Mortgage-REIT Roll
Is Still Going Strong
NEW YORK -- Mortgage real-estate investment trusts have been on a tear over the past two years, posting explosive double-digit -- and in some cases, triple-digit -- returns. And the party isn't over just yet.
Mortgage REITs generated total returns, which include dividends, of 77% on average in 2001, according to the National Association of Real Estate Investment Trusts. And they had advanced another 16% in 2002 as of May 7.
To put this in perspective, equity REITs posted returns of 14% on average in 2001 and were up 9% as of May 7. The disparity is even greater in the broader market: The S&P 500 fell 13% in 2001 and was down another 6.5% by early May, while the Nasdaq Composite index slipped 21% in 2001 and was off another 17% by the same point in 2002.
Investors began flocking to the beaten-down mortgage REIT sector in 2000, thanks to the group's lofty dividend yield -- which back then averaged 13.5% -- and cheap stock prices. At the time, interest rates were falling, making the group's outlook attractive.
Despite the group's big run-up over the past two years, the sector still boasts a 13.4% dividend yield on average, even now. This factor alone is enticing for investors, given that a number of high-profile market experts, such as billionaire investor Warren Buffett and bond guru Bill Gross, are predicting annual stock returns of only 7% and bond returns of 5% to 6% over the coming years.
The mortgage REITs' high dividend yield allows investors to achieve double-digit returns even if the stock price doesn't move.
The Fed's Effects
The mortgage REITs' stellar dividend yields, however, reflect the inherent risk the group is facing as the Federal Reserve Board gears up for a new round of interest-rate increases. If short-term rates rise, funding costs become more expensive and spreads (the difference between funding costs and the yield the company gets from its assets) start to contract. This, in turn, could mean lower earnings.
Yet, many analysts and investors believe the group's earnings and dividend yield remain safe and attractive through at least the end of this year.
Sam Lieber, chief executive of Alpine Management & Research LLC, which invests in mortgage REITs, said nobody is expecting the Fed to start boosting rates sharply anytime soon, given the current economic environment.
Joe Betlej, vice president and portfolio manager at Advantus Capital Management Inc., which also invests in mortgage REITs, estimates rates would have to climb 75 to 100 basis points from current levels before he would become concerned.
Another portfolio manager, David Shapiro from Phoenix-Seneca Real Estate Securities Fund, is even more bullish, saying rates would have to jump 200 basis points before he would pull out. Mr. Shapiro, however, cautions that he invests selectively in the sector, and that certain REITs might be more vulnerable to interest rate swings and other factors than others.
In general, mortgage REITs purchase pools of mortgages that have been bundled up as securities. Some focus on residential mortgages, others commercial loans. Some concentrate on high credit quality loans while others branch out into higher-risk mezzanine and subprime loans.
Mr. Lieber prefers mortgage REITs that originate mortgages in addition to purchasing them. He said this gives the REITs better control over the quality of mortgages they own and can often be cheaper than acquiring them. It also makes the REITs less dependent on Wall Street, he said. Mr. Lieber cites Impac Mortgage Holdings Inc. as a company that both originates and acquires mortgages.
Thornburg Mortgage Inc. started originating mortgages in 2000. But the REIT limits its originations to adjustable-rate mortgages and still purchases more loans than it originates.
Annaly Mortgage Management Inc., Redwood Trust Inc. and Apex Mortgage Capital Inc. are among those that solely purchase assets.
Phoenix-Seneca's Mr. Shapiro agrees companies that originate mortgages stand to perform better than those that don't. However, he said each company must be evaluated based on its business focus.
As an example, Mr. Shapiro spoke bullishly about Redwood Trust, even though this company doesn't originate mortgages. He noted that it focuses on a special niche -- jumbo loans -- and has built a profitable business in this area by either buying or guaranteeing these loans. Jumbo loans are loans of more than $300,000.
Advantus Capital's Mr. Betlej likes mortgage REITs that focus on commercial, rather than residential, loans. Such REITs face less risk from refinancings and prepayments, which can cut into profits. Commercial mortgages impose penalties if someone tries to prepay, which tends to discourage prepayments, he said. Residential mortgages have no penalty, he noted.
REITs focusing on the commercial end include Anthracite Capital Inc. and American Mortgage Acceptance Co.
Mixed Views on Subprime Loans
Market experts appear mixed when it comes to projecting the prospects for REITs that focus on subprime loans.
The subprime sector was hit hardest during the chaotic environment of 1998, which saw a string of mortgage companies file for Chapter 11 bankruptcy protection.
Advantus' Mr. Betlej is shying away from subprime mortgage REITs. However, another portfolio manager remains bullish on NovaStar Financial Inc., which focuses on subprime loans, noting that it successfully navigated its way through the turbulence, and today faces less competition.
UBS Warburg analyst Gary Gordon remains bullish on the sector overall. He rates Anthracite and Annaly Mortgage at strong buy, and rates both Thornburg and Impac at buy. He said many companies learned lessons from the troubling 1998-99 period, and changed their business models and hedging strategies to help insulate them from interest-rate changes.
Mr. Gordon believes much of the potential risks are already in the stock prices. "They wouldn't be trading at double-digit dividend yields unless they were," he said. Still, he predicts 2003 earnings for many mortgage REITs will likely be lower than 2002 numbers.
"The yields are still very attractive," concurred analyst Jim Ackor from RBC Capital Markets. Still, he downgraded the three mortgage REITs he tracks -- Annaly, Thornburg, and America First Mortgage Investments Inc. -- in late March to sector perform due to the stocks' "stunning performance" over the past 15 months, and the potential for interest-rate increases.
It is no longer a question of if interest rates will rise, but when they will rise, he said. And when they do, he said, margins, earnings and dividends will contract.
Still, Mr. Ackor doesn't expect the Fed will make big changes in rates before the end of 2002, given recent economic data and corporate earnings results. "The recent data suggests it's likely rates will be rising later rather than sooner." So the mortgage REIT sector's earnings and dividends are "stable for the time being," Mr. Ackor said.
Another issue that could potentially drive up the stock prices of certain mortgage REITs are their upcoming entry into indexes compiled by Frank Russell Co. Merrill Lynch & Co. has indicated it expects at least two -- America First and Apex Mortgage -- to be added in June when the Russell indexes are reshuffled.
Whenever new stocks are added to the indexes, there is often a surge in demand for these names as index investors snap up shares in these companies to mirror the index.
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