Bargain Alert: 14% Yield and Big Discount: BrightSpire Capital (NYSE:BRSP)

Co-author of Treading Softly

I have always been curious when people focus on the value of something versus the price. In many ways, value can be something that can be clearly calculated. For example, a CEF (closed-end fund) may have a market price that is the price it’s trading at and the NAV (Net Asset Value), which is the value of all assets minus all liabilities. If it’s an equity CEF that has common stock and preferred stock, you can easily add the NAV together to determine its value compared to what you’re paying for it.

The distinction becomes more complicated when you look at other sectors. How do you determine the value of holdings in a REIT (Real Estate Investment Trust)? How do you determine the value of holdings in a BDC (Business Development Company)?

When we look at the value of these other holdings, we need to evaluate their risk. A higher level of risk forces you to discount the value of the holdings from their face value. You then have to assess whether you think the risk you’ve assigned is appropriate, and that becomes a question of intrinsic value. When we value something intrinsically, we apply our own mindset, emotions, and perspectives to it. What may be a simple, boring baseball glove to someone may be of tremendous value to you because it belongs to your grandfather and represents all the memories and nostalgia of playing catch with him. It can be dangerous to assign false intrinsic value to securities in the stock market. I always like to remind people that if you own an investment, you should be married to it. Yes, you can have a long-term relationship with it. Yes, you can own it for the long haul. But you must always be willing to walk away from it if the risk becomes too great.

Today I want to examine a mortgage real estate investment trust (mREIT) that is trading at a massive discount of over 40% to its book value. The market believes that the risk of this particular company is so high that it should trade for half the value of its holdings. I think they are 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’ve read the headlines. Commercial loans are often variable rate loans, and the longer-term higher interest rates have created pressure for some borrowers. Some borrowers are choosing to abandon their properties, or they literally can’t afford the higher interest payments. The result is that there has been a rise in delinquencies in commercial real estate.

BRSP reported a decline in adjusted distributable earnings in the first quarter. The dividend is still covered, but the coverage is significantly lower. In addition, book value has declined primarily due to the current expected credit loss (CECL) provision, which is now at $1.10/share. source

Distributable earnings will decline even more in the second quarter. We know this because management has told us so. When asked about the size of the portfolio, CEO Mike Mazzei said:

We’re going to drive that down before we drive it up. And that’s really going to — we’re going to take some gains, but it’s really about the unwinding of the watchlist assets and some of the remaining REOs there. We’ve been chopping wood on that watchlist for quite a long time. We’re actually tired of talking about it too, but we’re going to make progress. We think there are some assets on the watchlist that are going to stay. We see two assets there, multifamily assets, that look like we can upgrade them. But we’re going to wait another quarter to make sure those business plans are really on track before we do that.

Mazzei is referring to the amount of loans BRSP has on its balance sheet. When you’re in the lending business, the fewer loans you have, the less money you make. In the fourth quarter, the loan portfolio shrank by $107 million. The majority of that came from repayments:

At the end of 2022, BRSP’s portfolio was over $3.5 billion, and on the way to $2.8 billion, it wrote off $148 million in loan losses as BRSP took possession of properties. BRSP still owns the properties and may or may not be able to mitigate some of these losses. In 2023, $453 million in loans were repaid as agreed. These repayments and BRSP’s decision not to immediately reinvest are the main reasons for the contraction of the loan portfolio and the primary reason for the lower distributable earnings. Analysts who focus on potential loan losses and blame loan losses for the decline in portfolio returns are missing the forest for the trees.

Now, it is true that BRSP has a dozen properties in its watch-listed portfolio. The main reason BRSP has not reinvested is because BRSP wants to have a conservative and flexible balance sheet so it can wind down the watch-listed properties for the best possible payback. BRSP lends money, but it also borrows money. By being conservative and having a leverage ratio of just 1.8x, BRSP ensures that its decisions about how to manage a defaulting property are not dictated by BRSP’s lenders. Management can foreclose on a property, restructure a loan, or sell a loan based solely on its judgment of what will return the most capital, rather than needing to quickly access cash.

The market appears to be punishing BRSP for its conservative approach. BRSP is currently trading at a 55% discount to book value, and that book value already includes a total of $1.10 in CECL general reserves.

Here is a breakdown of BRSP’s book value:

Note that $5.06 of the book value comes from items other than commercial mortgages. CECL is enough to cover about 16% loss on BRSP’s loan portfolio. That’s a lot. We doubt realized losses will be that high, but BRSP could realize losses of over 85% of its loan portfolio and its book value would still be $6.00/share.

BRSP’s valuation just doesn’t make sense. Perhaps BRSP is still grappling with the ghosts of the past when it was Colony Credit that had significant mezzanine and equity investments that became nearly worthless during COVID: source

How much does BRSP have allocated to these categories today? $0.68/share. Mezzanine and preferred positions are riskier than senior debt in good times. When Mazzei and company took over in April 2020, these assets were really ugly.

Some seem to be confusing COVID-related losses on these riskier assets with the likely loss rates on senior mortgages today. It’s a bit like comparing apples and orangutans.

BRSP is arguably the most conservatively managed mREIT in the commercial mortgage lending space and has one of the most experienced management teams in the industry. Given the true headwinds in the sector, we do not recommend trading it at NAV, but we believe BRSP should trade at a smaller discount than peers. At over a 40% discount to NAV, BRSP is a fantastic opportunity.

Diploma

One could rightly argue that BRSP is a fantastically managed company in a terrible market situation. That would be like the best swimmer in the group being forced to swim through a hurricane. Many would bet against you under those circumstances. But if you were truly a good swimmer, you could potentially survive. I don’t see the situation surrounding BRSP as being as tragic or as fraught as swimmers in a hurricane, but that’s how the investment community is treating this sector today.

BRSP is managed exceptionally conservatively. Prices are extremely low compared to book value. When all factors are considered from a fundamental perspective, how the company is performing, the balance tips towards reward versus risk. The dividend is covered. The yield is high. Management is exceptionally conservative and market sentiment will change as we expect a lower interest rate environment in the future.

When it comes to your retirement, you shouldn’t have to constantly manipulate your portfolio based on what everyone else thinks. You should be able to pick your positions, earn a good income, and let everyone else have their own opinion. I love it when a security is misunderstood by the market over the long term, which gives me more time to build that position and earn a good income from it. – BRSP is a perfect example of that. That’s the beauty of my income method. That’s the beauty of income investing.