There's often a lot of uncertainty involved when buying a company that has just recently gone public. But sometimes it is worth the risk. That appears to be true for mortgage real estate investment trust (REIT) Broadmark Realty Capital (BRMK -0.28%). The reason for this optimism? Broadmark isn't your typical mortgage REIT.
Here's what you need to know about this recent IPO, and why you might want to buy it before Wall Street catches on.
Broadmark is not what you think
The first thing to understand about Broadmark is that it deals in debt that is tied to property, but not mortgages as you know them. When most homeowners get a mortgage, a bank is basically fronting them the money to buy a home. The new homeowner agrees to pay back the loan, with interest, over time. The bank (or other company that originates the mortgage) often puts together a whole bunch of loans that it owns and sells them as a single batch to investors, which often include real estate investment trusts that specialize in owning these "collateralized" mortgages.
These mortgage REITs typically sell stock and, notably, borrow money to buy mortgage securities. They make their money the spread between their cost of capital and the interest rate on a pool of mortgages. Interest rate changes are a big deal since they can dramatically change the math on this spread. Notably, mortgage REITs often use shorter-term debt to fund longer-term investments. The leverage involved in this model is one of the reasons why mortgage REITs can be so risky.
For example, Annaly Capital Management (NLY 0.80%) has been a roller coaster ride for investors. One of the biggest names in the mortgage REIT space, the company's dividend has been all over the map, rising and falling, but has basically been in decline for a decade, essentially since interest rates started to fall toward historic lows following the 2008-09 Great Recession. Shares have tracked lower along with the dividend, though the yield has mostly remained in the 10% or higher space throughout. The total return (which assumes reinvestment of dividends) has been solid, but you need a very strong stomach to own Annaly. And if you lived off the dividends instead of reinvesting them, your total return wouldn't look nearly as good. Annaly is not a particularly good income investment, despite a perpetually high yield.
Throw all of that out when you look at Broadmark. It doesn't deal with pooled mortgage loans, it originates its own loans. Also, it largely deals directly with construction companies, not consumer mortgage loans. And finally (but importantly), it doesn't use debt to fund its loans, just cash on hand and equity sales. Broadmark is a different beast.
So what does it do?
Broadmark is what is known as a hard money lender. It provides construction companies cash so they can purchase property and/or fund construction as they work on a project. The loans tend to be short-term in nature, usually only lasting a couple of years. That helps reduce risk, since Broadmark isn't waiting 20 or 30 years to get paid.
And because construction projects are well defined going in, Broadmark has a good idea of what the end value of the effort will be. It creates its loans based on that, with the typical loan set at 65% (or less) of the expected end value of the project. This gives Broadmark a cushion in case something goes wrong along the way. In most situations, the worst-case scenario is that the REIT comes out whole on the loan. Over nearly a decade as a private company, it issued about $2 billion in loans, with only around $400,000 in write-offs. Management is either really lucky or has a pretty good handle on what it's doing.
The next bit of information to understand is the nature of the hard money market. Builders usually require quick turnaround times and reliable financial partners that understand the construction market. Banks are often too slow on deals like these and can request information and security commitments that a construction company just doesn't have or want to give. Broadmark, specializing in the hard money space, adjusts its processes to meet the needs of its customers -- and about two-thirds of its loans are made to repeat customers. It focuses on speed and, as noted, values loans on the project they are secured by. Builders are willing to pay a premium for these valuable traits, with interest rates on the loans Broadmark makes often in the mid-teens area. That's a premium that tends to hold in good markets and bad, making this is a lucrative niche.
To be fair, these are short-term loans, so Broadmark's portfolio is constantly turning over. That means there's always work for Broadmark's management team, as it looks to remain fully invested. There's a risk that a weak construction market could make it more difficult to put cash to work as loans roll off. However, Broadmark is relatively small, and the construction market, even in a downturn, is very large. At this point, management isn't particularly concerned that it will have trouble finding investments.
Then there's the issue of leverage: Broadmark doesn't use debt to fund its lending. This is a huge differentiator, because it materially reduces risk. Management doesn't have to worry about paying back bondholders or the impact of interest rate changes on its investment decisions. It can take its time and make good loans to competent construction companies working on projects with strong prospects.
If it wants to increase its scale, meanwhile, that would require issuing stock. That's a check, as investors won't typically be willing to provide funds to a poorly run operation. Don't underestimate this issue -- some once-proud names in the mortgage REIT space went bankrupt following the 2007-to-2009 recession because of their use of leverage.
What do investors get?
Broadmark is a mortgage REIT, but it dances to its own beat. While it might sound risky to invest in construction projects, the high interest rates on hard money loans, the short-term nature of the loans, Broadmark's conservative underwriting approach, and the lack of corporate-level debt actually suggest this is a pretty low-risk REIT. New and largely misunderstood on Wall Street, however, it offers a nearly 8% yield backed by monthly dividend payments. If you are a dividend investor looking for a high yield, you should take some time and get to know Broadmark -- it is highly likely to be worth your time and effort.