TRMT: Nano-Cap REIT With Huge Dividend Potential, Huge Risks

Tremont Mortgage Trust (TRMT) is a tiny mortgage REIT with a tiny dividend. However, this company looks very intriguing for a few reasons - most obvious being the combination of extremely low valuation and resilient income generation. Because the company invests in whole loans to commercial properties, the entire portfolio consists of only 14 loans making it easy to take a look under the hood. Some corporate movement further up the chain can potentially serve as a catalyst to generate significant value for shareholders as well.

As with any equity investment, TRMT has its share of risks. The stock price looks far more reasonable when these are taken into perspective (the whole "no free lunch" thing). I will touch on some of the more company-specific risks before closing.

Company can sustain a much higher dividend

Tremont has been paying out a $0.01 quarterly dividend for the past 3 quarters now. That annualizes to a whopping 1.4% yield around the current price of $2.80 per share. Yet, that quarterly rate was cut from $0.22 - or an absurd 32% yield annualized on current price - last paid in January. Management may have been prudent to aggressively cut the dividend (which they had failed to earn Q4) in light of all of the disruption seen from COVID as liquidity is paramount in highly uncertain circumstances. But, any feared deterioration in the company's income has yet to manifest.

Compiled by author from quarterly releases

The share count has remained steady during this time at 8.2M. Also, note that core earnings are essentially the same as net income in this case as, I believe, the only adjustment made is for non-cash equity compensation.

As shown in the table above, Tremont has been able to increase its core earnings over the course of the year, which makes sense given that it has a higher balance of loans outstanding. In normal times, mortgage REITs frequently pay close to their entire core earnings out as dividends and the long run average of this figure is a good proxy for a sustainable dividend.

Because Tremont is structured as a REIT, it will be required to pay out at least 90% of its taxable income (note that this is not the same thing as earnings, which SA readers often seem to assume) to shareholders every year. The dividend reduction will likely force management to increase the final payout declared this calendar year, as acknowledged in the carefully worded quote below:

In July, we declared a $0.01 per share distribution, the second consecutive quarter of a reduced distribution as a result of the economic distress brought on by the COVID-19 pandemic. However, our business continues to perform, and assuming nothing out of the ordinary, we may need to declare an increased distribution in December in order to pay out sufficient taxable income to maintain REIT status. The amount and payment types remain under review and will be determined during the fourth quarter.

CEO David Blackman, Q2 Conference Call

So, we have a stock trading at $2.80 per share that had TTM core earnings of $0.94 - that's one head-turning P/E ratio. The company could support a 30% dividend yield at the current cost and that implies at least 100% upside in a normal environment, even if the company remained significantly discounted (higher yielding) to peers. Unless the pandemic does ravage the company's ability to generate net income, which it has not done so far, this is one of the greatest dividend opportunities I see remaining in the market.

Loan portfolio is risky but performing

Tremont's strategy is to invest in whole commercial loans in the middle market on "transitional real estate." These are not Class A properties in prime locations and liquid markets, nor are they all stable, with a history of cash flow generation to fall back on. These are relatively short-term loans that are, in part, based on using the funding to improve the operating cash flow of the underlying property - not exactly a recession-proof recipe for success. However, two key factors work in Tremont's favor that help mitigate the risks.

• With only 14 total loans, managers can be selective in underwriting and proactive in addressing issues. Tremont operates with a master repurchase facility from Citibank. It essentially has only one counter-party for funding, which, again, simplifies negotiating should it be needed.
• COVID's effect on real estate is hitting urban core markets particularly hard. Retail and hospitality in places like downtown New York, LA, and Chicago are exceptionally challenged. Tremont does not have any exposure to these prime markets and the secondary markets it is in may garner increased attention from urban flight and recover more quickly.

To date, the portfolio has not produced any non-payments and management has not written down any credit losses, but there are some rumbling issues under the surface.

• Coppell, TX retail loan coming due early 2021. The property is not generating sufficient cash flow to cover debt service, but owner has used proceeds from sale of an outparcel to partially pay down the balance
• 6 loans for properties that are not generating sufficient income to cover debt service

The CEO David Blackman noted on the most recent quarterly conference call that the company's capital is now fully committed and it would be singularly focused on portfolio management and working with stressed borrowers rather than new originations going forward. Hopefully, all that focus will allow Tremont to continue to deftly avoid any credit losses going forward.

RMR Group could streamline mREIT vehicles

Tremont is part of the RMR Group's (RMR) family of companies. Some of their investment vehicles have had very poor track records, but they certainly have more reach than the market cap of TRMT would suggest. Their subsidiary, RMR Advisors, manages a fund that recently changed their name and investment strategy.

What is now RMR Mortgage Trust (RMRM) used to focus on investing in the equity of public REITs but will now seek to invest in commercial real estate whole loans in the middle market. That strategy should sound mighty familiar. The fund expects to de-register as an investment company with the SEC and transition to being structured as a mortgage REIT in the first half of next year. More details are available in this company press release.

If there were any doubt that RMR Mortgage Trust is going to end up looking a lot like Tremont, take a look at their first announced loan funding:

RMRM today announced the closing of a $30.0 million first mortgage bridge loan it provided to finance the acquisition of Finley Point, a 223,771 square foot multi-tenant office building located in Downers Grove, IL.

This floating rate loan includes initial funding of approximately $29.5 million and a future funding allowance of approximately $0.5 million for leasing capital. The loan is structured with a 38-month initial term and a one-year extension option, subject to the borrower meeting certain requirements.

This could easily have been a Tremont loan if they had more capital they wanted to deploy.

If RMR is going to have two mREITs pursuing identical strategies, one has to wonder how quickly the push towards combining the businesses to achieve better scale and cost synergies will get underway. I believe that any announced combination of the businesses will highlight the extremely low valuation of TRMT and greatly raise its visibility to investors.

This long-term possibility is something to keep an eye on as a tailwind down the road but is unlikely to realistically move the needle before the much closer catalyst of a dividend catch-up.

Hopefully, I have laid out an investment thesis that is compelling based on the valuation of potential dividends, underlying portfolio performance, and potential long-term corporate strategy of Tremont's parent. Now, for the bad news.

An issue with any of their loans can blow up the equity

Sure, there are all the usual risks that an investment in this industry presents: sensitivity to real estate markets, interest rates, and the need to continually tap financing. But the biggest issue is high leverage and a particular loan on a Texas property mentioned earlier.

The company's market cap is tiny compared to the size of its loan book. Even after cutting the dividend, the company's cash position is not going to cover much in terms of cash flow shortfalls or bringing additional collateral to their repurchase facility. High leverage works wonders in good times, as the company gets to capture the spread between the costs of their funds and the interest received, but in times of stress... well, for starters, this is what happens to the price of your stock:

source: finviz.com

Even if none of Tremont's borrowers' default, they can still try to negotiate reduced repayment rates or extensions on account of their own cash flow woes.

Another potential issue is that borrowers may be unable to repay the loan when the principal comes due. These loans are underwritten based on bringing properties up to plan. If valuations are too deeply impaired, the properties may not be able to produce enough cash in refinancing to pay off the principal. If transaction volumes remain depressed, owners may have to hang on to their properties instead of using sale proceeds to repay Tremont.

The Coppell, TX property, in particular, presents a huge risk. Not only is the property's valuation and cash flow generation probably far lower than anticipated, but the term of the loan ends in a mere 3 months and there will have to be a plan to sell the property, refinance, or extend the loan in place before then.

If you can stomach the risks associated with this nano-cap company, the potential returns are certainly enormous. Much will depend on the ability of a handful of properties to make it through to their next phase of financing without being seriously devalued in the market. If Tremont can navigate through to "normal times" ahead, the company's run-rate of net income can make it a dividend juggernaut based on the current stock price.

Disclosure: I am/we are long TRMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.