More room to run
Fears of rising interest rates sparked doubts about mortgage REITs’ prospects, but 2014 started with high hopes. Christopher O’Dea reports.
Perhaps in no other REIT sector is the debate about the timing and magnitude of higher interest rates more starkly illustrated than in mortgage REITs. After all, unlike other sectors, mortgage REITs do not invest in real property but, instead, own various blends of commercial mortgages, commercial mortgage-backed securities, ranging from federal agency insured issues to multi-family CMBS. Some even include distressed loans and other instruments that are more credit sensitive than interest-rate sensitive.
While no single interest rate determines a mortgage REIT’s profitability, owning a range of securities, of course, gives mortgage REITs direct exposure to changes in interest rates across the capital market. In a nutshell, mortgage REITs face a simple business proposition. Mortgage REITs borrow money based on short-term rates and use that money to buy long-term bonds. The greater the gap between short-term borrowing rates and what long-term bonds are yielding, the more profitable a mortgage REIT will be. Given prevailing rates on three-month and 10-year Treasury issues, the spread between the two has almost never been wider in the past 35 years – and the profit margins of mortgage REITs are particularly robust.
Following a drubbing in 2013 as fears of rising interest rates sparked a reconsideration of mortgage REITs’ prospects, the sector carried high expectations into 2014. Michael Widner, a REIT analyst at KBW Bank, for example, projected returns of 20% or more for the sector. On top of the high dividend yields paid by mortgage REITs, the 2013 sell-off left the average mortgage REIT at a 20% discount to the book value of its underlying bond portfolio, Widener says. He forecast a 20%-plus return to come from half of the current discount going away, in combination with ongoing generous yield.
The recovery took hold in the first part of the year. The largest mortgage REIT, Annaly Capital Management (NLY), posted a total return of nearly 20% through the end of April, rebounding from a loss of more than 18% in 2013. Still, Widener notes that Annaly cut its dividend from 35 cents to 30 cents per share in the fourth quarter of 2013. While he warned early in 2014 that further dividend cuts might be on the horizon, Annaly maintained the 30 cents per share rate through the second quarter of 2014. The dividend cuts, says Widener, resulted from the company deleveraging to reduce its interest rate risk, and costs associated with hedging against potential rate increases.
But it is not rates alone that determine returns. What’s more, mortgage REITs are not bond funds, but operating businesses that can use hedging techniques and changes in portfolio strategy to protect themselves from rate increases. In Annaly’s case, about half of its portfolio is hedged, analysts say.
There are several strategies to protect against rising interest rates. New York Mortgage Trust (NYMT), for example, is a hybrid mortgage REIT which invests in mortgage-related and financial assets including multi-family commercial mortgage-backed securities (CMBS), distressed residential mortgage loans, agency residential mortgage-backed securities (RMBS) and agency-issued interest-only strips. In anticipation of rising interest rates and the projected poor performance of agency MBS, New York Mortgage Trust during 2012 and 2013 shifted its capital into less interest-sensitive and more credit-sensitive assets such as CMBS issued for multi-family housing projects. Overall, New York Mortgage Trust has significantly increased its capital allocation to CMBS and distressed residential loans – it allocated just 33% in 2011 compared with an allocation of 69% in 2013 – and significantly decreased its capital allocation to agency securities.
The strategic portfolio shift helped New York Mortgage Trust sustain its quarterly dividend payments at 27 cents per share during 2013, while Annaly Capital cut its dividend three times in 2013 from 45 cents to 30 cents per share. The trust also trades at a premium to book value, a rarity in the mortgage REIT sector.
While many investors were enjoying an extended Fourth of July holiday, Sterne Agee analyst Jason Weaver published a report citing mortgage REITs as an opportunity in the low-growth economic environment – despite widespread expectations that interest rates will rise in the next year or two.
Weaver acknowledges potential issues in the sector, but says that although mortgage REITs are unloved and ignored, they still offer compelling upside following an over-reaction to fears of rising rates during the temper tantrum of 2013. He cites two potential purchases: MFA Financial (MFA), with a 9.8% yield; and Two Harbors Investment Corporation (TWO), with a 10.1% yield.
MFA is a self-advised REIT that owns and manages a portfolio of RMBS primarily secured by pools of hybrid and adjustable-rate mortgage loans on single family residences. Two Harbors also focuses on the residential market, holding agency RMBS, non-Agency RMBS, which are not issued or guaranteed by a US Federal agency, and prime nonconforming residential mortgage loans, credit-sensitive mortgage loans and mortgage servicing rights.
Weaver suggests that current market valuations for the group are implying overly negative outcomes than even the most sharply rising interest rate forecasts might produce, and says it is too early to call the relief rally in mortgage REITs as over. “Despite the impressive rally in MREIT shares to date following the tumultuous decline of 2013, the sector has further to go in our view,” Weaver says. Price-to-book ratios “remain well south of their historical medians even in comparable periods of heightened interest rate volatility, and dividend yields now appear far more sustainable and attractive versus comparable asset classes”, he adds.
Others see structural drivers for an improving outlook for mortgage REITs in the years ahead. In a recent forum at the National Association of Real Estate Investment Trusts, Annaly Capital CEO Wellington Denahan projected a bright future for mortgage REITs. “The REIT market and mortgage REIT sector, in particular, are still in the very early stages of their growth,” she says. Just as equity REITs experienced strong growth following the US savings and loan crisis, “mortgage REITs are going to be an important part of the private capital solution following Fannie Mae and Freddie Mac’s ultimate resolution and the Fed winding down its position” in mortgage securities.