Ready Capital Stock: Headwinds from rising interest rates (NYSE: RC)

The wooden block chosen by hand written with REIT means Real Estate Investment Trust

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Investment Thesis

The mortgage investment sector (mREIT) has gone through significant turmoil since the COVID-19 pandemic hit. My previous article on the Arbor Realty Trust (ABR) talked about mREITs as a set in the current inflationary environment with rising interest rates. REITs can be portfolio diversification tools that lead to mitigation of risk and maximize returns, but mREITs can be vulnerable to interest rate hikes due to the potential reduction in book value and the sharp difference in interest income.

Ready Capital Corporation (NYSE: RC) operates as mREIT, and therefore the same general rules apply. The company’s share collapsed in the first quarter of 2020 and has since risen, surpassing the overall performance of the S&P 1500 mREIT, after the ABR. However, the company’s performance was relatively volatile compared to ABR, which made me prefer ABR over RC.

RC vs. peers in total odds
Data from YCharts

RC has higher floating rate loans, vulnerable to rising interest costs as short-term interest rates rise. These rising interest rates are a significant headwind for RC due to the possibility of lower volume due to limited incentives for borrowers to refinance loans. As RC finances the purchase of High Yield Mortgage (MBS) securities through low cost financing, its spread and profitability are expected to worsen over the next period.

Although it is a good share of passive income, I rate RC as a commitment due to its volatile gains exacerbated by rising winds of rising interest rates and the availability of better mREIT stocks in the market.

Company overview

Ready Capital is a multi-strategy mREIT that creates, acquires, finances and provides Small Balance Commercial (SBC) loans (initial capital loans between $ 500,000 and $ 40 million), Small Business Administration (SBA) loans, home mortgages, and to a lesser extent, the MBS provided as collateral mainly by SBC loans or other real estate related investments. Its loans are used by companies to buy real estate used in their activities or by investors seeking to acquire real estate of multiple families, offices, retail, mixed use or warehouse. Its 3 functional areas are:

  • SBC Lending and Acquisitions: This is the largest part of the company that creates and serves loans for many families under the Small Balance Loan (SBL) Program of the Federal Home Loan Mortgage Corporation (Freddie Mac) and also acquires SBC loans to maximize value. The Acquisition of Red Stone related to this section. As of March 2022, SBC’s loans had an Unpaid Capital (UPB) of $ 6.76 billion and a book value of $ 6.71 billion (approximately $ 2.5 billion in December 2020). These loans, which are essentially all serviced loans, accounted for approximately 65% ​​of UPB and the carrying amount of RC’s total loan portfolio (approximately 55% in December 2020).

Ready Capital Corporation SBC Acquisition and origin Historical development

Presentation of Ready Capital Corporation for investors

  • Small Business LendingAcquires, creates and serves self-financing loans guaranteed by the SBA under Section 7 (A) Program (the SBA’s main program for financing start-ups and existing small businesses). RC is one of only 14 non-bank lending companies (SBLCs) licensed by the SBA and has been given the status of preferred lender by the SBA. These outstanding loans are either held for investment, placed in securitization structures or sold. The Acquisition of Knight Capital concerned this section. As of December 2021, the SBA loans acquired by RC, excluding Paycheck Protection Scheme (PPP) loans, had a UPB of $ 657 million and a book value of $ 635.1 million.

Ready Capital Corporation SBA Loans Originations Historical Growth

Presentation of Ready Capital Corporation for investors

  • Housing housing bank: Comes from mortgages eligible for purchase, guarantee or insurance from the Federal Mortgage Association (Fannie Mae), Freddie Mac, the Federal Housing Administration (FHA), the USDA (USDA) and the Department of Veterans Affairs (VA) through retail channels, correspondents and brokers. These outgoing loans are then sold to third parties, mainly agency agencies. This section works through GMFS mortgageis licensed in 18 states to provide home mortgage services, including home equity financing, home mortgage refinancing, reverse mortgages, new construction loans, and condo financing.

Distribution of equity Ready Capital Corporation and Split contribution of core profits

Presentation of Ready Capital Corporation for investors

The company has made 6 mergers and acquisitions since 2016, with Mosaic Real Estate Credit being last transaction closed last month.

Difficult winds from rising interest rates

The most recent 31% profit estimate, which surpassed EPS $ 0.67, marked the third consecutive quarter of a significant increase in the company’s profits. However, as the company invests in SBC loans, securities backed by SBC assets (ABS) and other real estate-related investments, it is particularly sensitive to rising interest rates because they generally reduce demand for mortgages in the wake of higher court debt. expenses. With interest rates rising 25 basis points in March and expected increases in 2023, the yield curve has reversed, with short-term interest rate costs likely to outperform long-term interest income.

The Company’s fixed interest rate assets are presented in accordance with the fair value rules and are subject to impairment if the assets are expected to generate lower returns than other benchmark interest rates, such as exchange rates and cash rates. As a result, impairment will negatively affect the income statement, reducing profits. In addition, the company’s ARM mortgages are subject to periodic and lifetime interest rates, but the company’s loans do not have a cap. If short-term interest rates exceed the ARM ceiling, the increase in interest expenses will outweigh the increase in interest income, leading to strained returns.

Instead, the company uses a number of hedging instruments to hedge against these interest rate hikes, particularly interest rate swaps that effectively set interest costs for a period close to the expected average life of the fixed asset portion of the relevant assets, securing the company from raising interest rates to a certain extent. However, these hedging strategies are not designed to protect the RC from impairment of net book value (NBV), which may continue to impede the company’s net income.

As RC tries to manage risk and liquidity in the short term due to the highly volatile market, the increase in profits is not expected to be impressive, leading to an overwhelming annual consensus EPS.

EPS forecast for Ready Capital Corporation

NASDAQ.com

Investor Returns

Although price performance plays an integral part of any investment, investors primarily add mREITs to their portfolios as a source of income and highly value the return and viability of their dividends. We have previously found that ABR is a good bet due to the steady and reliable increase in its dividends. However, despite having roughly similar payment ratios, ABR has historically lagged behind RC in terms of its dividend return and absolute dividend payment amount.

RC vs arbor realty trust: dividend yield
Data from YCharts

The company recently announced a quarterly dividend of $ 0.42 per share, representing an annual dividend of $ 1.68, a dividend yield of about 11% and an annual dividend payout ratio of approximately 75%. RC’s performance is higher than that of the FTSE Nareit US Real Estate Index 9.67%and the company is sufficiently liquid, with nearly $ 250 million in cash assets to cover its dividend distributions.

By comparison, both stocks offer a good long-term opportunity to diversify their investment portfolios, with RC offering higher returns but ABR offering greater consistency.

Real estate trust Ready Capital vs Arbor:% dividend change
Data from YCharts

However, in terms of growth, ABR completely outperforms RC during the 9 years of consecutive years of dividend increase with 3-year CAGR almost 11% and 5-year CAGR 17.28%, compared to RC 3 and 5 years CAGR 2.28% and 1.62%, respectively.

Investors need to know, too that most REIT dividends are taxed as regular income up to a maximum rate of 37% (39.6% in 2026), plus a separate additional tax of 3.8% on investment income. Taking into account a general discount of 20%, the highest real tax rate for REIT Certified Dividends is usually 29.6%. In addition, the maximum capital gain of 20% (plus the surplus of 3.8%) generally applies to the sale of REIT shares. Investors outside the US should consider Retained US tax rates on ordinary REIT dividends.

In terms of price increases, the stock has a consensus target price of around $ 17, but the stock has historically always lagged behind its target price. Therefore, it would be more important for investors to focus on distributions than on raising prices.

Line graph with ready capital

Looking for Alpha

conclusion

This article focuses solely on the two major concerns that a potential investor may have about RC stock in the current market. First, what is the expected return on the RC stock in the context of rising interest rates? Second, what is the status of the company’s dividend distribution?

In summary, rising interest rates threaten the company’s profits because most of the company’s loans consist of floating rate loans. Dividend distribution is high and sustainable, but lacks steady growth, as can be found in other similar stocks.

In essence, Ready Capital Corporation is a good source of income. Nevertheless, I rate it as holding back due to strong headwinds and the sluggish expected economic return that could lead to a drop in the share price on the road in 2022.

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