Co-produced with Beyond Saving
It has been a historic year for mortgage REITs (mREITs). In March, we saw unprecedented volatility in the valuations of mortgages and mortgage derivatives like MBS (mortgage-backed securities). This volatility even reached into the world of agency MBS – mortgage securities which have their principal guaranteed by government-sponsored enterprises.
As a result of this volatility, we saw several mREITs receive margin calls. Some were forced to sell assets at poor prices, or even had their collateral seized and sold by the lenders. Others managed to keep their heads above water, but pretty much all of them took a hit to their book values and share prices.
At High Dividend Opportunities, we had some exposure to the sector before March. Primarily in the lesser-hit agency mREITs and in preferred shares. Even among the preferred shares, we saw some preferred dividends suspended as mREITs hunkered down to preserve cash. We advised members to be patient, and that the suspensions would not last long. As it turns out, all of our mREIT preferred shares have announced the resumption of their dividends (and paid the accrued dividends) except for Exantas Capital (XAN) for their preferred series-C (XAN.PC). We expect that XAN-C will resume its dividend in Q3.
As we survey mREITs today, we can see various pockets of opportunities, and a few areas we want to stay away from. While many mREITs were forced to reduce or even suspend dividends due to the March volatility, as we move further out, they will be raising their dividends back up.
Take The Past With A Grain Of Salt
Many tend to look at mREITs like you might a company, looking at trends and expecting that those trends are consistent in the long term. In reality, an mREIT is not building some kind of infrastructure, they are not developing a base of customers, they do not create, sell or lease a product. They are pass-through entities, which take your capital, leverage it up and make an investment. Then they pass on the profits of that investment to shareholders.
An mREIT can go from being horrible one quarter, to being fantastic the next quarter. Their success or failure is going to be determined by the success/failure of their underlying investments and management’s ability to determine the best hedges and how much leverage to use to walk the line between catching the upside and controlling the downside.
Agency mREITs remain our favored sector. These mREITs invest in agency MBS where most of the credit risk – the risk that the underlying mortgages are not paid – are put onto GSEs like Fannie Mae and Freddie Mac.
Agency MBS is considered one of the safest investments around, usually trading in a very strong correlation with US treasuries. This is why it was quite shocking when the March volatility impacted agency MBS.
Looking at the MBS charts, it is easy to see just how out of place the drop was.
Source: Mortgage News Daily
That drop put a lot of strain on mREITs and forced them to de-leverage as the combination of hedging losses and a sharp decline in MBS value pressured their balance sheets.
Agency mREITs make their money by borrowing short-term repurchase agreements. These agreements are usually under 90 days, and so the rates on them are heavily impacted by the Federal Reserve’s target rate. They then buy agency MBS, which yields a premium over the 10-year treasury rate. The mREIT profits from that rate spread.
So when we see the target rate drops to zero, their borrowing costs collapse. This time is no different. Here is a look at repo rates over the past year.
Looking forward, agency mREITs are going to benefit from dramatically lower borrowing costs, while MBS prices went from volatile to incredibly stable. The Federal Reserve has been buying MBS to ensure that the market is stable, and we expect those actions will continue as long as necessary.
Right now, agency mREITs should be trading at a premium to book value like they were prior to March. Yet the market is still shy and March is fresh in everyone’s minds. Another March is unlikely to happen ever – that was the most extreme volatility in MBS including during the housing crisis – it certainly is not likely to happen this year with the Federal Reserve willing to provide near-infinite liquidity.
In general, you want to own agency mREITs when the Federal Reserve’s target rate is low, and be out when the target rate is being increased. As the smoke clears and cooler heads prevail, investors will realize that conditions for agency MBS are fantastic right now. Much better than they have been for years.
We have several agency mREITs in our portfolio. Annaly Capital Management (NLY) is yielding around 13% and is one of our favorites. They will benefit not only from great returns in agency MBS, but they are also internalizing management at terms that are very favorable to shareholders, making NLY a better investment.
Another type of mREIT is those that invest primarily in whole loans. These are a bit different because unlike MBS, there is no liquid market for whole mortgages, which means that estimates of book value can be significantly inflated.
The good news is that whole mortgages have been less impacted by margin calls, as the financing usually is not mark-to-market. However, if the underlying mortgages default, that will directly impact the cash flow of these REITs and it could trigger covenants on the REIT’s debt.
These REITs are likely to continue to struggle as they were forced to realize large losses. It will be a long road to recovery and with dividends slashed, we are not interested in the common shares.
In this sector, we prefer to stick with preferred shares. The preferred shares allow us much lower risk, while still getting a very good dividend. A good example is MFA Financial (MFA), the common shares have seen their book value cut in half. Meanwhile, MFA struck a deal with Apollo Global Management (APO) that raised capital but will result in dilution of current common shareholders.
We are currently recommending MFA Financial, 7.50% Series B Cumulative Redeemable Preferred Stock (MFA.PB) as part of our Preferred Stock Portfolio. The issuing company MFA had to suspend the dividend on the preferred, but per the June 16th earnings call, the accrued dividends will be paid with proceeds from the APO deal. We had to be patient, but the recovery of the preferred has been much faster than the common and we look forward to collecting our dividends in the near future. Source: TradingView — 6-month comparison of MFA common and preferred
This is exactly why we spent much of last year recommending to our investment community to move into preferred shares. While they were not immune to the sell-off, our income has been much safer. Even where we saw suspensions, less than 3 months later, we have seen them resumed with missed dividends paid. The suspensions were actually an opportunity to buy at much lower prices.
We had little exposure to diversified commercial mREITs before March. The reason is simple, they were expensive. Commercial mREITs became very popular as they tend to outperform in bull markets when interest rates are generally climbing.
We often see these mREITs have a mixture of MBS, whole loans and even outright owning and leasing properties. Usually, the loans they own are floating rate, which is why they tend to do better when interest rates are on the upswing.
It is going to take some time for this sector to get their legs back and as time goes on, we will keep our eyes open for opportunities. This is a sector we want to be exposed to in the middle of a bull market.
With most businesses currently open, or at least have re-openings scheduled, we expect that mortgage defaults are going to be low relative to prior recessions. Americans have been in a hurry to return to some semblance of normalcy. However, there could be some volatility in the near future. We want exposure in a couple of years, but for right now, we want to be highly selective.
Colony Credit Real Estate (CLNC) is our current pick in the sector. Unlike some of their peers, CLNC did not have any forced selling. They have a reputation – at least on Seeking Alpha – of being “low quality,” however the performance of their assets says otherwise. CLNC collected 99% of interest payments and 95% of rental payments from their net-lease portfolio.
Their portfolio is performing, the impact on their book value was very limited, they were not forced to sell anything at depressed prices and CLNC has not needed to go find a loan shark to provide private debt.
Last month we highlighted how CLNC is trading at a fraction of their book value, and despite gaining 55% in a month, CLNC is still trading at less than 50% of book value. With Ladder Capital (LADR) alum Michael J. Mazzei the newly minted CEO of CLNC, we look forward to further improvement. CLNC remains the best opportunity in the space today. The dividend is currently suspended, but we anticipate that it will be resumed by Q4. The market is saying that CLNC is “low-quality”, the actual results are saying otherwise. That means a great opportunity.
The mREIT sector is perhaps one of the most misunderstood sectors. Frequently, investors will look at trends and history, but fail to fully understand the underlying investments. The result is that when trends and history look the best, it is often close to the peak for those investments. They end up buying high because this mREIT outperformed the past five years, while selling low because this other mREIT has been a dog that keeps cutting their dividend.
When assessing mREITs, it is crucial to understand the investment the mREIT is making.
Agency mREITs are making a bet based on the interest rate curve. Borrowing short term, and buying long-term investments. So they benefit from the target rate being lowered, and from the 10-year plus being stable or increasing. There is no material credit risk so it is entirely about where treasury rates are.
mREITs that own whole loans and or non-agency MBS are betting on credit risk. They perform best when people pay their bills. Rises in defaults will harm them directly. Add in the risk of the leverage they use, and you have fear of defaults, collapsing prices and lenders demanding payment all at once. It can lead to a very vicious cycle that has historically led to mREIT liquidations or bankruptcies. Fortunately, the March panic was short-lived and we have yet to see significant defaults, so even the worst-hit mREITs are likely to survive. However, most investors should stick to the safer preferred equity level.
For diversified commercial mREITs, they are betting that businesses will pay their mortgages, which historically, they do more often than not. Since their loans are floating rate, they benefit most from a bull market, which creates optimism that businesses will pay their mortgages – increasing the value of the loans – and rising interest rates, allowing them to collect more. This is a sector we have our eyes on, and will buy more of as the risk of credit defaults diminishes and the odds of interest rates rising increase.
Mortgage REITs can provide a number of high dividend opportunities.
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Disclosure: I am/we are long CLNC, NLY, MFA.PB, XAN.PC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Source: Seeking Alpha