I’m Doubling Down On These Fabulous Dividends

Co-produced with “Hidden Opportunities.”

Market commentators love speculating which direction markets are heading and when they will likely turn. They are as right as much as they are wrong; do you want to bet your retirement at these odds? The media loves interviewing expert speculators, but they’re not much use to investors with a long-term focus.

From time to time, investors get lucky, but any experienced investor will tell you that it’s challenging to time the market – so you’re usually better off not trying to bet on which direction the market will go next week.

Instead, it is best to look at the long-term fundamentals and macroeconomic trends surrounding the companies in your portfolio. Your decision-making based on these assessments will position you well for the best return in the medium to long term.

We get asked this question often – how do you keep buying all the time? Don’t you run out of money?

This is the best part about being an income investor – my next paycheck is right around the corner. I know exactly when and how much money I’ll be getting, so I don’t have to nervously execute a sell order hoping that I am getting a good price. I just have to wait for my next dividend, and I can reinvest a portion of it.

Want to diversify your sources of income and reduce your dependency on your job? We have the tools to get you started. This article discusses two picks with up to 16% yields that will set you up for financial freedom.

Pick #1: ACRE – Yield 16.2%

We’ve been getting a lot of questions about Commercial Real Estate (or CRE) and our exposure to it. Consider a few quotes pulled from this news story:

Wow, scary right? Better sell everything that is CRE right away!

If you haven’t already, take a peek at the date. Yep, that story sounds like it could have been written last week. It was actually written on March 19th, 2010.

Did office space blow up? Did small to mid-sized banks collapse because of CRE? No. Buying every commercial mREIT (mortgage real estate investment trust) and bank you could find in March 2010 was a good idea.

Back then, delinquency rates actually were quite high. Source.

Today, they are extraordinarily low. Yes, default rates will likely rise. But when reading breathless news reports, keep in mind that default rates need to double just to get back to “average.” To get to GFC levels, they would need to rise 13-fold.

The reality is that these types of news stories are an overdramatization of the reality of lending and borrowing. This hysteria has created a buying opportunity for Commercial mREITs like Ares Commercial Real Estate Corporation (ACRE).

CRE loans are mortgages written against real property. If the borrower defaults, the lender has the ultimate option to seize the property and then keep it or sell it. The vast majority of defaults occur at the date of maturity. Making the interest payments is usually insignificant relative to the revenue a property produces. Even with “high” interest rates, the interest is much lower than the revenue the property produces.

Defaults occur most often when the loan matures and a “balloon” payment is due. Few borrowers intend on paying off property at maturity, so they simply don’t have the cash. Instead, they intend to refinance the property. The primary cause of defaults is when the borrower is unable to refinance. Something that the lender has a measure of control over.

A “default” rarely means a complete loss in commercial real estate because the property has value. A commercial mREIT has a variety of options at its disposal that they exercise on a routine basis. There are many realities that cause the realized losses from defaults to remain relatively low:

• Borrowers usually want to maintain the property. While there might be a handful of cases where the borrower prefers to walk away or is insolvent and unable to keep the property at any price, most borrowers want to refinance if it can be done in an economical way. It is very common for ACRE to offer loan extensions and modifications at maturity. These agreements usually cost a fee, and ACRE will also sometimes require the borrower to provide additional equity to reduce the loan. They will continue collecting interest until the new maturity date. This ultimately leads to more interest collected by the REIT than if the loan was paid as agreed.

• CRE loans are typically written below 70% loan-to-value. I’ve seen a number of calls for commercial real estate to lose “40%” of its value from peak. Ok. If the value of a property falls 20%, then it is still worth more than ACRE’s loan on the property. If it falls 40%, then ACRE would recover approximately 60% of the property’s value at the time of underwriting. Since they only loaned 70%, ACRE would recover approximately 85% of the original principal. And note this applies to properties that were mortgaged right at the peak of the market. ACRE holds loans that originated anywhere from 2018 to the end of 2022. So the peak valuation of the property could be materially higher than the valuation when the property was underwritten and a loan was issued at 70% LTV.

• mREITs have the infrastructure to operate a property. Banks typically have a choice between selling a loan that is in default to another lender or selling the property in what is usually a distressed sale at a discounted price. Mortgage REITs have a much less complex regulatory framework and have the option of repossessing and operating property. ACRE did this with the Westchester Marriott, foreclosing on the property in 2019; they were unable to sell it at an attractive price due to COVID. ACRE managed the property until Q1 2022 and sold the property, realizing a net gain on their investment.

• Market distress creates profitable opportunities. If you could go back in time to any date and load up with stocks, which day would you choose? I guarantee you would say some date in the past when stocks were distressed, fear was high, and prices were low. The best time to buy anything is when everyone else is selling it. It isn’t any different for lenders. The best time to be lending is when you can get higher prices because your peers aren’t lending. If banks cut back lending because they are worried about their own capital, that benefits mortgage REITs which don’t have depositors to worry about.

ACRE has leverage at only 2.1x debt to equity. This is quite low for the sector where around 3x is common. This is a defensive position in that it gives ACRE the ability to deleverage any troubled loans and work out a deal with the borrowers. It is also a position that allows ACRE to extend loans when the environment is best.

Meanwhile, ACRE is still benefiting from rising interest rates. Since 99% of ACRE’s loans are floating rate, higher interest rates directly lead to higher earnings.

ACRE has already been covering its dividend easily, with earnings covering the dividend by 110%. Source.

On a quarterly basis, dividend coverage was over 125% in Q4 as higher rates increased Q4 earnings – something we can expect to continue into the first half of 2023. This provides a very solid cushion for ACRE to absorb any variation that might be caused by defaults.

Finally, ACRE’s book value is $13.73. It is currently trading at a 30%+ discount to book value! Keep in mind that current expected credit loss (“CECL”) accounting already includes an estimate of the impact of credit losses ACRE might or might not realize. This provides investors today an additional layer of safety.

Yes, we do expect defaults to rise in commercial real estate. It is inevitable, given how low defaults have been in the past two years. The question is, how will defaults impact ACRE? And in that respect, we believe the market is greatly exaggerating the danger. The most important point is that ACRE has positioned itself defensively. The big risk to a mortgage REIT has little to do with who it lends to and it has everything to do with how it manages its own balance sheet. An mREIT that has to deal with its own balance sheet issues cannot take advantage of opportunities in the market.

ACRE is positioned defensively, management is prepared for turmoil in commercial real estate, the company has a substantial cushion protecting its dividend, and the discount to NAV provides a substantial cushion against any decline in NAV.

So while others are selling, I’m happy to be buying.

Pick #2: RLJ Preferred Shares – Yield 8%

RLJ Lodging Trust (RLJ) is a Real Estate Investment Trust (“REIT”) that owns premium-branded, high-margin, focused-service, and compact full-service hotels located strategically in high-demand locations in U.S. cities. Source.

RLJ is one of the largest U.S. publicly-traded lodging REITs in terms of the number of properties and room count. RLJ operates properties across leading global hotel brands.

As lodging companies transition from survival mode to post-pandemic portfolio improvement and profitability, RLJ is pursuing several opportunities to improve property value and quality. During FY 2022, the REIT completed three property conversions and kicked off two new projects. RLJ expects to pursue at least two conversions every year going forward. These conversions are geared towards improving market share and long-term profitability.

RLJ’s improving operations have been of benefit to shareholders. The company recently raised its quarterly distribution 60% to $0.08/share and repurchased $57.6 million of its common stock in 2022. Additionally, the REIT has provided Q1 2023 AFFO guidance of $0.29 – $0.33, which ensures the sustainability of the newly raised common distribution.

RLJ maintains a well-laddered debt maturity schedule with no maturities until next year. 85% of its debt is at a fixed rate or hedged. The REIT also has a substantial liquidity position by hotel REIT standards with ~$1.1 billion of total liquidity (comprising $536.4 million of cash and $600 million available under its revolving credit facility). This provides adequate flexibility with strategic priorities, acquisitions, and other portfolio improvement opportunities.

With that, let’s turn to RLJ’s convertible preferred security, which offers sustainable income prospects for long-term investors.

$1.95 Series A Cumulative Convertible Preferred Shares (RLJ.PA)

RLJ-A is not redeemable or callable and has no par value. RLJ-A preferred shares are referred to as a “busted convertible” – they are convertible into common shares at the option of the shareholder, but it is very unrealistic that RLJ’s share price will ever get high enough to even consider the conversion option. Likewise, the threshold for RLJ Lodging to exercise its conversion option would require almost a 10-fold increase in the price of the common shares.

RLJ spends $25 million on preferred distributions, a sum well-covered by the $221 million AFFO generated in FY 2022. RLJ is working to grow its common distribution which provides additional safety to the investors of its cumulative preferreds. RLJ-A offers an 8% yield at current prices and is well-positioned to serve as a perpetual cash machine for your portfolio.

Conclusion

Tens of thousands of people turn to Google every week to find out if now is a good time to buy stocks. It’s a loaded question, and it depends more on your investing goals and time horizon than on what the market is doing on a given day.

Let me clarify one thing: the markets will never give a green light saying everything is ok and roll out a red carpet for your entry. There will always be uncertainties in the form of geopolitical tensions, economic headwinds, and much more, but investors must focus on the fundamentals of their companies and make data-driven decisions.

1982 was a very scary period for this country. We’ve had nine recessions since World War II. This was the worst. 14 percent inflation. We had a 20 percent prime rate, 15 percent long governments. It was ugly. And the economy was really much in a free-fall and people were really worried, ‘Is this it? Has the American economy had it? Are we going to be able to control inflation?’ I mean there was a lot of very uncertain times. You had to say to yourself, ‘I believe in it. I believe in stocks. I believe in companies. I believe they can control this.’ – Peter Lynch about the 1982 market conditions.

At High Dividend Opportunities, we use market uncertainties to strengthen our income. Our model portfolio is built with 45+ equities with an average yield of +9%, with the objective to have regular income as part of a retirement plan. Need cash to take advantage of the market selloff or for your general expenses? Why sell shares at a loss? Investing your recurrent dividends allows you to make cash infusions at regular intervals, and when may really need it, such as during market volatility. This is the beauty of investing in dividend stocks!