Mortgage REITs (mREITs) provide liquidity to the real estate market by purchasing residential and commercial mortgages. They finance their mortgage assets with equity and short-term debt using high leverage and earn from the net interest margin (i.e., the spread of mortgage interest rate and funding cost). Although trading as common stocks, mortgage REITs have a low correlation with other equities and pay out high dividends, as they are required to distribute more than 90% of income to investors to benefit from tax exemption at trust level.
Many utilize the FTSE Nareit Mortgage REITs Index, which is comprised of 40 mREITs including about 70% residential and 30% commercial in market cap. Most residential mREITs invest in fixed rate agency mortgage-backed securities (MBS), which are exposed to prepayment risk while having limited credit risk. A few invest in non-agency residential mortgage-backed securities, residential mortgage loans and mortgage service rights (MSR). Commercial mREITS mostly invest in commercial mortgages, commercial real estate loans and commercial mortgage-backed securities (CMBS); therefore, shielding them from prepayment risk.
Mortgage REITs have had relatively strong performance so far this year. A few factors have contributed to this performance:
Lower rate volatility is an important contributor for residential mREITs. Since MBS are exposed to prepayment risk, they have negative convexity and a short volatility feature. Historically, interest rate volatility has seen a high correlation with returns of mREITs. Current swaption volatility is at post-taper tantrum (2013) level lows, which boosted mREITs’ performance.
Steeper yield curve provides mREITs with a favorable environment from three perspectives. First, mREITs’ liability includes a good deal of short-term debt financed through repurchase agreement (repo) markets. Since their assets have a long maturity, they need to roll over their debt frequently to fill the maturity gap. A lower rate in the front end will reduce the funding cost. Last year, due to the Federal Reserve (Fed) tightening and year-end funding pressure, the repo rate elevated to a much higher level, which resulted in a thin margin for mortgage REITs. Beginning this year, the Fed signaled a pause in the hiking cycle and assumed a dovish tone, which soothed repo rates and calmed rising funding costs for a few months.
Second, a flatter yield curve with a lower rate on the long end would suggest higher probability of prepayment, and MBS spreads would widen to compensate investors for the prepayment risk.
Third, a flattening curve may precede a risk-off environment, prompting a lower asset yield and higher rate volatility, which is negative for mREITs.
Wider Libor-Repo spread is a tailwind for mREITs. Some residential mREITs hedge duration risk by entering into payer swaps, which pay fixed rates and receive Libor. Commercial mREITs’ investment in loans receives a floating rate based on Libor. This year’s spread of Libor/repo was wider and enhanced mREITs’ return.
Other contributors include tighter CMBS and credit spreads, solid nonfarm payroll numbers and less liquidity stress. Tighter spreads benefitted commercial mREITs as their asset value increased with lower credit risk. Better-than-expected non-farm payroll releases and improving liquidity conditions compared to last year helped keep a low credit spread and rate-volatility level. Furthermore, sound housing credit with moderate wage growth and low unemployment provide healthy underlying fundamentals for commercial mortgage lenders.
Mortgage REITs have started strong in 2019, primarily led by decreased interest rate volatility, lower funding cost, a steepening yield curve, tighter spreads and solid economic releases. I remain cautious about mortgage REITs’ performance for the rest of 2019, with concerns of higher interest rate volatility later this year.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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