Mortgage REITs (mREITs) have had somewhat of a see-saw performance in the last several years, with returns alternating between positive and negative territory. The Federal Reserve’s most recent action on interest rates looks to have been positively received in the market, and points to a broadly more positive performance for the sector ahead.
mREITs have a high dividend yield—11.52% at the end of 2023, compared with 3.92% for equity REITs. Through Oct 22, mREITs were posting a dividend yield of 11.83%, compared with 3.65% for equity REITs. Listed mREITs paid $1.8 billion in dividends in the second quarter of 2024.
REIT.com spoke to Steve DeLaney at Citizens JMP, Stephen Laws at Raymond James, and Jade Rahmani at Keefe, Bruyette & Woods to gauge their thoughts on the mREIT outlook.
What does the recent shift in Federal Reserve policy mean for mREITs more broadly for the rest of 2024 and into 2025?
Steve DeLaney: Within the mREIT industry, the largest positive impact will likely be seen in the commercial mREIT segment, where higher rates have increased the cost of carry for borrowers with floating-rate bridge loans and higher NOI capitalization rates have lowered real estate property valuations. The agency mortgage-backed securities (MBS) mREIT segment should see the smallest impact as these companies swap out most of the short-term rate risk/benefit on their short-term repo borrowings using fixed-pay interest rate swaps.
The residential credit mREITs generally have their non-agency mortgage loan portfolios financed with permanent fixed-rate residential mortgage-backed securities (RMBS), but those with internal residential loan production platforms should see higher origination volumes as interest rates potentially decline across the yield curve.
Stephen Laws: The recent Fed policy shift and lower forward curve was positively received by mREITs. Buying new interest rate caps, which are typically required to extend CRE loans, are materially cheaper given the shift. This is likely to result in better portfolio performance, as borrowers are more likely to protect assets. Additionally, CRE companies with mortgage conduit business are likely to see an increase in volumes given the normalizing slope of the curve. On the residential side, companies that fund their portfolio on the short end of the curve should benefit from lower financing costs.
Jade Rahmani: Alongside Fed rate cuts, KBW’s more positive commercial real estate outlook adopted in early September was premised on three factors signaling a bottom: prices, volumes, and lender loss reserves. While Treasury yields are up 25 basis points since then, positive factors are still in place and three-month Treasuries are down. We believe lower interest rates will be a meaningful positive for the commercial mREITs due to less pressure on book value (i.e., net asset value), improved sector valuation, and immediate relief on portfolio stress factors such as interest rate caps on floating rate loans.
How have mREITs fared, and positioned themselves, during the challenges of the past few years?
Rahmani: The commercial mREIT sector has been challenged since the CRE market peaked in mid-2022. As KBW research has documented, commercial mREIT credit reserves increased from approximately 1.2% in 1Q22 to 3.85% as of 2Q24 while problem loans over that period increased from 2.3% to 8.6%. Cycle to date, we estimate cumulative loan losses (including reserves and realized impairments) total 6.4%, which is 71% of KBW’s full cycle estimate of 8.4%.
While this has translated into book value per share declines of 14.6% on average, we believe the commercial mREIT sector is now positioned for stabilizing book value. With declining interest rates, the risk of further credit shocks should decline which, in turn, should cause new investment to ramp, driving greater earnings/ROE predictability. This should improve valuations through tighter dividend yield spreads on lower base rates. Additionally, lower rates offer immediate relief on financing of non-yielding assets.
DeLaney: Over the past two years, there has been general stability in the agency and hybrid mREIT groups. In part due to the Fed maintaining higher interest rates over the past two years, mREITs have underperformed the broader stock market. This relative underperformance has continued in 2024.
Laws: Companies have largely been playing defense over the past couple of years, as they have prioritized increasing liquidity and resolving problem loans over new investment activity. Problems in non-office assets have mostly been manageable using extensions and modifications; however, office assets are much more challenging given a fundamental shift in this property type. Not surprisingly, the companies with the least office exposure have experienced fewer problems over the past few years.
What role do you see mREITs playing in income-generating portfolios?
DeLaney: In a diversified fixed-income investment portfolio, I believe there is a place for high-yield mREIT common stock dividends offering 10%-12% annual returns from assets that are backed primarily by real estate collateral. I would suggest a mix of 50% agency mREITs (those owning mostly Fannie Mae and Freddie Mac MBS) with current dividend yields in the 12%-14% range along with 25% each in residential credit and CRE credit mREITs with yields in the 8%-11% range.
Laws: mREITs provide an attractive source of income and should be a part of most income portfolios. However, it is important to remember that many companies are very similar, so owning a basket of mREITs may not provide as much diversification as one might think. Many companies have similar business models that are exposed to the same risks, although owning a basket of companies can reduce loan concentration risk given a larger aggregate portfolio. When choosing a basket of mREITs, we typically recommend selecting one or two companies from each of the mREIT subsectors: CRE, residential credit, and residential agency.
Rahmani: With book values potentially stabilizing, the commercial mREITs offer investors the ability to increase their portfolio yield. The sector trades with an average dividend yield of approximately 10.5% and median of 11%. In addition, commercial mREITs trade at 0.75 times price-to-book value, suggesting the potential for greater returns through book value stabilization and multiple expansion.
Which commercial property sectors are looking most attractive to mREITs at this time?
Rahmani: Commercial mREIT portfolios cover the spectrum of CRE by property type with approximately 44% multifamily, 22% office, and the rest a mix of industrial, hospitality, and some retail. We expect commercial mREITs to grow within their current portfolio footprints with an ongoing emphasis on multifamily, industrial, and hospitality, less emphasis on office, and some burgeoning opportunities in alternative asset classes such as data centers.
DeLaney: Multifamily will always top that list in my view, but it may surprise some that within the apartment space we favor suburban Class B workforce housing properties over urban high-rise buildings at this time. Warehouse and industrial properties are also quite defensive, but location is becoming increasingly more important in that segment. Hotels in resort markets also make a lot of sense. Office and mixed-use properties require the highest level of caution and diligence currently.
Laws: We continue to view multifamily the most favorably given a general lack of housing in the U.S and continued unaffordability of single family homes. Additionally, with the majority of new supply expected to be delivered within the next 12 months, we believe rent growth is likely to accelerate in late 2025 and 2026. And given the recent Fed actions and current forward curve, we believe multifamily borrowers are more likely to protect assets given rate caps are now cheaper and there is potential to recover equity if cap rates decline. The current rate environment is likely to result in lower multifamily delinquencies and lower loss severities versus expectations three months ago.
Where do you see the biggest opportunities and challenges for mREITs ahead?
Rahmani: With the banks potentially looking to de-emphasize direct CRE lending and grow credit facility and warehouse lending capacity, this should present an opportunity for non-bank lenders, such as debt funds and commercial mREITs, to gain market share. In addition, CMBS issuance volumes are up sharply this year, a potential benefit to commercial mREITs with CMBS conduit business lines. Finally, lower rates could precipitate more favorable and faster resolution of problem loans, leading to improved earnings.
Laws: We believe the best current opportunities for mREITs are the CRE companies focused on new originations and the residential companies that are likely to benefit from lower financing costs given Fed easing. With many legacy CRE lenders focused on reducing leverage and resolving problem loans, fewer lenders are willing to originate new loans. As a result, new loans are generating above average returns at lower attachment points compared to past vintages.
On the residential side, some companies finance their portfolio with debt tied to short-term rates, and we expect these companies to experience return on equity (ROE) expansion as the Fed eases rates. Regarding challenges, we expect portfolios with legacy office loans to continue to underperform from an ROE standpoint, with some resolutions taking many quarters, if not years.
DeLaney: I think the best strategy going forward for new or sub-scale mREITs will be to create a “REIT over TRS” structure where the mREIT has its own dedicated loan origination vehicle in the taxable REIT subsidiary to provide a steady flow of new non-agency residential loans or small balance CRE loans (including multifamily) to the parent mREIT, which would finance those new loans with new non-recourse RMBS or CMBS securitizations.
Are there any other issues, trends, or developments related to mREITs that you’ll be watching in the months ahead?
Laws: We will continue to keep a close eye on interest rates, as a reversal of the recent shift could result in headwinds for portfolio performance. Same with work-from-home, as an increase in employers requiring employees to return to the office could help address some issues with office and mixed-use loans. Portfolio financing will be another area of focus, both with some companies benefiting from lower short-term rates, while others will look to replace securitized financing as deals de-lever.
Rahmani: With impending rate cuts, KBW believes the CRE environment is set to improve in the fourth quarter and 2025. We expect to see increasing transaction volumes (including capital markets and office leasing), attractive returns on new equity and debt investments, emphasizing reset basis, and upside from better financing markets. We expect improving deal activity and sentiment to drive CRE stocks through year-end and into 2025.
DeLaney: I expect that we might see some consolidation in the industry. We have a lot of small mREITs with equity market capitalizations of $300 million or less that have a real challenge trying to attract interest and support from the institutional investment community. Some of these might want to consider a “merger of equals” with another small mREIT to gain scale. Others might receive a proposal from a larger private real estate lender or debt fund interested in going public by merging with an existing smaller mREIT.