Investing in mortgages requires the ability to sail on the occasionally roiling sea of the housing and commercial real estate markets and to handle the ebb and flow of interest rate changes. Leaders of Mortgage REITs (mREITs) have learned to adjust their strategies to shifting markets to balance their investments between interest rate-sensitive and credit-sensitive assets.
Investors consider mREITs to be “more vulnerable to changes in interest rates” than other REITs, according to Susan Persin, senior director of research at Trepp, a provider of analytics and information to the global CMBS and banking industry. They potentially “offer the benefit of higher returns, but they’re also a higher-risk investment than other REITs,” she says.
In the post-financial crisis landscape, investors have been attracted to mREITs, especially those that invest in low-risk government-agency-backed mortgages, says Matthew Howlett, director of U.S. equity research for UBS Investment Bank.
“By nature, mREITs lend long and borrow short, so good financing metrics and the support of government backing for the mortgages enabled these companies to raise capital,” he says. “Because the federal funds rate has been kept extremely low, the spread between their borrowing rates and their investments grew to record levels.”
The housing market distress helped mREITs, according to Howlett, because they could be confident when buying premium bonds that many homeowners were underwater on their loans and therefore wouldn’t prepay them. However, Jason M. Stewart, managing director and co-director of research for Compass Point Research, notes that mREITs hit a rough patch in the middle of 2013.
“In the summer of 2013 when the Fed had its ‘taper tantrum’ and interest rates rose, there were huge declines in book value among the mREITs,” Stewart says. “The mREITs are more stable now, but they face increased spread volatility when rates rise.”
Persin says mREITs are prepared for higher interest rates. If rates rise slowly, as expected, the sector should do just fine, she says.
Notably, mREITs hedge their portfolios against rising interest rates in part by using swaps. Furthermore, REITs have cut their leverage ratios since the financial crisis. Whereas the median leverage ratio of mREITs in 2007 was around 9 times book equity, that number fell to roughly 4 times in 2014.
Overall, mREIT leaders have confidence that the strategies they have in place will allow them to thrive in spite of market challenges.
Annaly Capital Management Inc. (NYSE: NLY), the largest and one of the most tenured mREITs, has been through numerous economic cycles since it went public in 1997, says Kevin Keyes, CEO and president of Annaly.
“Two-thirds of the mREITs were created since the housing crisis, but we have the strategic advantage of deep expertise in a variety of areas,” he says. “While our core business will remain agency-backed mortgages, we’ve managed credit strategies in alternative vehicles and public companies for over a decade.”
“We’re now a more diversified business, and the level of liquidity we have will serve us well,” says David Finkelstein, head of the agency portfolio team at Annaly. “Our core asset is still agency loans, but we now have broadened our investment opportunities with the growth of these credit alternatives,” he says.
Annaly’s strategy is to match the liquidity of their agency business with the durability of their credit business, according to Keyes.
“Non-agency-backed mortgages offer a different and complementary risk and return profile to agency MBS; they have an arguably low correlation to the agency sector as well,” Finkelstein says.
Finkelstein says agency loans are attractive because the sector is scalable and liquid and allows the company to obtain favorable financing terms and use reasonable leverage. However, these assets are more exposed to interest rate risk.
New Residential Investment Corp. (NYSE: NRZ) focuses primarily on mortgage servicing-related investments. The company was initially formed as a subsidiary of Newcastle Investment Corp. (NYSE: NCT) in September 2011 and was subsequently spun off in May 2013 to focus on investment opportunities in residential real estate.
Today, New Residential has three core business segments, with more than half of its investments in mortgage servicing rights (“MSRs”) and the rest in servicer advances and non-agency securities with associated call rights.
“There are very few REITs that have a sizable MSR business, and we think our portfolio is difficult to replicate. Furthermore, we have been able to achieve attractive, double-digit returns across our core asset groups,” says Michael Nierenberg, CEO and president of New Residential.
Nierenberg anticipates the servicing transfer from banks to non-banks to continue.
“In 2010, banks serviced 89 percent of the $10 trillion mortgage market, and by the first quarter of 2015, that number declined to 73 percent,” he says. “Given the regulatory requirements and operational pressure, we expect banks to continue selling their servicing assets, particularly credit-impaired loans.”
MFA Financial, Inc. (NYSE: MFA) primarily focuses on investing, on a leveraged basis, in residential mortgage-backed securities (RMBS). More than 70 percent of MFA’s RMBS are in adjustable rate, hybrid or step-up MBS.
Craig Knutson, MFA COO and president, says that the interest rate earned on these assets increases in a higher interest rate environment or through simply the passage of time, thus providing providing protection in the event that interest rates (and borrowing costs) rise.
Looming Interest Rate Hike
Since mREITs make their money on the spread in interest rates between their long-term investments and their borrowing costs, the predicted interest rate hike is anticipated to impact mREITs harder than other REIT sectors.
“When short- and long-term interest rates are close together, the mREITs make less money,” Persin says. “If both long- and short-term rates rise, their ability to make money is diminished.”
The Fed-supported market artificially compressed spreads, says Howlett, who thinks the withdrawal of the Fed could be painful for mREITs. “When interest rates rise, there are actually some benefits for mREITs because there are fewer prepayments of mortgages and they can buyer higher yield paper,” Persin says. “Assuming rates rise slowly, the sector is likely to weather increased rates and could even benefit from them.”
Looking ahead, Nierenberg believes that New Residential will be uniquely positioned to benefit from a rising interest rate environment.
“As interest rates increase, prepayments will likely decline, which should improve the duration of our servicing assets, particularly our MSRs. Lower prepayments and longer-duration assets should help enhance returns and extend cash flow for investors. We believe MSRs are one of the few fixed-income investments that will increase in value in a rising interest rate environment,” says Nierenberg.
Knutson says MFA Financial positions itself to cope with interest rate changes primarily through asset selection. MFA has increased its allocation to credit sensitive residential loans and MBS while reducing its investment allocation to interest rate sensitive agency MBS. While there are many strategies for handling rising interest rates, both mREIT executives are optimistic about providing continued good returns for their investors.
“We’re already structured to meet the challenge whenever the Fed chooses to make a move,” says Keyes. “I feel very comfortable with our conservative leverage stance and by the fact that we have a more balanced asset and liability profile than we’ve had in the past.”
While Nierenberg acknowledges that the mREIT sector has recently been under pressure, he states, “I am confident in the quality of our assets, and I believe we are very well positioned for the future. We have not only gained critical mass in MSRs and other mortgage servicing-related assets, but we have also established trusted partnerships with leading non-bank servicers.”