Co-authored by Treading Softly
I’ve always sounded curious when people focus on the value of something versus the price. In many regards, value can be something that you can clearly calculate. For example, a CEF (Closed-End Fund) can have a market price, which is what it’s trading at, and the NAV (Net Asset Value), which is the value of all its assets minus all its liabilities. When it’s an equity CEF that owns common stock and preferred securities, one can very easily tally up its NAV is to determine its value versus what you’re paying for it.
The distinction gets more complicated when you start looking into other sectors. How do you determine the value of holdings within a REIT (Real Estate Investment Trust)? How do you determine the value of holdings within a BDC (Business Development Company)?
When we start looking at the value of these other holdings, we have to evaluate their risk. A higher risk level will force you to discount the value of the holdings against their face value. You then have to evaluate if you think that the risk you’ve assigned is appropriate, and that becomes a question of intrinsic value. When we value something intrinsically, we’re applying our own mindset, emotions, and perspectives to it. What may be a simple, boring catcher’s mitt to someone may be of massive value to you because it may be your grandfather’s, and it represents all of the memories and nostalgia of you playing catch with him. It can be a dangerous thing to attach intrinsic value incorrectly to securities in the stock market. I always like to remind people that when you own an investment, you should have been married to it. Yes, you can have a long-standing relationship with it. Yes, you can own it for the long haul. But you must always be willing to part ways if the risk becomes too much.
Today, I want to examine one mortgage real estate investment trust (mREIT) that is trading at a massive +40% discount to its book value. The market thinks that this specific company’s risk is so high that it should trade for half the value of its holdings. I think they’re wrong.
Let’s dive in!
Huge Discount to Book Value Reveals Undiscovered Value
BrightSpire Capital, Inc. (NYSE:BRSP), yielding 14%, is a mortgage REIT that focuses on commercial mortgages. Commercial mortgages have been all over the news; I’m sure you read the headlines. Commercial loans are often at floating rates, and higher-for-longer interest rates have created stress on some borrowers. Some borrowers are choosing to walk away from properties, or they are literally unable to afford the higher interest payments. The result is that commercial real estate has seen an increase in defaults.
BRSP saw its adjusted distributable earnings decline in Q1. While still covering the dividend, coverage is much tighter. Additionally, book value has trended down primarily as a result of CECL (Current Expected Credit Loss) reserves, which are now $1.10/share. Source
BRSP Q1 2024 Supplement
Distributable earnings are going to decline even more in Q2. We know this because management told us they would. When asked about the size of the portfolio, CEO Mike Mazzei said:
We’re going to drive this down before we drive it up. And that’s really going to — we’re going to have some payoffs, but it’s really around the resolution of the watch list assets and some of the remaining REO there. We’ve been chopping wood on that watch list for quite a long time. We’re actually tired of talking about it as well, but we are going to make headway. We think there are some assets on the watch list that are going to stick around. We see two assets there, multifamily assets that look like we can upgrade them. But we’re waiting another quarter to make sure that those business plans are really on track before we do so.
What Mazzei is talking about is the amount of loans that BRSP is holding on its balance sheet. When you are in the business of lending, the fewer loans you have, the less money you are making. In Q4, the loan portfolio shrunk by $107 million. The bulk of that was from repayments:
BRSP Q1 2024 Supplement
At the end of 2022, BRSP’s portfolio was over $3.5 billion, and on its way to $2.8 billion, $148 million was credit losses written off as BRSP took possession of properties. BRSP still owns the real estate, and might or might not be able to mitigate a portion of those losses. In 2023, $453 million in loans was repaid as agreed. Those repayments, and BRSP choosing not to reinvest immediately, are the primary reasons that the loan portfolio has shrunk and the primary reason that distributable earnings are lower. Analysts who are focused on potential credit losses and blame credit losses for the decline in portfolio earnings are missing the forest for the trees.
Now, it is true that BRSP has a dozen properties in its portfolio on its watchlist. The main reason that BRSP has not been reinvesting is because BRSP wants to have a conservative and flexible balance sheet so that it can resolve the properties on the watch list for the best possible recovery. BRSP lends money, but it also borrows. By being conservative with a debt-to-equity ratio of only 1.8x, BRSP ensures that its decisions on managing a defaulted property are not dictated by BRSP’s lenders. Management can foreclose on a property, restructure a loan, or sell a loan based solely on their judgment of what recovers the most capital, as opposed to having to access cash quickly.
The market is apparently punishing BRSP for its conservative approach. BRSP is now trading at a 55% discount to book value, and that book value already includes a total of $1.10 in general CECL reserves.
Here is a breakdown of BRSP’s book value:
BRSP Q1 2024 Supplement
Note that $5.06 of book value comes from items other than commercial mortgages. CECL is enough to cover approximately a 16% loss on BRSP’s loan portfolio. That’s a lot. We doubt that realized losses will be that high, however, BRSP could realize losses of over 85% on its loan portfolio and its book value would still be $6.00/share.
The valuation of BRSP simply doesn’t make sense. Perhaps BRSP is still dealing with the ghosts of the past, when it was Colony Credit which had significant mezzanine and equity assets that ended up becoming nearly worthless during COVID: Source
Colony Credit Q3 2019 Supplement
How much has BRSP allocated to these categories today? $0.68/share. Mezzanine and preferred positions are higher risk than senior loans during good times. When Mazzei and company took over in April 2020, these assets were really ugly.
Some seem to conflate the losses realized with those higher-risk assets through COVID, with likely loss rates for senior mortgages today. It is a bit like comparing apples and orangutans.
BRSP is arguably the most conservatively managed mREIT in the commercial mortgage space, with one of the most experienced management teams in the industry. We won’t suggest it should trade at NAV considering the real headwinds in the sector, but we do believe that BRSP should be trading at a smaller discount than peers. At a 40%+ discount to NAV, BRSP is a fantastic opportunity.
Conclusion
One could correctly argue that BRSP is a fantastically run company in a terrible market situation. This would be like the best swimmer in the group is being forced to swim through a hurricane. Many would bet against you in those circumstances. But if you were truly a great swimmer, you could survive, potentially. I don’t see the situation surrounding BRSP being as tragic or as fraught as swimmers in a hurricane, but that is how the investor community is treating this sector today.
BRSP is run exceptionally conservatively. Its prices are extremely discounted compared to its book value. When all factors are considered from a fundamental viewpoint of how the company is performing, the scale tips towards reward versus risk. The dividend is covered. The yield is high. Management is exceptionally conservative, and market sentiment is due to shift as we look to a lower-rate environment in the future.
When it comes to your retirement, you shouldn’t have to constantly game your portfolio based on what everyone else thinks. You should be able to pick your positions, collect great income, and let everyone else have their opinions for themselves. I love when a security is misunderstood by the market for the long run, giving me more time to accumulate that position and receive great income from it – BRSP is a perfect example of this. That’s the beauty of my Income Method. That’s the beauty of income investing.
