When you dig down into a stock, there's always some important nuance that needs to be understood before buying it. That's particularly true when it comes to Broadmark Realty Capital (NYSE: BRMK), a relatively young mortgage real estate investment trust (REIT), known as an mREIT. Here's why this company's 17% dividend hike is different from the hikes taking shape at its mREIT peers.
The normal mREIT model
The typical mREIT, like Annaly Capital Management (NYSE: NLY), owns a portfolio of mortgages. Usually, these are bought and sold in pools, known as collateralized mortgage obligations (CMOs). Most mREITs use these assets as collateral for loans so they can go out and buy more CMOs. These REITs make the spread between their interest costs and the rates on the mortgages they own.
That said, leverage enhances returns in good times but can cause problems when the value of the CMOs backing an mREIT's loans fall. When this happens, leveraged mortgage REITs can receive margin calls. This doesn't happen often, but when it does, mortgage REITs can be forced to sell assets at exactly the worst time, putting additional pressure on the business. There were material concerns about margin calls in early 2020 as the coronavirus pandemic started to spread.
Mortgage REITs cut their dividends to get ahead of any problems and ensure they had the liquidity they needed to muddle through a period of market dislocation. Broadmark cut its dividend, too -- but not for the reasons noted here, because it isn't your typical mortgage REIT.
Broadmark is a hard money lender. As mREITs start to up their dividend again now that margin call fears have passed, it's increasingly important to understand this difference.
The Broadmark difference
Hard money lenders provide short-term mortgage loans to builders, which use the money to fund construction. The loans are repaid after the property is built and/or sold. Unlike typical 30-year mortgages, where market rates dominate, hard money loans are a bit more risky, so the yields Broadmark charges tend to be pretty high (think 10% or so) and they don't move around as much because the pool of lenders is smaller.
Broadmark deals with the riskier nature of a construction loan by only loaning around 60% of the completed value of a project, giving it ample leeway for bad developments before it has to worry about taking a hit.
The other key piece of the puzzle for Broadmark is that it doesn't use leverage. It isn't looking to play the spread; it's looking to grow its business over time by expanding the size of its loan portfolio. The goal is a reliable, stable (maybe even growing) dividend.
The problem is that it went public at a particularly bad time: just before a global pandemic. Although the housing market didn't really skip a beat, construction projects were delayed by COVID-19 shutdowns. Thus, payments on Broadmark's loans were disrupted and delayed. That's why it cut its dividend -- there was never a concern about a margin call.
By the third quarter, Broadmark's business was getting back to normal. And, perhaps hinting that the business has notably improved, the company recently increased its dividend by 17%. This should be a sustainable dividend over time, no matter what happens to interest rates.
Note that the company earned $0.18 per share in the third quarter and paid out $0.18 in dividends. The new rate for the monthly pay dividend is $0.21 per quarter, so it's highly likely that fourth-quarter earnings will be pretty good, even if it's the outlook for 2021 that's most notable.
Which brings up the really exciting thing here. Broadmark ended the third quarter with around $170 million of cash on its balance sheet. That's money it hoped to put toward new loans to grow its portfolio and increase its ability to pay dividends. This is a growth story, not a yield spread story, which makes Broadmark a very different mortgage REIT.
The dividend increase is a sign it's on the verge of showing just how important that difference is. Investors should pay keen attention to that cash balance when the mREIT reports fourth-quarter results. If it runs out of cash (which would be a very good thing, since it means the loan portfolio is growing) it can sell shares to replenish its coffers to support even more portfolio growth.
The safer alternative
Mortgage REITs are known for offering high yields. Broadmark's forward dividend yield is a juicy 7.9% or so. But that's actually kind of low for the mortgage REIT space, where 10% yields are pretty common. When you look at the differentiated business model, however, you can see why Broadmark's yield is lower and much less risky, since it doesn't rely on leverage to juice its returns.
Dividend investors looking to maximize the income they generate should probably avoid most mortgage REITs, but don't toss this baby out with the bathwater -- Broadmark does things differently, and the dividend hike here is a sign that portfolio growth is on the way.