Co-authored by Treading Softly
I’ve long been cursed with the inability to picture or visualize how something could look in the future. I’m highly practical and analytical, so my mind thrives on figuring out systems and conducting research. My wife, however, can imagine redesigning our entire living room and living in that space in the future. We complement each other well. She can dream of our retirement together and all we want to do; I can figure out how to make that happen financially.
When it comes to retirement planning, most people have nebulous goals. They’re not practical or down to earth. For example, many people are recommended to simply save $2 million as if retirement is a one-time payment, and after that, there is no cost.
Most approach retirement using the oft-repeated advice of deducting 4% of their portfolio’s value annually, so $2 million turns into $80,000/year to live off of. An income investor can also reproduce this income stream today with a smaller amount of capital, leaving room for added reinvestment or more financial flexibility by applying my Income Method.
Today, I have two excellent picks to help you actively achieve that goal.
Let’s dive in!
Pick #1: ARI – Yield 11.9%
The mortgage REIT sector has been getting a lot of attention recently. Apollo Commercial Real Estate Finance (ARI), yielding 11.9%, is a mortgage REIT that invests in floating-rate commercial mortgages.
They have a mix of mortgages with hotels, office, retail, residential, and more. It is worth noting that ARI‘s mortgages tend to be relatively short-term, with an average term remaining of 2.4 years. 95% of their mortgages are first lien, and when they have a subordinated mortgage, ARI typically owns the senior mortgage as well. Source
This is very typical of what we see with other commercial mortgage REITs. One thing that sets ARI apart from its peers is that it has been active in Europe, with 48% of its portfolio on the other side of the Atlantic, including 54% of its office portfolio.
ARI’s earnings have benefited from rising interest rates. Since it owns floating-rate loans, rising rates have been generally positive for cash flows. Over the past year, ARI’s distributable earnings have covered the dividend by 130%, in a sector where the payout ratio for distributable earnings is typically 90-100%.
In recent quarters, we have seen ARI get more defensive. In Q3 2022, ARI had 67 loans with a carrying value of $8.9 billion and a weighted average yield of 5.1%. Today it has 49 loans with a carrying value of $8.0 billion yielding 8.9%. ARI has fewer loans, with a higher yield. ARI’s debt to equity has declined from 3.0x to 2.8x.
ARI increased its liquidity from $364 million in Q3 2022, to $480 million in Q3 2023. This defensiveness explains when distributable earnings have come down over the course of 2023, even as interest rates went up.
At the end of 2023, we saw ARI’s share price going up with the market’s expectations that interest rates are likely to decline. This seems backward when we look at charts like this showing lower rates equals lower earnings:
Why would the market be happy about declining rates for ARI?
ARI is trading at a large discount to book value. Book value was $14.74 at the end of Q3 before general CECL (Current Expected Credit Loss). So it is trading at a 20%+ discount. The market is fearing large book value losses. Since ARI’s loans are typically intended to be short-term loans, the borrowers will usually pay off a loan they take out either by selling the property to someone else or refinancing it with fixed-rate financing. High interest rates reduce sales activity in the real estate market and reduce values, and they make it more difficult for a borrower to refinance. As a result, even as interest rates have driven earnings higher, the risk of defaults has also risen. Now that interest rates are viewed as declining, the market is getting optimistic that defaults won’t be as bad as previously feared. Borrowers will be more able (and more willing) to refinance at fixed rates.
Our primary concern with mortgage REITs is always the balance sheet. We are happy to see ARI’s leverage below 3.0x, as this provides room for ARI to manage defaulted properties without being cornered into selling them at a bad price. Let’s face it, when you are lending money, sometimes borrowers won’t repay the loan. ARI currently owns and operates three properties, since they are cash-flow positive, ARI has the luxury of selling them when it can get a good price.
Having a strong balance sheet with enough liquidity that ARI can address its own debts, allows it to maximize value when a borrower can’t pay the loan as agreed.
We were buyers of ARI throughout 2023, and we are buyers today with the 20%+ discount to book value at an attractive price.
Pick #2: NEP – Yield 13.3%
NextEra Energy Partners (NEP) was once a Value stock that traded like a Growth stock. Green energy was all the rage, and NEP was able to leverage its high valuation to issue equity at high prices and sustain a double-digit distribution growth rate. Growth investors piled in, and NEP frequently traded with what I considered an uninvestible yield. Then, NEP committed the greatest sin any “growth” stock can do: it slashed forward guidance. The price crashed, and the yield soared. Within a year, NEP went from Growth darling to deep value.
Since then, NEP has successfully refinanced their due debt, albeit at a higher rate, and completed the sale of its Texas natural gas pipeline to Kinder Morgan (KMI). Both of these actions show that management is successfully managing their plan to avoid issuing equity at a poor price while handling its debt burden
We expect, looking forward, as interest rate pressures alleviate when they start to fall, either this year or next, that NEP will have successfully navigated this period of higher-cost debt.
While dividend growth expectations were severely slashed, we get to enjoy a double-digit yield that is primarily paid out as “return of capital,” which reduces one’s cost basis and defers taxation until the time that they sell. This favorable tax treatment is only possible because of their large depreciating assets that the IRS requires to be depreciated in an orderly manner, even if the assets are not losing value, along with the recognition of tax credits meant to encourage the development of green energy.
Utilities as a whole have been heavily punished due to rising interest rates. We see this abating as interest rates begin to fall, and we’re happy to collect double-digit yields from NEP as we wait for that to occur.
With NEP and ARI, We can enjoy extremely well-covered, generous, double-digit yields. Both of these companies can provide these yields because their sector is either being down or misunderstood. Neither one of these yields will stay this high forever because, as the economic conditions shift or investors’ understanding of them becomes fuller, both these companies’ share prices are expected to climb, thus reducing the yield. Today, you can enjoy double-digit yields, as well as future capital gains.
When it comes to retirement, you must have practical goals that help you achieve your grand vision. For my wife and I, she is the grand visionary, visualizing what she thinks our retirement will look like, and I’m the practical one, developing my Income Method to make that possible. You can have the same income stream as somebody who has $2 million in their retirement portfolio and is only withdrawing 4% a year. With a diversified portfolio of high-income producers such as these two picks, it would take less than half of the capital that they have invested to receive the same income stream. And if you have more than half of what they have, that allows reinvestment to grow your dividends going forward.
That’s the beauty of my Income Method. That’s the beauty of income investing.