.76 billion and a book value of $6.71 billion (approximately $2.5 billion as of December 2020) . These loans, almost all of which are performing loans, represented approximately 65% of UPB and the book value of RC’s total loan portfolio (approximately 55% as of December 2020).
- Small business loans: It acquires, originates and manages homeowner loans guaranteed by the SBA under its Section 7(A) program (the SBA’s main program for financing start-ups and existing small businesses). RC is one of 14 non-bank Small Business Lending Companies (SBLCs) to hold an SBA license and has been granted SBA Preferred Lender status. These originated loans are either held for investment purposes, placed in securitization structures, or sold. The acquisition of Knight Capital concerned this segment. As of December 2021, SBA loans acquired and issued by RC, excluding Paycheck Protection Program (PPP) loans, had a UPB of $657 million and a book value of $635.1 million .
- Residential Mortgage Banking: It issues residential mortgages that can be purchased, guaranteed or insured by the Federal National Mortgage Association (Fannie Mae), Freddie Mac, the Federal Housing Administration (FHA), the US Department of Agriculture (USDA) and the US Department of Veterans Affairs (VA) through retail channels, correspondents and brokers. These issued loans are then sold to third parties, primarily agency loan programs. This segment is operated through GMFS Mortgage, licensed in 18 states to provide residential mortgage services, including home purchase financing, mortgage refinancing, reverse mortgages, new construction loans and condominium financing.
The company has completed 6 M&A deals since 2016, with Mosaic Real Estate Credit being their last deal completed the previous month.
The headwinds of rising interest rates
The most recent earnings estimate of 31%, beaten with EPS of $0.67, marked the company’s third consecutive quarter of substantial earnings growth. However, since the company invests in SBC loans, SBC asset-backed securities (ABS) and other real estate-related investments, it is very sensitive to rising interest rates as they generally reduce demand for mortgages following an increase in borrowing. costs. With the recent 25 basis point hike in interest rates in March and expected hikes through 2023, the yield curve has inverted, likely resulting in short-term interest expense exceeding income long-term interest.
The Company’s fixed rate assets are presented under fair value rules, subject to an impairment charge if the assets are valued to generate returns below other benchmark rates such as swap rates and cash. Therefore, the impairment will negatively affect the income statement, decreasing profits. In addition, the Company’s variable rate mortgages (ARMs) are subject to periodic and lifetime interest rate caps, but the Company’s loans are not capped. If short-term rates exceed the ARM cap, the increase in interest expense will outpace the increase in interest income, leading to tight earnings.
On the other hand, the company uses certain hedging instruments to protect itself from these increases in interest rates, in particular interest rate swaps which effectively fix the interest expense over a period close to the expected average life of the the fixed-rate part of the assets concerned, protecting the company against rising interest rates up to a certain point. However, these hedging strategies are not designed to protect RC from net book value (NBV) depreciation, which can further hurt the company’s bottom line.
As RC struggles to manage short-term risk and liquidity due to high market volatility, earnings growth is expected to be unimpressive, resulting in a disappointing full-year EPS consensus estimate.
Even though price return is an integral part of any investment, investors primarily add mREITs to their portfolios as income stocks and highly value the yield and sustainability of their dividends. We previously established that ABR is a good bet due to its consistent and reliable dividend growth. Yet despite roughly similar payout ratios, ABR has consistently lagged RC in terms of dividend yield and absolute amount of dividend payout.
The company recently announced a quarterly dividend of $0.42 per share, representing an annualized dividend of $1.68, a dividend yield of approximately 11% and an annualized dividend payout ratio of approximately 75% . RC’s yield is higher than the 9.67% of the US FTSE Nareit real estate index, and the company is sufficiently liquid, with nearly $250 million in liquid assets to cover its dividend distributions.
Comparatively, the two stocks offer a good long-term opportunity to diversify investment portfolios, with RC offering higher yield but ABR offering greater consistency.
However, when it comes to growth, ABR completely outperforms RC in its 9 consecutive years of dividend growth with a 3-year CAGR of nearly 11% and a 5-year CAGR of 17.28%, compared to 3 years and 5 years RC. CAGR per year of 2.28% and 1.62%, respectively.
Investors should also be aware 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. After taking into account a 20% general deduction, the highest effective tax rate on qualifying REIT dividends is generally 29.6%. In addition, the maximum appreciation rate of 20% (plus 3.8% surcharge) generally applies to the sale of REIT shares. Non-US investors should consult US withholding tax rates on REIT ordinary dividends.
In terms of price growth, the stock has a consensus target price of around $17, but the stock has consistently lagged its target price. It would therefore be more relevant for investors to focus on distributions than on price growth.
This article has exclusively focused on the two main concerns a potential investor might have about RC stocks in today’s market. First, what is the expected performance of RC stock in a rising interest rate environment? Second, what is the company’s dividend distribution situation?
In summary, rising interest rates threaten company earnings because a greater portion of the company’s loans are made up of floating rate loans. The dividend payout is high and sustainable but lacks consistent growth as can be found in other similar stocks.
Essentially, Ready Capital Corporation is a good income stock. Still, I view it as a hold due to strong headwinds and disappointing expected financial performance that could drive the stock price down in 2022.