It's not uncommon for mortgage real estate investment trusts (REITs) to have double-digit yields. So, compared to its mREIT peers, Broadmark Realty Capital's (NYSE: BRMK) roughly 7% yield might seem less than compelling. Only there's a lot more to this story than just a dividend yield, especially when you compare Broadmark's business model to that of its peers.
Normal and not so normal
Unlike a typical property-owning real estate investment trust, mortgage REITs don't invest in physical assets. They buy mortgages and/or provide mortgage loans. So, an mREIT's portfolio is really a collection of IOUs. In and of itself that's not a terrible thing. In fact, some property-owning REITs dabble in mortgages, too. Broadmark, specifically, provides loans to builders.
The problem with mortgage REITs is that they often use leverage to enhance returns. When times are good, that can be a very positive thing. When times are bad, however, it can quickly become a mess. Broadmark has chosen a different path and doesn't use debt. This is a big difference and materially alters the risk investors face.
To understand why, you need to consider the normal mREIT model. Without any physical assets, the collateral backing the debt mortgage REITs take on is the collection of loans they own. Usually these loans are bought as collateralized mortgage obligations (CMOs), which are basically mortgage loans that have been grouped together and sold like a single bond. The prices of CMOs fluctuate.
When there's a market dislocation, like the one that happened in early 2020 during the early days of the global pandemic, CMO prices can fall dramatically. That, in turn, means that the assets backing an mREIT's own loans can decline to the point where its lenders may require more collateral. If the REIT can't come up with the required cash to satisfy the margin call, it could be forced to sell assets. This is often referred to as mark to market risk, and Broadmark, with no debt, never has to deal with the issue.
Take New Residential Investment Corporation (NYSE: NRZ) as an example of what this issue can lead to. Although a little more complex than most mREITs (it originates and services mortgages in addition to investing in CMOs), as COVID-19 started to spread, New Residential quickly sold assets to reduce its mark-to-market risk. Effectively, it was worried that it would get a margin call so it got rid of mortgage loans and the associated debt. This was no small change, as its mortgage portfolio went from $20 billion at the start of 2020 to roughly $3 billion at the end of the first quarter. That resulted in the REIT trimming its dividend from $0.50 per share per quarter to $0.05. This was all done so it could ensure that it wouldn't face a margin call. Given the uncertainty at that point in time, it was probably a prudent move, but for an investor who thought they owned a stable, dividend-paying stock, these changes would have likely been a bit shocking.
To be fair, Broadmark also cut its dividend as the pandemic hit, taking its monthly dividend from $0.08 per share to $0.06. However, the reason was very different. The collection of mortgages it owns is tied directly to construction projects. Because of the economic shutdowns used to slow the spread of COVID-19, social distancing requirements, and enhanced safety measures, many construction projects were delayed. Loans of this type, called hard money loans, tend to be very short term in nature, providing the cash needed to finish construction. Once the property is sold, the loan gets paid back. Although a bit of a simplification, construction delays basically resulted in delayed payments.
However, with no debt on the balance sheet, Broadmark could take the setbacks in stride. It quickly went to work with its borrowers to ensure that things got back on track as soon as possible. Interestingly, if a loan does become a problem, Broadmark can actually take over the project and complete the construction itself. So, because it makes loans directly, it can salvage some value even in a worst-case scenario.
A better model
The key takeaway here is that Broadmark is not a typical mortgage REIT. Its direct lending model, focus on construction, and avoidance of debt provide a huge amount of safety when times get difficult. If that sounds like a good thing, well, it is. Although the REIT's 7% dividend yield may not be as enticing as the 10%-plus that you can get from a typical mortgage REIT, when long-term dividend investors consider the differentiated business model, that step-down in yield looks like a very worthwhile risk/reward tradeoff.