KBW: mREITs facing ‘prepayment wave’

But the report also raises concerns that a “prepayment wave” may lessen mortgage REITs' dividend returns the third quarter, due to the historically low interest rates in the US and globally providing prepayment incentives to borrowers.

Mortgage REITs experienced a slight 0.5 percent average bump in overall value in the second quarter of this year and they outperformed stocks with an 11.1 percent average total return versus 2.4 percent for the S&P 500, a new report from KBW shows.

Mavericks_Surf_Contest_2010bBut a “prepayment wave” may lower mortgage REITs’ dividend returns in Q3 due to historically low interest rates in the US and globally providing borrowers with significant prepayment incentives.

“Prepayment risk is the most visible near-term threat to dividends,” according to the report, which adds that the agency expects a 15-20 percent increase in prepayments in 3Q 2016.

“Mortgage REITs typically amortize the premium of their mortgage-backed security based on the weighted average life of the portfolio,” the report states. “A pick-up in prepayments shortens the life of the amortization period, hence increasing the expense.”

In addition, the post-Brexit decline in treasury yields has sent mortgage rates lower, and KBW believes they have room to fall even further.

Eric Hagen, an associate at KBW and co-author of the report, told Real Estate Capital that there was only a “moderate pick-up” in prepay activity in Q2 but that Brexit will likely “pull people from the sidelines” into prepayment in the coming months.

That said, the increase in Brexit-related prepayments is not likely to be a “full-on wave” like the one seen in 2012, when the 30-year fixed rate mortgage-backed securities had an annual rate of prepayment, or Constant Prepayment Rate (CPR), ranging between 20-30 percent, he added.

The projected CPR 30-year mortgage-backed security jumped from 3.5 percent at the end of Q1 2016 to 17 percent by the end of Q2.