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Investment thesis
Franklin BSP Real Estate Trust (New York stock market :FBRT) is a name that popped up on my radar as potentially undervalued. At 7.7x forward earnings and 0.81x book value, the stock looked cheap relative to what it was worth. Investors may be concerned that the company holds a lot of real estate debt, but I think that fear is already largely priced in. Furthermore, I believe management has managed this risk well by carefully positioning its portfolio with floating interest rates and focusing primarily on multi-unit properties, not offices. In conclusion, I rate FBRT stock as a buy due to its strong liquidity and high dividend yield at a cheap price.
Company presentation
FBRT is an mREIT that “creates, acquires and manages a diversified portfolio of commercial real estate debt secured by properties located in the United States” according to their websiteUnlike other mREITs, Franklin BSP focuses on lending money specifically to commercial real estate, creating a “diversified portfolio of senior floating rate loans.”
According to the recent 10-Q, “commercial mortgage loans held for investment, net of allowances for credit losses, as of March 31, 2024 and December 31, 2023, had a total carrying value of $5,184.2 million and $4,989.8 million, respectively.” The average carrying value per loan, by my calculations, is $35.75 million, dividing $5.185 billion by 145 total loans. Investors can see that the portfolio is well diversified and saw a slight increase of 3.9% from last quarter.
The portfolio is comprised of primarily floating rate loans, with 96.5% of the loans reported as floating rate as of March 31, 2024. With a weighted average coupon of 9.2%, investors can see that floating rate loans have been a nice benefit when rates have risen. Finally, most of the loans have a short maturity of one year, so interest rate fluctuations don’t really impact the value of the loan due to the shorter term.
I am very surprised that management has positioned its portfolio strategically, with high coupons, low duration and mostly floating rate loans. The market seems to underestimate the strength of the portfolio as it appears very resilient to interest rate changes, offers high yield and management has great flexibility to redeploy capital due to strong liquidity in my opinion.
Liquidity and debt levels are very healthy, with presentation stating “$1.0 billion in liquidity including $240 million in cash” and “a net debt to equity ratio of 2.4x”. I believe management is prepared to redeploy capital and accumulate this dry powder to purchase distressed loans from the commercial real estate sector. This should enhance shareholder value and I expect earnings to continue to be able to cover the dividend. Ultimately, this is one of the strongest commercial mREITs in the market in my opinion due to the company’s strong liquidity, healthy leverage and low-duration loan portfolio.
Profits are increasing steadily
The company announced earnings for the first quarter of 2024 with the following results,
- Delivered first quarter GAAP ROE and distributable earnings ROE (a non-GAAP financial measure) of 8.9% and 10.4%, respectively
- Book value of $15.68 per diluted common share on a fully converted basis
- First quarter cash dividend on common shares declared of $0.355, representing an annualized yield of 9.1% on book value per share, fully converted
Earnings continue to grow steadily as their multi-unit portfolio continues to perform very well. I believe this earnings report demonstrates the strength of their loan portfolio and that they can perform well under inflationary pressures and higher rates. Additionally, the dividend is still well covered as earnings transcription revealed that “our dividend coverage of distributable profit for the quarter was 115%.”
The company appears to be in an offensive position with an aggressive liquidity position that allows it to provide a significant number of loans to grow. In their earnings call, they explain:
We have been actively originating loans and have committed $756 million in loans year-to-date, fueling net growth in our portfolio.
I believe this net portfolio growth will continue as long as liquidity and debt levels remain high. Book value could therefore begin to increase, to $16 per share and above, as financing activities continue. Management can also increase book value per share through repurchases, as it “repurchased 151,123 shares of common stock at a net average price of $12.42 per share for a total of $1.9 million,” according to the quarterly press release.
With an aggressive liquidity position, share buybacks and 115% dividend coverage of distributable earnings, investors have something to like here. The market has yet to fully price in these positive developments in my view and the price-to-book gap should close over time. This quarter’s earnings reinforce the bullish case for Franklin BSP as they highlight the strength of the loan portfolio, earnings growth and a potentially accretive book value going forward.
Focus on multi-family housing protects investors
Companies that focus on lending against multifamily properties are, in my opinion, well insulated from inflation and the challenges of the commercial real estate sector. People have to live somewhere, and as buying a home has become increasingly unaffordable, many people are turning to renting space in multifamily properties to live in.
According to National Association of Home Builders“NAHB has updated its housing affordability chart for 2024, and the latest data shows that 66.6 million households, or 49% of a total of 134.9 million, cannot afford a $250,000 home.”
In my view, this means that multi-unit properties are more attractive to Franklin BSP investors as more people are forced to settle for renting apartments and living in condominiums in the current real estate market. As a result, multi-unit property loan performance should remain strong as growing demand pushes up rental prices, giving borrowers greater ability to repay their debts to Franklin BSP.
Furthermore, I see the increased distress and carnage in the commercial real estate sector as an opportunity for Franklin BSP as they have plenty of cash ready to deploy and many of their loans are coming due. Many borrowers who took out loans to purchase office buildings are suffering The situation is bad today, and I suspect that many of these distressed mortgages will soon be sold on the secondary market at rock-bottom prices.
I think Franklin BSP can buy a lot of these loans at very low prices, which could really add shareholder value, if done correctly. So investors can see that challenges can turn into opportunities and Franklin BSP has the balance sheet, the liquidity and the management team to make the most of this real estate debt crisis, in my opinion.
Appraisal – Fair value at $15
The stock should trade at book value in my view, given the strength and performance of the loan portfolio. Book value per share was around $15 for the quarter, which is why I am setting my price target there. I believe book value is a good indication of the true value of the business, as the loans are performing, high yielding, and low duration, which makes them attractive to me in the current market environment.
At 7x forward earnings, it trades at a discount to the industry median of 10x forward earnings, which tells me the stock is misvalued. I believe the strength of the loan portfolio and quality of management should merit at least an industry median multiple, so if we apply a 10x multiple to $1.50 per share, that also reaffirms my $15 price target. I think $1.50 EPS should be sustainable from here on out as the company has demonstrated an aggressive stance in originating loans and growing its portfolio.
The dividend needs to be protected as earnings more than cover the payout. With a forward dividend yield of 11%, income investors may find their payout attractive. Going forward, I believe their dividend coverage by distributable earnings will continue to be above 100%, given the excellent performance track record of their loan portfolio.
Risks
Coverage of past dividends does not guarantee coverage of future dividends. If management decides to increase liquidity, it may decide to reduce the dividend and redeploy capital in the market to purchase/create attractive loans for the portfolio. Furthermore, a decline in rates could hurt Franklin BSP as its loans are floating rate and the interest it receives may decline accordingly. However, it should be noted that this risk is relatively low as most of its loans are short term.
If inflation and the job market really weaken, it is possible that the performance of the multifamily real estate sector could deteriorate. Rents could become unaffordable for the average person and this could hurt the performance of Franklin BSP’s multifamily loans. In addition, some of their office loans could default as the entire sector continues to post low occupancy rates.
Improving housing affordability could reverse the upward trend in multifamily housing as people move out of apartments and into houses. In addition, government regulations that try to make rents more affordable could negatively impact loan performance, as rent caps and other measures limit the amount of cash flow borrowers can earn to repay their debts.
Buy Franklin BSP Realty
While fear and uncertainty weigh on the commercial real estate sector, I view Franklin BSP Realty as one of the few commercial mREITs well-positioned to take advantage of this challenging situation. It has distinguished itself by its resilience to interest rate volatility, its protection from commercial real estate headwinds due to its focus on multi-unit properties, and its high, well-hedged dividend yield. Therefore, I recommend that investors looking for high dividend yield stocks consider buying Franklin BSP Realty.
