Cherry Hill: Attractive mREIT On Strong Yield & Low Valuation

~ by Snehasish Chaudhuri, MBA (Finance)

Cherry Hill Mortgage Investment Corporation (NYSE:CHMI) is a small-scale real estate investment trust (REIT) that invests in residential mortgage assets to generate strong current yields through dividend distributions. CHMI also aims to generate capital appreciation for its investors in the long term. The company recorded an extremely high yield of almost 16 percent. The high level of inflation and uncertain macroeconomic situation (primarily a likely rescission) that resulted from the Covid-19 pandemic and Russia’s invasion of Ukraine have resulted in high volatility, and currently CHMI is trading at an extremely low price. This creates a good opportunity for its investors to earn stable and high returns over a longer time horizon.

An Overview of Cherry Hill Mortgage Investment Corporation

Incorporated in 2012 in New Jersey, Cherry Hill Mortgage Investment Corporation generates interest income through servicing mortgage loans. It acquires, invests in, and manages residential mortgages in the United States. The company emphasizes on originating long term assets and a significant proportion of the company’s current portfolio includes 30-year Agency residential mortgage-backed securities (RMBS). However, a year ago, CHMI’s management started a small restructuring of its assets. The company has paired those RMBS with Mortgage servicing rights (MSRs).

Agency RMBS is constructed by government backed agencies, namely Government National Mortgage Association (Ginnie Mae), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). These agencies originate a large number of residential loans, and then package them together into a single pool of loans. After that these agencies sell bonds backed by this pool of loans. The payments on these loans are shared with those bond investors. Those agencies keep a fee for the management of the pool of loans, and the risks of default on these mortgages are shared by both these agencies and investors.

MSRs, on the other hand, are sold by a mortgage originator to a mortgage administrator, which administers the mortgage and collects the payments. The original lender pays the servicer a fee for performing this work, and the mortgagor remains unaffected. MSR assets are financed by a combination of revolving credit facilities, repurchase agreements, and collateralized securitization transactions. MSR assets thus provide a hedge to CHMI’s portfolio of Agency RMBS, hedging both interest rate and mortgage spread risk, and moderating the full impact of spread widening in Agency RMBS.

Is 16 percent Yield Sustainable?

Cherry Hill Mortgage Investment Corporation has a stable and robust dividend policy, but due to the covid-19 pandemic crisis, the mREIT had to reduce its pay-out. As the company is reporting increased profit per share, I am hopeful that the company will increase its pay-out. A dividend yield of 16 percent is already extremely attractive for income seeking investors. An increased pay-out will obviously enhance the yield. However, the price will increase, and the yield will come down, maybe lower than what it currently is. But the capital gain will help investors generate strong returns. This makes CHMI a strong buy at current price levels.

However, rising cost of borrowings can hamper plans. Rising interest rates generally result in lower demand for mortgage loans. Issuance of fewer mortgage loans will reduce its capacity to acquire assets that meet its investment goals. Also, the target assets issued by CHMI prior to interest rate hikes may also generate lower yields than they are offering at present. The company has the option of hedging this interest rate; however, the cost of such hedging might become a burden for such a micro-cap REIT. For reference, Cherry Hill Mortgage Investment Corporation has a market capitalization of only $101 million.

Valuation and Risks

Low market capitalization means low share price. Cherry Hill Mortgage Investment Corporation is trading around $5, almost near the pandemic period price. Prices dropped by almost 44 percent during the past 1 year, primarily due to the concern over interest rate hikes, high inflation, sky-high food prices, and looming recession. However, it’s also true that the company was not able to recover from the pandemic shock during the past 30 months. CHMI used to trade within a range of $15 to $20 prior to covid-19 pandemic, which has come down to a range between $5 and $10 post pandemic.

Even by post-pandemic trends too, the stock is a bit undervalued. CHMI is trading at a Price/Book (P/B) multiple of 0.74 and Price/Cash Flow (P/CF) multiple of 1.88. Price/Earnings (P/E) ratio is currently a bit high at 16.65, primarily due to a low earnings per share (EPS) of $0.31. But, considering Seeking Alpha’s forward EPS of 1.19, the forward P/E will come down to 4.2. In my opinion, CHMI has an attractive valuation, and its 16 percent yield makes it further lucrative. However, investors should also consider the inherent risk of investing in Cherry Hill Mortgage Investment Corporation.

Investment Thesis

Recession and sustained high level of inflation are the prime factors that will determine the future course of action for Cherry Hill Mortgage Investment Corporation, and the mREIT has been preparing itself for the worst possible scenario. The company’s portfolio is quite stable with some minor tweaking. This residential mortgage REIT is strengthening its RMBS portfolio and trying to be more constructive on agency mortgage spreads. Its strategy of pairing agency RMBS with agency MSRs is helping CHMI mitigate risks.

Cherry Hill Mortgage Investment Corporation most likely will not be able to sustain the current yield of 16 percent, in case the price shoots up. However, that will be compensated from the capital gains. The yield may decline even if the price doesn’t rise – that is due to decreased pay-out, resulting from lower earnings, in case the recession hits hard. But, as CHMI is trading at an extremely low price, even a 30 percent reduction in pay-out will still enable the investors to earn double-digit yield, provided the price remains stable. CHMI currently is trading around $5, and thus provides an attractive option to investors to earn stable and high returns over a longer time horizon.

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