Produced by The Belgian Dentist for The Income Strategist
My coverage of mREITs goes back to my first days writing on Seeking Alpha. Over the years, however, I expanded my coverage and in so doing, ended focusing on only a few select mREITs that I thought were well managed and fit well into my diversified portfolio within the ‘high yield’ bucket – even though the underlying mortgages these mREITs invest in are highly rated credits and backed by the US government – at least for now.
Over the last few years, with expectations that rates will rise, I shifted my focus to Blackstone Mortgage Trust (BXMT) which implements a model that benefits from rising rates. Now that rates are expected to decline – on the short end – and the yield curve will presumably steepen – it’s time to shift back over to more traditional mREITs.
While equity REITs invest in physical properties, mortgage REITs invest in mortgages or mortgage-backed securities (MBS), making them real estate debt owners. Mortgage REITs typically derive their returns from the income produced by the mortgages in their portfolio as well as changes in the mortgages’ net present values. This is not dissimilar to equity REITs, which derive their returns from rents paid by tenants and the changes in its properties’ valuations.
Mortgage REITs acquire mortgages, which generally have long maturity terms, such as 15 or 30 years. They finance the purchase of these with short-term debt, which generally comes with a lower interest rate than the mortgages pay. For example, if a mortgage REIT buys a 15-year mortgage that pays 3% per year and finances it with debt that costs 2% per year, the 1% spread represents the profit. The wider this spread, generally the more profitable it is for the mortgage REIT.
Of course, shareholders aren’t interested in earning a 1% or 2% return, so these companies use a great deal of leverage to boost returns.
One could say that mortgage REITs resemble bank in certain ways, that also use short-term funding (besides equity) to give long-term loans and earn the spread. Mortgage REITs focus solely on mortgages while the bank’s loans are more diversified. A point of note is that leverage in a bank is even higher than that of mortgage REITs.
Despite falling under the REIT umbrella, mortgage REITs are often analyzed separately from equity REITs due to differences in asset bases, business models, and funding profiles. In this vein, the Global Industry Classification Standard (GICS) classifies equity REITs in the ‘Real Estate’ sector, while mortgage REITs land in the ‘Financials’ sector.
Both Financials and mortgage REITs tend to benefit from a steepening yield curve.
The Fed will cut interest rates
For investors, the focus is now on how the Federal Reserve responds to falling inflation expectations. Exhibit 1 shows long-term inflation expectations versus the fed funds rate. Historically, when long-term inflation expectations converge with the fed funds rate, it has been a signal that current monetary policy is too tight and rate cuts are imminent.
Exhibit 1: Fed funds rate vs. inflation expectations
Furthermore, when the Fed begins cutting interest rates, it is difficult to stop. Over the last 30 years, whenever the Fed has cut rates, it has followed it up with another rate cut within six months 81% of the time. As we said before, lower short-term rates are benefits for mortgage REITs, as are higher long-term rates.
Forward markets imply that the U.S. curve will twist-steepen over the next year: that is, yields at the front end will fall precipitously as the Fed delivers cuts, while rates on 10-year notes and longer maturities will creep higher.
Exhibit 2: Forward markets
So, this is double good news for mortgage REITs.
Mortgage REITs have been under pressure for several months thanks to flattening yield curve, which by some measures has inverted.
Exhibit 3: Mortgage REIT performance
The expected opposite move – yield curve steepening – will benefit mortgage REITs.
The Fed cutting rates helps mortgage REITs
In exhibit 4, we show the performance of Annaly Capital Management (NLY) versus the price of Eurodollar contracts. Both have tended to rally when the Fed is cutting interest rates. Note that Eurodollar contracts rise in price when interest rates fall.
Exhibit 4: Mortgage REITs when Fed is cutting rates
The Fed cutting rates helps mortgage REITs in several ways. Falling short-term interest rates lowers the cost to fund the mortgages in which the REITs are invested.
Also, falling interest rates often lead home-owners to refinance their mortgages, which means paying off that mortgage at par value. Even with this refinancing, a mortgage REIT’s portfolio of mortgages still has a longer duration than that of the money it borrows to finance its ownership of mortgages. This can lead to a rising asset value of the company’s portfolio of mortgages. This explains why NLY performed so strongly into the teeth of the 2000-2002 recession and the global financial crisis that ended in 2009. These drivers can combine to create expanding valuations.
Exhibit 5 shows how the price/book ratio of Annaly Capital Management expanded during 2000-2002 when the Fed was cutting rates and very few investments prospered.
Exhibit 5: Mortgage REITs when Fed is cutting rates
A quick look at historical returns reveals that you shouldn’t invest in mortgage REITs for price appreciation. It’s all about the yield. I’m been involved in sometimes ‘heated’ debates about mREITs when some readers have highlighted the historical price declines of mREITs and called them money-losing investments, without looking at the impact that dividends had on total returns.
The chart below shows a perfect example of this concept. Notice that over the last 5 years, the Vanguard Real Estate ETF (VNQ) returned 43%, while Annaly Capital provided a total return of 40%. But the price of Annaly was down 20% during that period. An investor looking at their statements will see a ‘losing’ investment, when in fact, the position actually provided a decent return over the period. Don’t fall into this trap. The double-digit yields offer quite a bit of protection against price declines.
Exhibit 6: Historical returns
The table below reiterates that point. Notice the difference between price returns and total returns.
After trading at 10-20% discounts over 2016 and 2017, residential mortgage REITs now trade near or above book value, while commercial mortgage REITs continue to benefit from a healthy 10%+ premium to book value.
Exhibit 7: Price to book value
While the pace of mortgage REIT issuance has slowed since 2014, high quality mortgage REITs trading above book value have been able to tap equity markets on a consistent basis.
Exhibit 8: Healthy capital raising
As we said before, dividends make up the bulk of total returns for mortgage REITs. And dividend yields are clearly rising.
Exhibit 9: Dividend yield
Comparing mortgage REIT dividend yields with other high yielding alternatives, we can see from the chart below that mREITs certainly lead the way when it comes to providing investors with a high income alternative.
Exhibit 10: Dividend Yield Comparison
If we look forward, we might conclude that short-term rates are more likely to decline and that the yield curve is more likely to steepen. That would be positive for mortgage REITs, as we stated earlier in this article and in a previous article called Income Strategies for an Inverted Yield Curve. We don’t know when this yield curve steepening will happen, but, in the meantime, you get paid a nice dividend yield while waiting.
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