While my stance on Sachem Capital (SACH) is in the middle, neutral is not the right term as I am simultaneously a strong bull and a worried bear. With the information available today, the result for common shareholders could go in either direction depending on how a few key factors play out. Thus, we are choosing to be on the sidelines, ready to strike at the time when it becomes clear which way events are going to unfold. We believe there will be a window of opportunity during which the fundamental direction gains more clarity but before the market price properly adjusts. It is in this period that we would invest.
To this end, it behooves us to have a clear understanding of the key moving parts that will ultimately determine the outcome.
Understanding the niche business model
Sachem originates and holds mortgage loans on residential development including significant exposure to fix-and-flip redevelopments. This is a high risk space as it is essentially on spec with the hope that there will be a buyer once the development/redevelopment completes.
Sachem Capital writes loans with the knowledge that there will be a high default rate. Historically, the default rate on their loans has been about 18% annually as seen in the description of their business from the 10-Q:
“Our loans typically have a maximum initial term of one to three years and bear interest at a fixed rate of 5.0% to 13.0% per year and a default rate of 18% per year. We usually receive origination fees, or “points,” ranging from 2% to 5% of the original principal amount of the loan as well as other fees relating to underwriting, funding and managing the loan, such as inspection fees. Since we treat an extension or renewal of an existing loan as a new loan, we also receive additional “points” and other loan-related fees in connection with those transactions”
This is a niche that is filled by REITs as banks cannot accretively handle real estate owned through foreclosure. For a REIT, a failed loan is not always a bad thing. When the loan defaults, the REIT takes over the asset and can then either rent or sell the property to try to recoup their principal. As loan to value is often well below 100%, defaulted loans can turn out to be significantly profitable.
Thus, the business model has multiple modes of profitability.
- If the loan performs SACH earns its profit through origination fees and the high interest rate that it charges the borrower.
- If the loan defaults SACH still gets its origination fees and has a chance to earn a substantial profit through monetizing the foreclosed property.
As one might surmise, there is significant risk incurred in this process. If the taken over real estate fails to generate proceeds equal to or greater than the principal balance of the loan, losses are incurred. Thus, it is a business strategy that requires significant skill, underwriting expertise and cooperation of the macro economy.
Well, today, the macro economy is not cooperating; so what happens?
- Annual default rate is likely to be significantly higher than the normal 18% resulting in the eventual takeover of a significant number of properties
- Taken over properties have uncertain value and the risk of REO (real estate owned) being impaired is greater than normal
- Origination fees have slowed to a crawl as developers are pressing pause until there is more clarity
The market is largely aware of these risks and is pricing them in by trading SACH at a significant discount to book.
The valuation is attractive right now relative to history. SACH has consistently traded at a premium to book value and a higher premium to book value than other investment companies.
Today, however, it trades at a significant discount to book value and a larger discount to book value than other investment companies.
The risks mentioned above are the reasons that both SACH and the index trade at a discount to book and the question is whether the damage will be more or less than what the market is pricing in.
Note that book value is a somewhat delayed figure. The damage incurred during the crisis has not hit the recorded book value yet as that is a 3/31/20 figure. Let us look at how problems could potentially filter through the balance sheet and impact book value.
Book Value impact
Let us begin by noting why mortgage receivables (highlighted in blue below) went up substantially in the first quarter.
Quite simply, SACH originated quite a few loans in the first half of 1Q20 so the receivables which are the asset recorded when they make a new loan went up. As you can see, cash and cash equivalents went down by a similar amount as receivables went up. This cash was paid out as loans and the principal of those loans is now owed by the borrowers to SACH causing the receivables asset to go up.
This is just business as usual, but I wanted to point it out because often when a receivables line item goes up this dramatically it can mean the company is failing to collect on what is owed to them.
As referenced in the 10-Q, there are 42 loans currently in forbearance.
“Currently, of our 480 mortgages receivable, we have 42 COVID-19 forbearance requests representing $9.2 million of mortgages receivable and a total of approximately $283,000 of deferred interest”
That $9.2mm could eventually show up in the REO highlighted by the red box in the table above but there is a bit of a process to get there. SACH would have to foreclose on the properties and evict the borrowers, but that is presently impossible as courts are not open for evictions per the 10-Q:
“currently there is no access to the Connecticut court system to process foreclosures and evictions.”
It goes on to explain the process of forbearance:
“Once a forbearance request is initiated by the borrower, we promptly request documentation to determine the validity of the request and if valid and reasonable, we defer the borrower’s payment of interest for a period of 90 days.”
After those 90 days if the loan is still delinquent and assuming courts are unclogged to be able to process foreclosures, SACH can begin the process of eviction. Once borrowers are evicted, the collateral associated with the failed loans goes into REO.
Thus, while the amount of loans in forbearance is a known quantity, the end result is still up in the air. These loans could go any number of directions including the following:
- Become re-performing loans where after some period of forbearance the borrower pays the interest owed.
- Become REO that is successfully sold at break-even or a profit
- Become REO that is impaired or unsellable
Depending on how much of these loans end up in each bucket, the damage could be minimal or substantial. That said, let us estimate assuming all of the loans in forbearance become fully REO that is unsellable and essentially useless.
Between the $9.2mm in forbearance and the $283K of deferred interest we are looking at potential damage to SACH of up to $9.48mm or about $0.42 per share. This amount is fully priced into the stock. SACH is trading at $2.70 and had a 3/31/20 book value of $3.71, so even with a hit to book value of $0.42, there is a bit of discount remaining.
However, the problems could extend well beyond the loans already in forbearance. Some portion of the loans that were performing at the time the 10-Q was written could become delinquent or the existing $7.3mm of REO could become impaired. SACH has $111.8mm of outstanding loans, all of which were underwritten at times when the economy was far stronger than it is now.
House flipping is always a risky undertaking, and I would imagine fix-and-flip is substantially riskier now than before. Per a recent presentation:
“67% of loans are for single residential projects, primarily homes that are fixed and flipped”
The point I am trying to make is that the amount of damage to Sachem’s book value from the crisis is inestimable at this time. It will depend on how quickly Coronavirus can be beaten, how extensive unemployment remains and a whole host of other factors which I am not smart enough to predict.
If things go well, SACH could be an excellent opportunity at these prices. My intent is to try to exploit a window of time in which the fundamental picture is more clear but the price is still cheap. To do this, I will be watching certain factors:
- Housing demand
- Loan performance data directly from SACH
- Home values
I don’t think anyone yet knows how the crisis will impact the value of homes. If values remain relatively stable, SACH could be well positioned even if large portions of their loans default. Sale or rental of the collateral could result in a strong recovery of SACH’s invested capital. If these data points come in favorably and SACH’s price is still where it is today, that is the time to strike. Part of the reason I believe this window of mispricing could persist even after the data comes out is that SACH is a tiny company with a market cap of just $55mm.
As such there is almost no institutional following and its market price can fluctuate wildly. This mispricing can be used to one’s advantage by waiting for the improved clarity before making the decision. Perhaps those with a better crystal ball could invest today, but the risk has me sidelined at this time.
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