Timbercreek Financial (TF) shares have diverged significantly from peers in recent months, falling over 15% YTD on a total return basis. We believe the selloff represents a widening disconnect between sentiment and fundamentals.

We believe the combination of higher rates, staged loan uncertainty, and dividend cut fears have created selling pressure. Alongside a 4% drop in the share price last week, average daily volume reached the 94th percentile relative to the prior two years. The question we’re asking ourselves is what’s priced in at this point?

To frame it in terms of loan loss expectations, the current P/B multiple of 0.67x implies $217M of impairments assuming a return to TF’s long-term average valuation, which we view as overly punitive.

It’s important to recognize that a healthy mortgage lending business will always have some level of staged loans. A zero staged loan balance would signal overly conservative underwriting standards, meaning the portfolio is under-earning its potential. In TF’s case, management has previously stated that a normal staged loan balance is ~7%.

Using this 7% baseline, we can back into a current “excess” staged loan balance of $171M. As an exercise, assuming a highly punitive nil recovery on the excess balance would result in a book value per share of $5.81, well above today’s share price of $5.26.

As we highlighted in our initiation, we’re not making the case for a full recovery of TF’s staged loans. We believe losses are likely as resolutions are reached and that some level of discount is reasonable to reflect the uncertainty. Our contention is that a $217M implied impairment is overdone, as it represents losses greater than a complete write-off of the excess staged loan balance.

We estimate a potential impairment of $34-57M, materially below the market’s imputed $217M. We arrive at our estimate using a 1.0-1.5% cap rate increase between 2022 and 2026 (sourced from Colliers cap rate reports; Vancouver multifamily), a 1% development spread, and an illiquidity discount among other factors.

Given the magnitude of TF’s book value discount, we suspect the market is pricing in a dividend cut in addition to impairments. Comparing current trading levels to TF’s 10-year average yield premium over 2Y GoC bonds would imply a 26% dividend reduction.

Adjusting for changes to the yield premium in TF’s peer group (which has compressed), one could argue the market is pricing in a more aggressive dividend cut of >30%.

On the prospect of a cut we’d note that TF has maintained a consistent dividend since going public (even during the 2023/24 challenges), supported by distributable income that fully covers the payment. With management declaring monthly dividends until the end of 2026, we believe there’s been no change in confidence around the portfolio’s earnings power.

We’d also note that unlike companies changing their capital allocation strategy, a Mortgage Investment Corporation (MIC) like TF pays out everything by design. A MIC pays no corporate tax because it distributes all income to shareholders, incentivizing a continued 100% payout structure regardless of the base dividend level. Were TF to retain income, it would be taxed at the ordinary corporate rate, reducing shareholder returns accordingly.

It seems investors are waiting for detail on the magnitude of loan impairments that the market can underwrite - which we believe is likely to come over the next few quarters. In its Q2 call, management stated the following about their excess staged balances:

We expect these resolutions will come with modest impairment totals relative to what’s currently priced, representing potential share price upside. Resolutions should also ease speculation on the dividend policy, as focus shifts toward the impact of capital moving into performing loans.

We estimate TF will get back >$100M of equity capital post-resolution, driving an EPS uplift of roughly $0.06 once redeployed into performing loans. Importantly, any incremental earnings should be paid out to avoid taxation, giving us confidence in the long-term income generating potential of the vehicle.

While there’s near-term uncertainty, we continue to view this dislocation as an opportunity for patient investors, so long as the post-pandemic interest rate volatility behind the initial portfolio stress doesn’t repeat. Recent insider activity could be another positive signal, with Blair Tamblyn (CEO) buying ~$150K in the open market last week.