Market analysis by our public securities expert, Geoff Shaver
March 26, 2020
Why Has Market Volatility Hit Mortgage REITs so Hard?
by Geoff Shaver
Director of Public Securities
The substantial volatility in the public real estate investment trust (or “REIT”) market over the past several weeks has left several sectors in varying levels of decline from the highs achieved in February 2020. The mortgage REIT sector is one of the sectors that has endured the most pain caused by the economic disruption resulting from the COVID-19 pandemic. As a proxy for the sector’s performance, the iShares Mortgage Real Estate ETF (REM) is down 49% year-to-date on a price-only basis, and that includes a 21% rally on March 26(1).
Why Are Mortgage REITs Vulnerable in Times of Market Distress?
A mortgage REIT (or “mREIT”) is a company that principally invests in debt or mortgages backed by real estate. Typical investments could include commercial mortgage backed securities (or “CMBS”), residential mortgage backed securities (or “RMBS”), whole loans, and even mortgage servicing rights. MBS can consist of hundreds, and in some cases, thousands, of underlying mortgages secured by individual properties. These long-term mortgage securities, which produce an underlying yield around 3 – 4%(2), are purchased with borrowed funds that use shorter-term debt that bears an even lower rate, creating what is known as leveraged net interest rate spread. These mechanics can increase that same 3% - 4% yield to a high single digit and even double digit (7-15%) yield depending on how much leverage is used to purchase the underlying securities. Simply stated, mREITs use shareholder equity to purchase debt, then use these debt instruments as collateral to borrow funds and buy more assets. Yield-seeking investors often gravitate to these types of investment opportunities as the stated returns on the surface look attractive in a normal market environment.
In times such as now when the credit markets are seizing up and there is a general lack of liquidity available, the risk in the underlying structure of mREITs is exposed. Through an exponential use of leverage, using debt or shareholder equity to purchase debt, many mREITs are levered 9:1 or 90%(3). In other words, they are borrowing $9 for every $1 of equity. When short-term borrowing rates jump sharply due to lack of available liquidity, as evidenced recently in the volatility of the repo market, the spread between the underlying mortgage yields and the borrowing rates gets squeezed. Even worse, if the value of the mREIT’s pledged collateral falls, a margin call might be issued; this requires the mREIT to post cash or collateral to pay down the debt used to purchase the additional mortgage securities. In times of distress, an mREIT’s use of substantial leverage takes what was otherwise a safe and secure investment, a pool of mortgages at 50-70% leverage(4), and can quickly cause a potential liquidation event.
Which Mortgage REITs are Suffering the Most?
Specifically, earlier this week, Invesco Mortgage Capital (IVR) saw nearly half of its equity value erased by running into the above-mentioned issue through its inability to meet margin calls. To shore up its position, the company announced that it will delay its dividend payments until its cash situation improves, temporarily eliminating the yield benefits that investors expected to receive. In one of the most extreme examples, MFA Financial (MFA) experienced a 95% decline from March 2nd at $7.60 per share to its low on March 24th of $0.36(5). Margin calls have forced MFA to suspend dividends not only on their common stock, but, also on their Series B preferred stock as well. Although MFA has rebounded over 370% from its March 24th low(6), unless they are able to negotiate favorable terms on margin calls with their lenders or obtain some relief from future stimulus packages, there could be real concerns for the ongoing viability of the company.
Recently, the Federal Reserve has moved to inject liquidity in the markets to stem further systemic credit issues by stating that they would purchase an unlimited amount of mortgage securities originated by Fannie Mae and Freddie Mac (the “Agencies” or Agency MBS), two government-sponsored enterprises. Two of the largest investors in the agency space are Annaly Capital Management (NLY) and AGNC Investment (AGNC), which experienced double-digit percentage increases in the past week in response to the Fed’s action. That being said, they are down 33% and 24%(7) respectively year to date, and investors should further consider that their double-digit yields (15.8% and 14.3%, respectively(8)) are a sign that liquidity risk persists, and the current dividend payout will likely be reduced in the coming days or months. However, given the actions taken by the Fed to backstop liquidity in this space, NLY and AGNC appear to have some pricing floors and are better positioned than some of their peers that don’t have as much exposure to agency MBS.
What this pandemic has again exposed is the asymmetric downside risk of owning mREITs, which means that there is more risk in achieving negative returns than positive returns. In a normal interest rate environment and in normal economic conditions, the leveraged interest rate spread, while potentially attractive to what can be achieved in other yielding investments, is largely capped based on the relatively low yields in the underlying mortgage securities. In times of stress the exponential used of leverage severely amplifies downside risk and, in some cases, can cause a complete loss of capital. Due to this asymmetry, we are taking a deeper dive in to the underlying mREITs comprising our mREIT Block to ensure quality risk management is being employed by management teams.
(1) - stock prices from Google Finance
(2) - based on portfolio holdings from iShares CMBS ETF (CMBS) as reported on Yahoo Finance
(3) - Source – NAREI - https://www.reit.com/sites/default/files/reitwatch/RW2002.pdf
(4) - Source – Freedie Mac, Fannie Mae
(5) - stock prices from Google Finance
(6) - stock prices from Google Finance
(7) - stock prices from Google Finance
(8) - stock prices from Google Finance
Director of Public Securities
Geoff leads the construction and monitoring of the public real estate securities portfolios available in our Path by Origin app. Prior to Origin, Geoff spent the last 12+ years researching and investing in public REIT securities at both Duff & Phelps Investment Management Co. and J.P Morgan Asset Management.
Geoff Shaver and clients of Path by Origin, LLC own DLR, PSA and AMH. Neither Mr. Shaver nor Path have a business relationship with any company whose stock is mentioned in this article.
Path by Origin, LLC (“Path”) is an SEC registered investment adviser. Mr. Shaver is the Director of Public Securities of Path. The views expressed herein are subject to change, and no forecasts can be guaranteed. The comments provided are for educational purposes only and may not be relied upon as recommendations, investment advice or an indication of trading intent. In preparing this document, the author has relied upon and assumed, without independent verification, the accuracy and completeness of information available from public sources. The stocks mentioned in this article have been highlighted based on some reported news, quality or characteristic and do not necessarily represent all of the securities recommended for a particular portfolio. Path is not soliciting any action based on this communication. Investments involve risk, including the possible loss of principal and fluctuation of value. Past performance is not indicative of future results. Mr. Shaver and Path disclaim responsibility for updating any information herein. In addition, Mr. Shaver and Path disclaim responsibility for any third-party content.