Orchid Island REIT: A Strong Asset in Turbulent Times (NYSE:ORC)

With a prospective dividend yield of nearly 14%, Orchid Island Capital (ORC) not only looks like a good medium to long-term investment for dividend-seeking investors, it also compares well to its competitors.

The Macro View: Is it the right time to invest in the real estate market?

During this current short-term (or medium-term?) crypto crisis, it seems even more reasonable to at least partially add strong and highly profitable assets to a portfolio. Owner investing, in particular, has a reputation for providing a fairly stable (but not always the highest) return on assets. This is one of the main factors why REITs have become increasingly popular in recent years.

One of the biggest advantages for an investor investing in a REIT is that their cash flow is already diversified and comes from more than one tenant. She doesn’t need to buy a lot of residential properties to diversify, she just needs to allocate some of her cash in a REIT to participate in the resulting cash flow.

But are there currently any downsides to investing in the RMBS market? Of course there are. The greatest downside risk appears when comparing US household income to US household debt over the past two decades. While the median household income increased from $59,887 in 2003 to $68,703 in 2019 (+14.7%) according to US census data, total household debt more than doubled over the same period, from around $7 trillion to over $14 trillion in 2020. According to Visual Capitalist, 68% of this debt is mortgage debt.

It is therefore safe to say that the debt to income ratio must be considered when investing in REIT RMBS like ORC. On the other hand, it seems impossible to predict how this new level of household indebtedness will affect mortgage loans in the medium or long term. Money – and debt – have never been so cheap in the last 100 years. Financial markets, strongly influenced by the QE policy of central banks, are currently operating in a mode that takes us into uncharted waters. If the indebtedness of households exceeds their income further, it is difficult to imagine a mortgage delinquency rate at or below the actual rate of approximately 6.38%.

Nevertheless, this growing gap between household income and household debt in the United States can (and most likely will be, if not handled properly) a disruptive force for the economy as a whole and not just for mortgage markets.

The Micro View: ORC and its competitors

However, if an investor chooses to allocate at least a portion of their funds in RMBS REITs due to the aforementioned advantages of investing in such an asset over investing in apartments or single-family homes, they might want to focus not only on ORC but also on its competitors. .

First, let me briefly introduce you to Orchid Island Capital. This Florida-based REIT invests in residential (agency) mortgage-backed securities. This alone makes ORC quite attractive since agency-backed mortgages generally require higher lending standards than private label mortgages. This makes their cash flow more reliable for an investor looking for dividends. ORC went public in 2010.

Agency mortgage-backed securities may consist of CMOs or CDOs (mortgage bonds/secured debt), certificates, such as pass-through securities, plain vanilla and/or structured residential mortgages, backed by a GSE.

Despite the fact that there are over 30 popular RMBS REITs to choose from, I have selected a few competitors based on similar or at least slightly similar market cap to ORC. Since ORC belongs to the mid-sized RMBS REITs, I have not compared it to the larger or smaller competitors.

My list includes:

1. New Senior Investment Group Inc. (SNR)
2. Dynex Capital Inc. (DX)
3. Captstead Mortgage Corporation (CMO) and…
4. Great Ajax Corp. (AJX)

The avid reader should keep in mind that not all invest solely in RMBS, some also invest in CMBS, and not all invest exclusively in mortgages backed by agencies like Orchid Island Capital.

Source: seekalpha.com

If we compare Orchid Island Capital to its competitors in terms of its net profit margin (net income divided by revenue), we can clearly see that it is doing quite well. While Dynex Capital and Capstead are just a bit more profitable using their assets, their dividend is quite low compared to Orchid.

Another interesting fact is the price-to-book ratio. Yes, Orchid Island is just a little richer than Dynex, Capstead or Ajax, but again the prospective dividend yield gives a good reason to disregard this minor difference. On valuation alone, New Senior Investment Group is out of the race.

The final category is return on common equity, which gives us an index of how profitable a REIT is using its assets. And again, Orchid Island does pretty well in comparison.

Worst case and best case scenario

Since today’s financial markets are impossible to predict, an investor interested in adding ORC to their portfolio should create as realistic a worst-case and best-case scenario as possible. It’s always a guessing game and sometimes it’s hard to paint a bad enough worst case scenario and a realistic enough best case scenario for the modeling to make sense. And to make matters worse, these scenarios are often based on historical data. Yet, while past performance is no indicator of future performance, it can at least give our investor some direction for their scenarios.

While ORC stock has been a fairly stable investment over the past few months (it was trading at $5.11 on September 1, 2020, while it is now trading at $5.59 on May 21, 2021), and even profitable over the last year (+36.34%) it has experienced a slow but steady decline from 2016 to today of almost 47%.

Assume, for our worst-case scenario, that this trend continues over the next five years to 2026. An investment of $100 would then reduce to an investment of $53.

What we observe quite often with REITs when their valuation drops is that the dividend remains stable for a certain period of time. In such cases, it is usually funded by increasing the leverage of REITs as a short to medium term remedy. Eventually it will be cut (e.g. in half) or reduced completely. And although in such a case the dividend yield generally increases, when the stock goes down, it will not concern our investor since he is already invested.

So further assume that the average dividend yield, currently 13.95%, will also decline to 10% per year. A dividend yield of 10% would yield $61 over the same period. This is before tax.

In our worst-case scenario, our investor could sell his $100 investment for $53, but he would receive a dividend of $61, earning a pre-tax profit of $14 or 2.66% per year.

The reason my worst case doesn’t include a REIT bankruptcy is that while mortgage debt may rise further, house prices may also rise, but not for the same reasons as before 2008, when bad lending practices were to blame; now it seems to be a supply and demand problem.

It is difficult to predict how likely this worst-case scenario is and whether it really is a realistic worst-case scenario for the next five years.

Modeling a realistic best-case scenario is equally difficult. Assume that the valuation and dividend yield remain stable. The reason I decided to go for 0% stock price appreciation is that I think a rise in interest rates could have a negative effect in the short to medium term for REIT RMBS and I don’t see why RMBS portfolios should rise in value with an ever-increasing debt-to-income ratio for private households. Thus, with a dividend yield of 10% per year ceteris paribusour investor would then be looking at a return of 84.24% over five years.

Let’s sum it up!

Yes, there are speed bumps ahead for RMBS investors such as possible rate hikes by the FED and an ever-higher household debt-to-income ratio. However, with a solid net profit margin, an attractive price-to-book valuation and a prospective dividend yield of nearly 14%, ORC could be a good medium-term complement for anyone looking to gain exposure to the equity market. RMBS.