Mortgage REITs Are Cheap Right Now, But Could Get Even Cheaper

Mortgage REITS, or mREITs, have suffered lately with interest rates finally seeing some life these past few weeks and especially after the Fed’s tapering announcement last Wednesday. To get an idea of how the mREIT sector has performed of late, here are two mREIT ETFs, iShares FTSE NAREIT Mortgage Plus Capped Index Fund REM and Market Vectors Mortgage REIT Income ETF MORT.

Over the past 3 months, REM and MORT have provided shareholders with returns of -18.05% and -19.04%, and 1-month returns of -13.12% and -12.53%, respectively. Clearly, the mREIT sector has been slumping. Here’s why:

Higher Interest Rates, Lower Book Values:

For those of you that don’t know, mortgage REITs deal in investment and ownership of property mortgages. Mortgage REITs either loan money for mortgages to owners of property, or they purchase existing mortgages or mortgage-backed securities (MBS). To receive the funds necessary to make these investments mREITs borrow money that is highly leveraged (7-8x leverage is normal). They then generate profits by receiving the interest that they earned on their mortgage investments, less the interest they must pay on their borrowed funds.

Thus, a large portion of an mREITs balance sheet, or value as a company, stems from the value of their mortgage investments. Since, like bonds, the price of mortgages and related mortgage backed securities are inversely related, mREITs have experienced a large hit to their balance sheets as a result of the higher interest rates the market has experienced lately. A large part in why mortgage REIT stock prices across the sector have plunged this past quarter is because book values have been dropping. As a result, the markets have corrected the prices of mREITs to properly reflect the true value of these balance sheet bombarded stocks.

Since mortgage rates mirror movements in Treasury yields, let’s examine just how violently Treasury yields have fluctuated recently. As reported by the U.S. Treasury’s interest rate statistics page, the 10-year Treasury notes interest rate hit a low this year on May 1 at 1.66%. Yesterday, 10-year Treasury notes closed at a year-to-date high yield of 2.57%. In less than 2 months, the 10-year Treasury notes have seen a 54.82% increase in its yield, a monstrous increase. The 30-year Treasury note has seen a 27.21% increase in the same time period.

Because of the highly levered nature of mortgage REITs, even small changes in interest rates can largely affect the book values of these companies. As if this recent surge in treasury yields and interest rates wasn’t enough, 8x leverage, for example, only magnifies the drop in MBS prices and book values for mREITs.

Credit Suisse Downgrades

In a report published yesterday, Credit Suisse decreased its price targets on 16 mortgage REITs, including American Capital Agency AGNC, Annaly NLY and Armour ARR with an average price target decrease of 9%.

Credit Suisse attributed the price target cuts to declining book values and estimated that book values across the sector dropped 10% on average during the second quarter, “with 5% of that decline coming since the FOMC meeting last Wednesday.”

See the table at the bottom showing Credit Suisse’s estimates of upcoming mREIT book values for the second quarter of this year highlighted in yellow.

Credit Suisse also shed light on extension risk, which pertains to the extended durations on mREITs’ mortgage backed securities. The duration of a security is the sensitivity of that securities market price to changes in interest rates. As interest rates go up, duration increases. As duration increases, the greater the interest-rate risk on those securities. Credit Suisse’s report identified that mortgage REITs have a “need to reduce duration” and can hedge their extension risk on their assets by “extending the duration of [their] liabilities.”

A way for investors to hedge their own risk when buying mREITS is to invest in hybrid REITs, such as Two Harbors TWO and Invesco IVR rather than Agency-only firms. Hybrid REITs are a combination of equity REITs, which invest in physical real-estate properties and mortgage REITs. The combination of these two types of REITs decreases the interest rate risk for investors, while also providing high dividend yields. 

Buying Opportunity?

The Credit Suisse report went on touch upon the current valuation of mREITs within the sector. “The mortgage REITs are trading at a10% discount to our estimate of current book. While we view the sector as cheap relative to current book value, we think it is too soon to broadly buy the sector until we see some stability in rates.”

Yes, mortgage REITs are cheap right now, but there’s a good chance that this under-valuation is justified. If interest rates continue to increase, which they easily could, then we will see even further drops in book values.

Once interest rates stabilize, however, it will present an extremely attractive scenario for buying up some cheap mREIT stocks, especially with the double-digit dividend yields these stocks provide. The tricky part though will be determining when this stabilization of rates will occur.

In the meantime, sit on the sidelines while we wait for some stability in the mREIT sector and in interest rates.