Mortgage real estate investment trusts (REITs) are, generally speaking, high-risk dividend stocks. The really big issue is the leverage that is employed, which can amplify returns when times are good but also amplify losses when times aren't good. Broadmark Realty Capital (NYSE:BRMK) upends that model, focusing on hard money lending and a debt-light balance sheet. Here's what that means and why dividend investors should prefer Broadmark over other mortgage REITs.

Breaking the mold

Normally a mortgage real estate investment trust buys mortgage securities that have been pooled together into bond-like securities called collateralized mortgage obligations (CMOs). That, in and of itself, isn't a big deal. The real problem arises because those mortgage securities are often used as collateral for loans, with the additional cash used to buy more CMOs. That leverage is a huge benefit when times are good, because it allows mortgage REITs to amplify their returns.

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But times aren't always good. When capital markets tighten up or the value of CMOs declines, mortgage REITs can find themselves in a bind. When the collateral backing of these loans fall in value, lenders ask for more collateral, which is called a margin call. If the borrower can't come up with additional collateral, the lender can sell the CMOs backing the loan. Those sales, meanwhile, would basically be occurring at the worst possible time, since by definition the CMOs involved would be at a low price.

It's a terrible situation that mortgage REITs will go to great lengths to avoid. For example, New Residential Investment sold roughly 70% of its mortgage, consumer debt, and mortgage related securities in the first quarter of 2020 to avoid such mark-to-market financing risks. Along the way it cut its dividend by 90%. That's an extreme example, but this risk is a big reason why investors should generally avoid mortgage REITs, despite the often high yields they offer.  

But Broadmark upends this model because it does things very differently, including the fact that it prefers to avoid leverage.   

It's just not the same

In some ways, it's unfortunate that Broadmark is considered a mortgage REIT because its business is vastly different from the group with which it is being compared. But, in the end, it is the most appropriate structure because the company is, indeed, making loans backed by property. Only it's doing so at a much earlier stage in the process. Most mortgages are tied to property that is fully built with the loan made to the person buying the asset. Broadmark specializes in making loans directly to builders that are putting up new homes or redeveloping/rehabbing older ones. This is what's known as hard money lending. These aren't giant pools of faceless mortgages; Broadmark writes each and every loan itself.

There are a few key differences here. First, the loans are relatively short-term, since they are simply meant to get the building built and sold. Second, there's not much competition for providing these loans, which allows Broadmark to set pretty beneficial terms. And third, the ability to act quickly is important, leading to a high level of repeat business once a company like Broadmark has proven itself to be a good partner.

BRMK Chart

BRMK data by YCharts

Broadmark can usually charge double-digit interest rates regardless of the market environment, and its customers are happy to pay. It normally requires that a loan be for no more than about 60% of the expected sales price of the property it's backing, providing ample security should something go awry. (Broadmark has stepped in to complete projects and still come out ahead.) And since the loans are short-term, there's only a small window of risk for each loan. 

And then there's the fact that Broadmark doesn't make use of leverage. So, not only are the loans it is backing different from what most mortgage REITs own, it doesn't amplify its risks by taking on debt.

That's not to suggest Broadmark is immune to difficult periods. Indeed, it recently trimmed its monthly dividend from $0.08 to $0.06 per share. In fact, after the first quarter, it noted that COVID-19 has delayed construction activity, which stretches out the projects it is backing. That, in turn, hampers the company's cash flow and ability to generate new loans.    

It's also facing a nearly 15% default rate right now. However, the roughly 60% loan-to-value metric and lack of debt means it can afford to step in and rework those loans or complete the projects itself. Simplifying things a little, as long as the value of the expected sales price of a project doesn't fall by 40% (which would be a massive decline), Broadmark will still be OK in the end. To put a number on just how powerful that is, the REIT proudly highlights that its loan losses over the past 10 years (the majority of this time it was not a public company) amounted to less than 0.1% of the loans it originated. That's an incredible record, though the current recession, which started in February, is really the first true test of the business model in the public space. Still, compared to many of its "peers," Broadmark is holding up pretty well so far.    

A better option

If you have ever looked at a mortgage REIT, you need to do a deep dive into Broadmark. With a nearly 8% yield (paid monthly) and no debt, this differentiated mortgage REIT should hold up better than other mortgage REITs when markets are in a state of flux, as they are today. For dividend-focused investors looking to maximize current income, it's a much better way to play this REIT niche. Take the time to get to know Broadmark Realty Capital and it's highly likely you'll consider adding it to your income portfolio today.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.