As the housing market recovers, investors are taking another look at some of the investments derived from bets on mortgage credit.
Real estate investment trusts that buy mortgage-backed securities and other income-producers may be ready for their moment, according to analysts interviewed by MarketWatch.
Year-to-date share price appreciation among mortgage REITS is mixed, but several are in the double digits.
Mortgage REITs offer chunky yields by raising money in short-term markets like the “overnight repurchase,” also known as repo, market, to borrow more in order to buy mortgage securities.
Famed bond investor Bill Gross recently told Barron’s that he liked funds like Annaly Capital Management
which uses leverage more judiciously than banks to invest in government-guaranteed mortgages and produce an 11% yield. Annaly is levered four to six times, whereas banks are levered eight or nine times, he noted.
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Such a strategy has meant a rocky road in recent years. For mortgage REITs, “interest rate volatility is not your friend,” said Rick Daskin, who runs investment firm RSD Advisors. When rates are volatile, it costs managers more to hedge.
The REITs do best in a particular environment, Daskin thinks: a positive yield curve, stable interest rates and spreads between mortgage rates and Treasury yields, and a “reasonably performing” real estate market. Many analysts believe that describes the current economy.
A few years ago, the strategy of borrowing in the overnight markets caught the eye of regulators like the Financial Stability Oversight Council and the International Monetary Fund. The FSOC, which was created in the wake of the financial crisis, wrote in a 2013 report that it was worried about the dependence of the two markets on each other.
But regulators took notice because many REITs were ramping up then, and because there was still some lingering concern from the financial crisis, when the repo markets effectively shut down, said Doug Harter, a Credit Suisse analyst.
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Chris Whalen, a long-time bank analyst now with Kroll Bond Ratings Agency, told MarketWatch that regulators’ concern about liquidity is misplaced. Mortgage REITs are “durable,” Whalen said.
While it’s true that REITs’ business model of paying out a certain percent of their net income to shareholders makes it harder for them to accumulate capital, they don’t need as much liquidity as regulators assumed, Whalen said.
“They don’t tend to have a liquidity need like a lender who has to do a closing every month. REITs only tend to raise money when they need to go out and buy more assets,” Whalen said.
The biggest risk right now to REITs is from the Fed, Whalen said. REITs do best when the yield curve is steep, and policymaker speculation about the possibility of negative interest rates in future downturns isn’t helping. Mortgage REITs profit when borrowing at low rates and reinvesting in longer-term, higher-yielding instruments.
Harter, the Credit Suisse analyst, believes mortgage REITs come in enough “flavors” that one can be found to support nearly any investment thesis.
Credit Suisse has an “outperform” rating on New Residential
, and a target price of $17. New Residential has been essentially flat since the beginning of 2016 but has a dividend yield of 15%.
NRZ also invests in mortgage servicing rights, but more than half of those investments come from mortgages other than those backed by Fannie Mae
and Freddie Mac
, meaning NRZ is less exposed to refinancing activity than other similar REITs, Harter said.
The REIT had an impressive 2015. Core earnings for the full year of $389 million were 77% higher than in 2014, and the dividends paid out rose 63%.
Harter also likes Starwood Property Trust
, in part because of one of its business lines, which focuses on commercial loan workouts. That type of business will be in demand as riskier 10-year commercial loans made in 2006 come due, Harter said.
But some investors still shy away. “There are several ways to lose money in mortgages,” Daskin said. Although he believes mortgage REITs are largely undervalued, he likes to spread out the various risk – credit, prepayments, interest rates, and so on – by investing in a mortgage REIT ETF like Van Eck’s Mortgage REIT
or the iShares Mortgage Real Estate REIT