Non-resi REITs may be better placed to weather rates rise, reports Ruchira Roy Chowdhury
Mortgage Real Estate Investment Trusts, beloved of yield hunters, have started to feel the heat, with net margins compressing and interest rates increasingly volatile ahead of an expected rate hike by the Federal Reserve.
However, the dozen or so M-REITs focused on commercial real estate lending, rather than residential mortgages, may be better placed to deal with the more challenging environment.
Experts are divided on the degree to which M-REITs are insulated from the impact of rate rises, but some say residential M-REITs may take a bigger hit than commercial ones, since the latter mostly lend at floating rates on better yielding transitional assets.
One reason rising interest rates are particularly significant for M-REITs is that they make money from the spread or net interest margin between their lower cost of borrowing and the interest income from the mortgages they invest in.
For some M-REITs, these spreads may be squeezed when the Federal Reserve starts raising key rates, pushing up short-term borrowing costs. Most residential mortgages have fixed rates and as interest rates rise, the value of mortgage-backed securities in the portfolio will fall.
Long-term interest rates have already started rising, with 20-year treasury yields up over a percentage point this year to 3%. Seven M-REITs, including American Capital Mortgage Investment, Capstead Mortgage, Dynex Capital and Ellington, cut their dividends in the first quarter of this year because of interest rate volatility.
RATE RISES ARE LITMUS TEST
Interest rate volatility is likely to prove a good litmus test for how well mortgage REITs can handle a squeeze on margins, since most commercial M-REITs only became listed entities after the financial crisis. For example, the biggest of them, Starwood Property Trust, with a current market cap of about $5bn, listed in 2009.
The second largest, Blackstone Mortgage Trust (with a $2.5bn market cap), was formed in 2013 after Blackstone Real Estate Debt Strategies took over Capital Trusts’ CT Investment Management Co (CTIMCO), quickly renaming the M-REIT Blackstone Mortgage Trust.
Colony Capital and Apollo Commercial Real Estate started operating as trusts in 2009 and 2011 respectively. This will be the first time these REITs will have to operate in an environment where interest rates are steadily rising.
However, a senior executive at one of the larger commercial M-REITs says: “I am actually rooting for a little more volatility. I think for us and for our competitors, that is way more good news than bad news. When markets are liquid and complacent, it gets harder to implement our business strategies.
“If rising rates result in some volatility, I would welcome that. A little bit of volatility tends to chill the CMBS market a bit, which the longer players like us look at as a source of opportunity.”
Mike Nash, global head of Blackstone Real Estate Debt Strategies, adds: “We are a floating-rate lender, so on the income side, we have nothing but good news if the Fed moves short-term rates higher. A dramatic and unexpected move in long-term rates usually reduces confidence in the market, but the Fed has telegraphed that well so far.”
The Federal Reserve has made it fairly clear that interest rates will only rise when economic growth has sufficiently stabilised, meaning stable demand for space from retailers, manufacturers and other occupiers.
Stephen Plavin, Blackstone Mortgage Trust’s chief executive officer, says: “As economic activity gets more robust, rates rise, but income from real estate, hotel room and apartment rates will also grow.
“If income grows, property owners can handle a slightly higher rate environment. It’s more challenging if a rise in rates is sudden or unexpected and not accompanied by greater economic activity.”
PRESSURE TO DIVERSIFY
Some M-REITs anticipate more margin compression, rising interest rates and pressure to meet target dividends by either diversifying or gearing up, according to a report released by Kroll Bond Rating Agency in June.
However, as most M-REITs are limited
in their ability to increase leverage due to leverage covenants from banks and repurchase lenders, diversifying into lending on higher-yielding commercial properties may be the only option.
“Attractive [repurchasing finance] is not available to everybody,” says Nash. “Banks are very responsible in terms of how they make it available to people. So we are in a good place.”
Plavin says that it could make sense for residential-focused vehicles “to try and diversify into an activity better suited to the current rate environment. But the big question is, how will they execute it?”
One recent example is New York-based Annaly Capital Management, one of the largest residential mortgage REITs, which had focused on agency residential mortgage investing for over two decades – buying RMBS issued by Fannie Mae and Freddie Mac. In May the group hired a GE Capital Real Estate team to expand its commercial real estate originations business.
The team consisted of Jeffrey Thompson, GE Capital RE’s managing director, strategic capital group, plus Patrick Maroney and Daniel J. Jagoe.
KBRA says Annaly may increase its investment in commercial real estate mortgages and CMBS from 4% of its assets to anywhere up to 25%.
TWO HARBORS CHANGES FOCUS
New York-based Two Harbors Investment Corp, one of the largest M-REITs in the US, has also moved into commercial real estate, lending in partnership with Pine River Capital Management, after previously focusing on residential mortgage business.
Two Harbors last year hired Prudential Real Estate Investors’ senior executives Jack Taylor, Stephen Alpart and Steven Plust to start a commercial real estate division, funded with $500m in capital. The wave of CMBS maturities in the next two years and a need for diversification had prompted the decision, the firm said last year.
Meanwhile, PennyMac Financial Services launched PennyMac Commercial Real Estate Finance last December, focusing on multi-
family housing and non-residential loans securitised by PennyMac Mortgage Investment Trust. Steve Skolnik, former CEO and co-founder of ReadyCap Commercial, was recruited to head the division, while Kevin Portnoy joined from Capital Crossing.
Industry experts are sceptical about M-REITs’ ability to get into a lending business as complex as commercial real estate – unless they can hire teams like this with specialised skills relating to product pricing, valuing transitional properties and making origination calls.
Some M-REITs have very small teams and may lack the talents or skills to manage the risks that come with commercial real estate mortgages, says KBRA associate director Boris Alishayev.
“CRE is a different animal. About 20-30 people work on every $100m loan we originate,” says a senior executive from one of the largest mortgage REITs. n
M-REITS HAVE BEEN YIELD-HUNTERS’ IDEAL PREY
Mortgage real estate investment trusts are mostly publicly traded companies (although some are privately held) that invest in mortgages and mortgage-backed securities by originating or buying mortgage portfolios.
They generally specialise in residential or commercial lending, the commercial mortgage REIT sector being relatively small and nascent.
M-REITs make money from the spreads between the interest charged on long-term mortgages and short-term funding costs. Since M-REITs give away most of their gross income (90%) as dividends to shareholders, they rely on capital raised through a variety of funding sources, including common and preferred equity, repurchase agreements, structured financing, convertible and long-term debt, and other credit facilities.
Yield hunters have loved the asset class for its high-yield dividends, which, in the past two years, have far outperformed those of other stocks. The FTSE NAREIT Mortgage REIT Index returned 11.5% in dividend yields, exceeding the S&P 500’s 2% dividend yield.
There are 224 US REITs, equity and mortgage, with a total market capitalisation of $890bn, while the 13 key commercial mortgage REITs have a total market capitalisation of $23bn.