Thousands of words have been devoted to explaining Warren Buffett’s investment strategy over the years, both by the legendary investor himself and others. All of this, however, can be boiled down to one piece of advice: buy quality businesses at reasonable prices. Simply put, you want to buy a solid business that will last without paying too much for it.
Let’s look at two Real Estate Investment Trusts (REITs), Rhythm Capital (RITM -2.85%) and Medical Properties Trust (MPW -3.33%)and a bank, Live Oak Bancshares (LOB -5.86%) Not only do they qualify as Buffett stocks, but they also offer a nice dividend that lets you earn $500 a year in passive income if you split a $10,000 investment equally among the three.
Rithm Capital is a unique type of REIT. Unlike other REITs, it does not specialize in owning and leasing property; instead, it borrows money and invests in mortgages, mortgage-backed securities, and mortgage servicing rights. This type of REIT is called a mortgage REIT (mREIT).
In good times, it’s a great deal. mREITs earn the same spread on interest rates as banks and other financial institutions, but they do so without spending millions (or even billions) in physical locations. This generates tons of free cash flow and currently supports an 11% dividend yield for Rithm.
The problem, and the reason Rithm is undervalued, is that when interest rates rise, MREITs can find themselves in a mess where they have to refinance the short-term debt used to buy their investments (usually mortgages with durations of 15 or 30 years). Yet these investments pay a lower interest rate than new debt.
The market certainly understands this dilemma, and Rithm is currently trading at just 0.74 times book value, well below its five-year average of just below book value.
Rithm offsets interest rate risk with mortgage servicing rights. The company that holds the right to service a mortgage collects payments, manages the escrow account, and performs other administrative tasks. He then collects a commission from the institution that holds the loan.
When interest rates rise, the value of mortgage servicing rights increases. This is because the borrower is less likely to refinance the mortgage (which would render the interest worthless). Rithm has mortgage servicing rights to $623 billion in mortgages.
Medical Properties Trust
Medical Properties Trust is another classic Buffett type business. It owns and leases hospitals to experienced hospital managers. Healthcare is the type of business that isn’t going away any time soon. Yet it has the elasticity of demand to increase prices with inflation – and Medical Properties Trust is increasing its leases to steadily increase its revenue over time.
It is also a value. The REIT is trading just below its book value because investors fear that rising interest rates will slow its expansion and make it difficult for the REIT to refinance existing debt. Falling prices pushed its dividend yield up to almost 7%. A return to its five-year average price-to-book ratio would mean a 50% gain from current prices.
The question for investors is whether interest rate fears are legitimate. As for the debt part of the question, the answer is probably no. Only 25% of the REIT’s debt matures before 2026, and an additional 25% does not mature until 2029 or later. You will have plenty of time to develop a plan by then if interest rates are well above current levels.
As for growth, my answer is that it doesn’t matter. The REIT has plenty of cash to meet its current dividend, and a safe and consistent 8% yield has a place in my portfolio until the market turns and the REIT begins to grow again.
Live Oak’s dividend (currently yielding 0.35%) is certainly lower than the two REITs in this article, but its appeal as a value play may still be worth it. With REITs, you are betting on the status quo; with Live Oak, you bet on the future.
Live Oak is an online bank specializing in loans backed by the Small Business Administration (SBA). The bank can sell the secured portion of these loans (usually around 70% of the loan value) and collect a premium on the sale.
Rising interest rates put an end to this activity. The Bank sold $211 million in SBA loans in Q1 2022 and got a 10% premium and $50 million, at an 8% premium, in Q2 2022. That’s a 73% drop . The market reacted and the stock fell to $34 per share from a high of around $100 last year.
The market is right in the near term, but rates will eventually stabilize and small businesses across the United States will be ready to refinance maturing conventional commercial loans with lump sum payments, and Live Oak will stand ready to offer them. SBA loans. When that happens, revenue will grow and hopefully the dividend will follow.