Blackstone Mortgage Trust: Valuation Is Getting Risky (NYSE:BXMT)

Dear readers/followers,

Last I wrote about Blackstone Mortgage Trust (NYSE:BXMT) was in May just after the company has released its Q1 2023 earnings. I issued a BUY rating for the stock at $17.33 per share, mainly because I saw the valuation as overly depressed, as the market was pricing in a total write-down (with zero recovery) for nearly 10% of the entire loan book.

I fully expected some defaults to take place, but since the troubled office sector accounts for “only” a third of their portfolio and has a reasonable LTV of 50% (assuming values at underwriting), I felt that the margin of safety we were getting on BXMT’s well managed portfolio was sufficient to justify the risk of defaults.

To put some math behind this, let’s talk about office values over the past year and a half. The indisputable fact is that valuations have dropped across the board as interest rates increased. Looking at cap rates, at the time of my last article, quality office REITs such as Boston Properties (BXP) or Highwoods Properties (HIW) traded at implied cap rates of 8.5-10%. Compare this to a typical cap rate in a major city prior to Covid of 4.5-5% and it becomes clear that office values have been roughly cut in half.

But here’s the thing. With valuations down 50%, the REIT will be able to recover most of its outstanding debt in case of default (since the LTV is 50%).

Even if we assume a 75% drop in valuations, which is quite extreme, the REIT would still recover about half of its money on a defaulted loan. That to me is a large margin of safely.

Still the market didn’t care about the math and priced in implied defaults for 20% of the portfolio (assuming a very conservative 75% draw down in valuations), creating what I considered a good buying opportunity.

Since then, the stock has outperformed handsomely returning over 30% or more than 3x the S&P 500 return. And because I’m generally not a big fan of holding mortgage REITs for the long-term and therefore considered this more of a swing trade, such outperformance begs the question whether now is a good time to trim/sell.

Mortgage REIT basics

I’ve covered the basics of investing in mREITs in many of my past articles on BXMT, Granite Point Mortgage Trust (GPMT) and BrightSpire Capital (BRSP).

What’s important is that the vast majority of mREITs (BXMT included) have nearly 100% floating rate exposure. This means that any increase in interest rates has an immediate effect of increasing the REIT’s earnings. In particular, the 1M SOFR, which is the base rate for the vast majority of BXMT’s loans, has increased from 0.93% this time last year to 5.04% this year.

Higher interest creates a higher burden for borrowers, especially in troubled sectors such as offices. This often eventually leads to some borrowers not being able to meet their debt payments. But there’s generally a lag between the increase in interest and defaults of several quarters.

Since interest rates have only stabilized recently, there’s a risk that BXMT’s earnings are currently elevated due to higher net interest income, and could eventually drop as defaults pick up. This could put downward pressure on earnings and therefore increase the risk of a dividend cut.

Recent Earnings

BXMT recently reported their Q2 2023 earnings.

In short, they have been pretty good.

Distributable earnings (DE) came in 20% above consensus at $0.79 per share. The result has been on par with Q1 numbers as higher interest rate tailwinds (+$0.03 per share) have been offset by loan modification, cost recovery accounting and net portfolio contraction (-$0.03 per share).

The loan modification component is largely a risk-reducing step as it consists of trading lower interest for partial loan repayment for certain borrowers.

In terms of cost recovery, all 5-rated impaired loans continued to pay interest during the quarter, but this income was reported as loan pay-down rather than income, therefore reducing DE. If these loans recover, it will eventually be recognized as income, if they default, it will reduce future losses.

Distributable earnings during the quarter covered the $0.62 per share dividend (11.3% yield) comfortably with a payout ratio of 78%.

The portfolio has remained largely stable as 8 loans have been upgraded and 7 loans downgraded with the weighted average risk profile stable at 2.9x. The proportion of performing loans has dropped by 1% to 96%.

Management has increased their CECL reserve by a further 8% to $380 Million ($2.20 per share). The reserve is now almost 300% higher than this time last year and covers 20% of all 5-rated loans.

Notably, the reported book value has increased ever so slightly by $0.02 per share as excess earnings have more than offset the increase in CECL reserve.

BXMT has also decreased its leverage by 0.1x quarter-over-quarter to 3.7x and increased its liquidity to a record $1.8 Billion.

Overall, the REIT has posted a solid quarter of stable results. And following the 30% price increase since my last article, the valuation has understandably become more expensive.

Adjusting the reported book valued for the CECL reserve (adding it back), the stock currently trades at 0.78x BV (vs 0.61x in my last article).

With 4x leverage ($20 Billion in liabilities vs $4.5 Billion in equity), we can once again calculate that the market is currently pricing in default (with zero recovery) for 5.5% of the loan book. That means that our margin of safety has been cut in half since the last time I wrote about the stock.

Before making the call, let’s consider some key risks:

Risks to consider

Since BXMT is a highly leveraged company, they too have to make their debt payments. Those payments are largely floating rate, which means they have increased a lot over the past year. While this time last year, the REIT was paying just $136 Million in interest per quarter, now it’s paying almost $350 Million.

With $520 Million in interest income, the cost of debt is well covered for now, but should a sizeable part of BXMT’s loan book stop making payments, there will come a point at which the company could be forced into bankruptcy. In particular, it would take over a 30% reduction in interest income (i.e. a third of borrowers not paying another penny).

I see the risk of bankruptcy as extremely small here, because even if a third of borrowers default (very unlikely), the company still has almost $2 Billion of liquidity which is enough to cover its debt obligations over 5 quarters.

A more realistic risk, however, is that of a dividend cut. With distributable earnings now boosted by higher interest rates, I fear that we’re now seeing peak DE and I expect some loans to default over the coming quarters. This could easily increase the payout ratio to 100% or more and could potentially lead to a dividend cut, which would be devastating for the stock price as many investors buy into mREITs for the dividend.

Last but not least, mREITs have a terrible track-record, especially when compared to equity REITs. Over the past 20 years, they have returned just 1.9% (including dividends) and therefore have largely been value traps. This is the main reason why I don’t hold any mREITs for the long-term.

All things considered, BXMT has been a very rewarding swing trade for me, but since I don’t want to hold the mREIT for the long-term and the margin of safety has been effectively cut in half, I will sell my position and rate the stock a HOLD here at $22.12 per share.