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Mortgage REITs beginning to regain their strength

By Susan Persin,
senior director research, Trepp

Earnings season got underway this week, with the first mortgage REITs (mREITs) reporting second quarter performance.
Early results indicate that, following a weak 2013, the sector’s turnaround is becoming more sustained.

Susan Persin
Susan Persin

CYS Investments (CYS), a residential mREIT with market cap of about $1.5 billion, reported a notable 6.5% increase in book value during the second quarter.
It was the second consecutive quarter of rising book value for the company. The higher book value makes it more likely that CYS will be able to maintain or grow its dividend payment. The company’s stock value has risen 33% so far this year.

Total returns are another indicator of the sector’s renewed strength. MREIT returns have been flat so far during July, but on a year-to-date basis, returns have measured 17.40%, according to NAREIT.

These returns compare favorably to 2013, when uncertainty about the Fed’s tapering of its economic stimulus led to higher interest rates that reduced the value of their mortgage-backed security holdings, caused book value per share to drop, and led to a widespread sell off of REIT stocks. MREIT returns declined 1.96% during 2013.
MREITs are attractive to investors in the current interest rate environment, which boasts a very low rate. Most of their total return comes from their 10.25% dividend yield that far exceeds equity REITs’ 3.46% yield.

Most mREITs are currently maintaining dividend payouts, but not yet growing
them. With stock trading below book value, some companies repurchased their own shares this year, and some mREITs bought competitors’ shares.
As of mid-2014, MREITs still largely trade at slight discounts to their net asset values.

MREITs have taken steps to reduce their risk, but remain inherently risky because of their sensitivity to interest rates.
They have deleveraged themselves and strengthened their balance sheets in preparation for higher interest rates. Additionally, they are increasingly using hedging to reduce interest rate risk.

The strengthening housing market has also reduced residential mREIT risk. Because non-agency MREITs assume credit risk in their investments, they benefit as home values rise, which reduces borrower defaults.

Agency REITs, which invest in government-guaranteed or government-supported mortgages, do not assume credit risk, but they also benefit from the decrease in delinquencies because defaults act like prepayments for them. In an economic climate where interest rate is falling, loan defaults would leave MREITs with money to invest at generally less advantageous terms.

Low interest rates, increased clarity about interest rate movements, and the spread between short and long term rates have propelled mREITs forward during 2014.
If long term rates stay at or near current levels, mREITs’ margins should be sufficient to enable them to maintain or begin to grow their dividends.
The sector outlook is positive and offers a return commensurate with its risk.

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