Blackstone Mortgage: Now Is Not The Time To Buy (NYSE:BXMT)

Dear readers,

Blackstone Mortgage Trust (NYSE:BXMT) is one of the largest and most well-known mortgage REITs (mREITs) in the world with a $25 Billion loan book. The stock may appeal to investors for many reasons, but the two biggest ones are likely that:

• the fund is managed directly by a very capable Blackstone (BX) team
• and pays a high dividend yield of over 11%

I’ve published three articles on the stock with a total RoR of about 40%. Most recently, in August, I downgraded the stock a HOLD because the valuation became quite stretched after a sharp 30%+ rally and the margin of safety shrank to a point where the market was pricing in default of “only” 5.5% of the portfolio. While that may seem sufficient now, sentiment was very different 6 months ago. Sure enough, the stock price hasn’t moved much since August. And as a result, the S&P 500 (SPX) outperformed the stock by 10% over the period.

Not only has sentiment and especially interest rates changed significantly since last summer, but the company has also given us an additional earnings report (Q3 2023) which didn’t show any major cracks and has maintained its high $0.62 per share quarterly dividend.

Notably, a renowned short seller Muddy Waters has issued a relatively good short report, which raises concern about the ability of borrowers to repay their loans and consequently questions the sustainability of BXMT’s dividend.

How interest rates affect BXMT

High interest rates are a double-edged sword for mortgage REITs.

Because the vast majority of outstanding loans have a floating interest rate, when rates increase, so do BXMT’s interest-related revenues. As a result, everything seems fine in the beginning.

But the thing is that higher interest payments put borrowers under more financial stress and increase the probability of some loans not performing. The risk is particularly high for distressed properties that have vacancy issues. And defaults generally only occur after a significant lag of many quarters, especially if borrowers have hedges in place, which BXMT generally requires (discussed in detail later).

This is why I put so much emphasis on the margin of safety in my previous articles and it is also the reason why mREITs have a terrible track record in a high inflation/high interest rate environment with negative total returns 70% of the time. Unlike equity REITs, mREITs run a business model that isn’t suitable for the high (and volatile) rate environment we find ourselves.

It is true, however, that interest rate expectations have decreased substantially since last summer with the 10-year yield down from 5% to about 4%. Still, rates have a long way to go before we can say that mREITs are out of the woods and all borrowers will easily make their payments.

And some of the 35% of office properties in the portfolio may never make it to that point due to structural vacancy issues. Once again reiterating that an mREIT such as BXMT is only investible at a big enough discount to book value to justify the risk of some write-downs.

Short report concerns

A recent report by Muddy Waters largely confirms my view that despite things looking up today, there are potentially some defaults coming in mid to late 2024 and the dividend may not be as safe as it seems.

They claim that management has been trying to make things seem better than they are by modifying and renegotiating loans that would otherwise be in default. In particular, they estimate that $1.6 Billion of loans, or about 6.3% of the entire loan book have already undergone such changes.

This doesn’t necessarily mean that there’s something shady going on. It’s quite standard for management to try to avoid defaults, even if it means renegotiating a loan with slightly worse terms. As long as it’s done in good faith and there is a reasonable chance that the loan eventually recovers, it’s the right step for shareholders.

What I find more worrying though, is Muddy Water’s claim that absent hedging, many loans may be underwater by a significant margin.

When BXMT underwrites loans, it requires the borrower to enter into interest rate swaps to hedge their exposure against rate increases. These hedges have proven very valuable over the past couple of years as rates skyrocketed and have been the single biggest reason why we haven’t seen any major defaults or write-offs, yet. But the thing is that a large portion of these swaps is likely to expire in 2024. By Muddy Water’s estimate as much as $16 Billion.

I find this estimate inflated. Swaps are usually done for a period of three years and although 2021 saw peak underwriting activity, I estimate that just above a third of loans may have hedges that expire this year. That’s still $10 Billion of loans. And as hedges expire, they will be near impossible to refinance at a reasonable cost and borrowers will start to feel the full effect of higher interest rates.

I went through Muddy Water’s calculation and find it plausible that absent swaps, many borrowers won’t have the cash flow to cover their debt service. With property values (especially for office) down across the board, that’s recipe for loan defaults.

Margin of safety

BXMT currently trades at $21.30 per share which (adjusted for the CECL reserve of $2.20 per share) corresponds to 0.76x book value.

The company has $19.5 Billion in liabilities and $4.5 Billion in equity for leverage of 4x.

Therefore the current valuation implicitly assumes that 6% of loans default with zero recovery. This roughly corresponds to the amount on loans with already renegotiated terms through Q3 2023. Though it’s important to note that zero recovery is extremely unlikely and the true implied rate of defaults is closer to 10%.

Takeaway

I’m not nearly as pessimistic as short sellers and wouldn’t recommend shorting BXMT here, because doing so will cost you almost 15% annually in the dividend (which you’ll be liable for when you short) + short fees.

But I don’t see BXMT as a good buying opportunity either.

There is a decent discount to book value, but I see the risk of expiring swaps as very real and wouldn’t be surprised to see defaults pick up in the second half of the year. Given BXMT’s leverage, just a handful of defaults would likely lead to a dividend cut and would quickly burn through the company’s equity position, resulting in severe downside in stock price.

Therefore, I reiterate my HOLD rating here at $21.30 per share.