Sachem Capital: Disciplined Real Estate Lender

 

PRIME SERIES

 

·        ‘Hard money’ loans are a little known, but fast-growing corner of short-term lending in the U.S. real estate market, which is showing signs of a strong recovery in 2022.

·         Real estate lender Sachem Capital is leveraging access to public securities markets as a route to finance expansion through both debt and equity capital.

·         Armed with a new streamlined underwriting platform, Sachem is gaining a foothold in new loan markets from Maine to Florida and even Texas, where real estate activity is flourishing.

·         Sachem earns enviable returns over 11% on its portfolio of short-term real estate loans, driving growth in interest revenue and fueling cash flows for dividends.

·         Sachem offers alternatives for investors to play the ‘hard money’ loan market:  an undervalued common stock with a forward dividend yield near 10%, redeemable preferred stock with a 7.75% dividend, and several publicly traded note issues with a range of coupon rates from 6.0% to 7.75%.

 

Sachem Capital (SACH:  Nasdaq) provides capital to real estate developers needing short-term financing to facilitate residential and commercial projects.  Sometimes called ‘hard money’ loans, Sachem helps developers with property acquisitions, construction, renovation, or rehabilitation.  The company has a lengthy history in Connecticut and has found early success in expanding to other states, including New York, New Jersey, Virginia, Florida, and Texas, among other markets in the Northeast and mid-Atlantic regions of the U.S.

The securities of Sachem Capital provide interesting vehicles to play a relatively unknown corner of the real estate lending market.  It is worthwhile for investors to explore the world of ‘hard money’ and get acquainted with Sachem Capital’s position in it.  

 Growth in Real Estate Lending

Investors may be understandably a bit hazy on the private lending market.  It is after all ‘private’ and characterized by close relationships between lenders and borrowers.  In the hard money corner of the private lending sector, usually a single lender works with a developer or builder that needs financing for a residential or commercial project.  A time-consuming, conventional bank loan may not work.  Sometimes rather cavalierly referenced as ‘fix and flip’ or ‘non-prime bridge’ loans, a hard money loan can be quickly arranged.  Based primarily on the value of the property and less on creditworthiness of the borrower, no one save the two sides know the loan details.  Consequently, the aggregate size and composition of the hard money lending market remains opaque.

The Wall Street Journal has reported that residential hard money loans may represent as much as 10% of residential real estate annual debt originations.  According to ATTOM, a property database, after a dismal pandemic-threatened experience in 2020, residential real estate recovered in 2021 to a record $482.6 billion in new loans originated.  This suggests the nationwide residential hard money loan market opportunity could be near $4.8 billion. 

The Mortgage Bankers Association (MBA) tracks the commercial real estate lending market and estimates that loan originations sank to $409.2 billion in 2020 as policies to fight the coronavirus pandemic cut into business activity.  However, in 2021, developers were able to resume regular business activity as the spread of COVID-19 has slowed, boosting commercial real estate lending. The MBA reported that mortgage loan originations were 79% higher in the fourth quarter of 2021 compared to the year-ago quarter, and increased 44% sequentially.  The MBA expects the final loan volumes in the year 2021, will demonstrate record improvement near 67% over 2020.     Even though no reliable figures are available, it is logical that hard money lending is also growing at a pace similar to the broader real estate market. 

Ready to Grab Market Share

Favorable trends in real estate lending have not gone unnoticed by Sachem leadership.  The Company has laid the ground work to move aggressively in its target markets.

Mid-2021, Sachem Capital adopted a new underwriting model to automate loan documentation.  The new process makes it possible to better serve borrowers with a more accurate and accelerated process.  The new model could also boost profit margins by facilitating an increase in loan production without having to add personnel. 

Perhaps more importantly, Sachem took on new capital to fill its loan war chest.  In June 2021, the Company sold a total of 1.70 million shares of preferred stock with a 7.75% dividend, raising $45.5 million in new capital net of fees.  Sachem also sold a total of 6.10 million shares of common stock in the first nine months of 2021, pursuant to a shelf registration statement.  The at-the-market offerings yielded $30.88 million in new capital and brought total shares outstanding to 29.4 million by early October 2021.

More recently the Company raised capital by floating two new note offerings.  In early December 2021, Sachem raised $43.3 million in net proceeds from the sale of 6.0% notes due in 2026 and then in March 2022, an additional $48.2 million net of fees was received from the sale of 6.0% notes due in 2027.  Based on a cash balance of $19.2 million at the end of September 2021, the pro forma cash resources are now $110.7 million.  If Sachem’s corporate back gets pushed against a wall, an additional $56.1 million in financial securities could be converted to cash as well.            

Expansion into New Markets

Fortified with new capital to lend, Sachem leadership has laid out a strategy to win new customers in lucrative markets.  Local markets are screened for robust economic conditions with strong job creation and employment opportunities.  Sachem loan representatives pour over real estate transfer data county by county, the foot prints of a robust real estate market.  They also look for evidence of household creation such as house construction or renovation permits. 

Sachem uses a network of contacts among real estate professionals to reach borrowers.  The Company has also placed direct sales personnel in Austin, Texas and Naples, Florida, two real estate markets that have shown particular strength in recent years.  Of course, there is a direct sales effort run out of the Company’s headquarters in Connecticut. 

The Sachem pitch to borrowers emphasizes flexible loan structures to meet their needs and capacity to close loans quickly, sometimes in just five business days.  The Company can brag about a strong loan track record, with over 1,500 loans made in twelve states.  Sachem also offers competitive rates, sometimes as low as 7.0%.  This compares to interest rates in a range of 9% to 14% disclosed by the one other hard money lender that also publicly reports its financial results, Manhattan Bridge Capital (LOAN).      

Competitive Tactics

Sachem’s loan officers seek out builders with residential or commerical building projects.  New construction loans represent about 15% of the Company’s loan portfolio.  More often Sachem pursues developers with property to renovate and resell, offering a ‘fix and resell’ loan.  Other borrowers just need a short-term loan as a ‘bridge’ to long-term financing from a bank or mortgage lender for purchase of an existing property.  Quickly arranged short-term financing can make a difference in winning bids in a hot property market.    

About a third of Sachem’s loans are made to repeat borrowers, who have come to appreciate a strong relationship with the Company.  However, in new markets, Sachem sales personnel must win a customer away from a broad mix of alternative lenders. 

The short-term real estate loan market is highly fragmented, with numerous hard money lenders operating in local markets.  In 2019, the American Association of Private Lenders (AAPL) estimated there were at least 8,300 hard money lenders in the U.S.  AAPL suggests most of them are targeting the ‘home flipping’ market. 

New players are also entering the field for short-term real estate loans. For example, private equity funds are looking for higher yield alternatives to syndicated real estate loans.  Experience with private lending has provided such funds a vantage point to migrate into hard money loans with real estate as collateral.       

Undeterred by the crowd, Sachem leadership is focused on loan quality, targeting more experienced, stable developers that might need larger size loans.  The average loan size of Sachem’s current loan portfolio is $434,000.  Underlying properties used as large loan collateral may be less susceptible to value changes.  To mitigate interest rate risk on larger loans, Sachem keeps the term to one-year and allows renewals for borrowers that need a longer duration.  This approach may also allow Sachem a means to present a differentiated profile to prospective clients.

Profit Potential

What attracts so many lenders to the table?  In a nutshell, it is spread  -  the difference between lending rates and cost of capital.  At the time of its last financial report filed in November 2021, Sachem reported earning 11.92% on its loan portfolio in the first nine months of 2021, while its cost of capital was near 7.40%.  Sachem’s 4.52% spread appears enviable compared to bank interest rate spreads.  For example, according to the St. Louis Federal Reserve Bank, spreads on high-yield corporate bank loans remained well below 4.0% throughout 2021, rising only in late February 2022, as a consequence of macroeconomic conditions.

Nonetheless, preads could compress over the next few years as the Federal Reserve shifts policies on its benchmark lending rate and the composition of its bond portfolio.  Indeed, Sachem has already reported a reduction in portfolio returns to 11.92% in the first nine months of 2021 compared to 12.28% in the prior year.       

Economic trends notwithstanding, to wring the most return from its capital, Sachem follows a disciplined lending approach.  Like most hard money lenders, the Company’s loan term is typically less than three years. At the end of September 2021, more than two thirds of the loan portfolio was due in 2022 and just 1.1% had lengthier maturities.  

Another element of Sachem’s lending practices is interest charges.  The interest rates represented in its current portfolio fall in a range of 5.0% to 14.2%, although the Company advertises rates as low as 7.0%.  Of course, this is Sachem’s primary source of revenue.  Interest income from loans totaled $6.1 million in the quarter ending September 2021, bringing total interest income for the first nine months of 2021, to $15.3 million.  Interest income grew 59.4% over the prior year and it is likely that when the Company next reports financial results, comparison of the full year 2021 will demonstrate similar growth. 

The Company manages risk in its loan portfolio with a strict policy capping the loan-to-value ratio at 70%.  All of Sachem’s loans are made on a first lien basis so borrowers must themselves invest cash at least 30% of the project value.  In combination, the two requirements help attract only the strongest and most financially committed borrowers and give Sachem a favorable position to recover in the event of default.  

At the time of Sachem’s last quarter report filed with the SEC, eight loans in Sachem’s portfolio were subject to collection or some kind of legal action.  That represented about 0.4% of the portfolio’s dollar value.  While late payments or even default represents an interruption in the planned loan cash flow, it does not mean Sachem will lose the money it loaned out.   Since the Company strict loan-to-value policy, the loan collateral typically exceeds the amount due.  The Company can and has taken property in default events.

Growth Goals

The need for ready capital drove Sachem’s leadership to the public capital markets, floating first a public common stock in 2017, then a Series A preferred stock in 2021and more recently publicly traded notes.  In a recent conversation, management suggested access to public capital markets access could support a loan portfolio in the $600 million to $700 million range.

It is an ambitious growth goal, but perhaps plausible.  Most of its competitors are privately-held hard money lenders that must rely on internal cash flows for new capital.  That means expansion is limited to recent profits, limiting the lender’s ability to compete for new business.  Some of the new entrants to short-term real estate lending are getting capital from institutional investors.  An example, is Roc360 and its infusion of $2 billion in cash from insurer Athene Holding Ltd. (ATH:  NYQ).   Unfortunately, capital from an investment fund or insurance company, that are ultimately subject to unpredictable investor redemptions, could be unstable and negatively impact the short-term lenders’ competitive position.    

Sachem’s capability to compete aggressively for new business is aided by access to a line of low-cost revolving bank credit.  With an interest rate equal to 1.75% below prime rate, the line provides the Company with an attractive marginal borrowing rate to support its lending decisions in the short term.  Management can also sell its loans under a master repurchase financing facility established with a New York-based real estate investment firm.  Sachem has yet to sell any of its loans, but the ability to ‘put’ loans to a third-party provides the Company with important flexibility to manage its loan portfolio.

On a pro forma basis following the recent issuance of notes, debt represents 56% of Sachem’s capital structure with equity at 33% and preferred stock at 11%.  The Company’s pro forma cost of capital is near 6.2%.  Ultimately, Sachem leadership would like to reach a capital structure composed exclusively of equity.  At the current stock price, equity has an implied cost near 5.9%  -  presently the Company’s lowest-cost capital source.  

Conclusion:  Ways to Play

Common Stock.  Investors ready for a stake in Sachem’s hard money lending success have the obvious equity play through the Company’s common stock.  Sachem Capital is organized as a REIT (real estate investment trust), mandating a 90% minimum payout policy.  Consequently, Sachem is expected to pay out $0.48 per share over the next year.  At the current stock price, the forward dividend yield is 10.0%.

If yield alone is not enough to entice investors, some encouragement may come from a comparison of how the market is pricing Sachem’s earnings with what shareholders are getting through growth from reinvested earnings.  The comparison is made by using the price-earnings ratio and the earnings growth rate -  Price-Earnings to Growth Rate or PEG ratio.  A PEG ratio greater than 1.0 means the stock is overvalued and less than 1.0 undervalued.

Of course, the usual price-earnings to growth rate or PEG ratio is not the right measure for a REIT like Sachem.  Instead, PEGY is needed, that is the ratio of Price Earnings to Growth Rate Plus Yield.  The following are the relevant metrics:  PE of 11.44 and forward dividend yield of 10.0% as of 3/11/22; earnings growth rate of 4.88% in the 12 months ending 9/30/21.  At the current price, PEGY equals 0.77, suggesting SACH is in the bargain bin.  

Debt and Preferred.  For investors needing a fixed cash flow on their investment, there are also the Company’s various notes and a preferred stock, all listed on the NYSE American exchange.  There are five notes outstanding offering 7.125% (SCCB), 6.875% (SACC) or 7.75% (SCCC) or 6.00% (SCCD, SCCE) coupon payments and preferred stock with a 7.75% dividend (SACHPRA).  All are trading at small premiums to par value, so realized yields are slightly lower than coupon rates.  

Does Sachem have enough cash flow to pay its interest obligations?  Based on data in the most recently reported quarter ending September 2021, the Company’s interest coverage ratio was 2.20 times (earnings before interest and taxes to interest expenses).  This compares favorably to an average interest coverage ratio of 1.89 for non-bank credit institutions in 2021 as calculated by Ready Ratios, a provider of financial reporting services.

Cautious investors can wait for the Company’s 2021 annual report to observe one more quarter of financial performance.  The report is expected near the end of March 2022, and most likely will underscore SACH as an undervalued common stock and strong support of interest burden on fixed income securities.

 

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

Underwriters of the Prime series may have a beneficial interest in, serve as agents of, or act as advisors to the companies mentioned herein.