Thousands of words have been dedicated to explaining Warren Buffett’s investment strategy over the years, both by the legendary investor himself and others. All of that, however, can be boiled down to one advice: buy quality businesses at reasonable prices. Put differently, you want to buy a sound business that will last while not overpaying for it.
Let’s look at two Real Estate Investment Trusts (REITs), Rithm Capital (RITM -2.85%) and Medical Properties Trust (MPW -3.33%), and a bank, Live Oak Bancshares (LOB -5.86%) They not only qualify as Buffett stocks but also sport a nice dividend yield the future prospects to allow you to make $500 a year in passive income if you split an investment of $10,000 equally between the three.
Rithm Capital is a unique type of REIT. Unlike other REITs, it doesn’t 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 the good times, this is a great business. mREITs earn the same spread on interest rates that banks and other financial institutions do, but they do it without spending millions (or even billions) on brick-and-mortar 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 get into a pickle where they need to refinance the short-term debt used to purchase their investments (usually mortgages with 15- or 30-year terms). Still, those investments pay a lower interest rate than the rate on new debt.
The market certainly understands this quandary, and Rithm currently trades for just 0.74 times book value, well below its five-year average of just under book.
Rithm compensates for interest rate risk with mortgage servicing rights. The company that owns the right to service a mortgage collects payments, manages the escrow account, and does other administrative tasks. It then collects a fee from the institution that owns the loan.
When interest rates go up, the value of mortgage servicing rights goes up. This is because it is less likely that the borrower will refinance out of the mortgage (which would make the right worthless). Rithm owns mortgage servicing rights on $623 billion worth of 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 won’t be going away anytime soon. Still, it has the elasticity of demand to raise prices along with inflation — and Medical Properties Trust bakes in escalations to its leases to increase revenue steadily over time.
It’s also a value. The REIT trades for just below book value because investors are worried that increased interest rates will slow its expansion and make it difficult for the REIT to refinance existing debt. The price drop has pushed its dividend yield up close to 7%. A reversion to its five-year average price-to-book value would mean a 50% gain from current prices.
The question, for investors, is whether the interest rate fears are legitimate. As far as the debt part of the question goes, the answer is probably no. Just 25% of the REIT’s debt comes due before 2026, and another 25% doesn’t come due until 2029 or later. There is plenty of time to come up with a plan by then if interest rates are far above current levels.
As far as growth goes, my answer is that it doesn’t matter. The REIT has plenty of cash flow to meet its current dividend, and a safe, consistent 8% return has a place in my portfolio while I wait for the market to turn and the REIT to start growing again.
Live Oak’s dividend (currently a 0.35% yield) is certainly lower than the two REITs in this article, but its attractiveness as a value play may still make it worth it. With the REITs, you’re betting on the status quo; with Live Oak, you’re betting on the future.
Live Oak is an internet bank that specializes in loans guaranteed by the Small Business Administration (SBA). The bank can sell the guaranteed portion of these loans (typically around 70% of the value of the loan) and earn a premium from the sale.
The rising interest rate environment has shut that business down. The Bank sold $211 million worth of SBA loans in the first quarter of 2022 and earned a premium of 10% and $50 million, at a premium of 8%, in Q2 2022. That’s a drop of 73%. The market responded and the stock is down to $34 per share from a high of around $100 last year.
The market is right in the short term, but eventually rates will stabilize and small businesses across the U.S. will be ready to refinance conventional business loans coming due with balloon payments, and Live Oak will be standing by to offer SBA loans to them. When that happens, revenues will rise and hopefully the dividend will follow.