Last year was hard for the financial sector. Banks struggled with elevated delinquencies, particularly in commercial real estate, and real estate investment trusts (REITs), especially mall REITs and apartment REITs, struggled with tenant delinquencies. The year was particularly hard on mortgage REITs, and many struggled to survive.
MFA Financial (MFA 0.34%) was one of those mortgage REITs. The company has largely navigated the crisis, however, and is now looking toward the future.
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Mortgage REITs have a different business model
A mortgage REIT is a different animal than the typical REIT. Most REITs use a landlord/tenant model, where the REIT builds properties like malls, office towers, and apartment buildings, and then rents out the units to tenants. It is a relatively easy-to-understand business model. Mortgage REITs, on the other hand, don't buy buildings -- they buy real estate debt.
MFA Financial specializes in the non-government guaranteed sector of the mortgage universe. While the big agency REITs like AGNC Investment focus on government-guaranteed mortgages and uses a lot of leverage to create returns, MFA focuses on taking credit risk. This allows MFA to operate at a substantially lower leverage ratio compared to the agency REITs.
The early days of COVID were brutal for the mortgage REITs
During the initial days of the COVID-19 crisis, interest rates collapsed and liquidity dried up in the mortgage market. Nervous banks required the mortgage REITs to post more cash margin against falling securities values, and many of the more esoteric assets simply went no-bid. MFA eventually entered into forbearance with its creditor banks while it sought a rescue package. Eventually, MFA negotiated a rescue package with funds managed by Apollo Global Management and Athene, which consisted of high-interest-rate loans and warrants to purchase MFA stock. During the third and fourth quarters, MFA was able to repay the loans and eliminate the warrant overhang.
MFA also spent the last two quarters replacing the "mark-to-market" debt (the source of the margin calls) with more durable and less risky longer-term debt and securitizations. This will go a long way toward reducing interest expenses in the future. MFA's cost of funds fell 140 basis points to 3.1% from June 30, 2020, to Dec. 31, 2020, and fell to 2.9% after the end of the year as the company called a high-rate debt issue.
MFA focuses on taking credit risk
MFA's biggest asset class consists of mortgage loans that are not guaranteed by the U.S. government because they fall outside of the Qualified Mortgage (QM) rules. These loans have a weighted average coupon rate of 6.15%, which is much higher than that of the typical agency loan, which pays below 3%. These are also quite conservative, with an average loan-to-value (LTV) ratio of 64%. This means if a borrower defaults and MFA needs to foreclose, the loan is more than amply covered by the value of the underlying collateral. As of December 31, 89% of the non-QM portfolio was current.
MFA also has a large portfolio of non-performing loans. It buys these at a discount compared to their face value and then it works with the borrowers to either get the loans current or take possession of the properties after they're foreclosed on. Rising real estate prices have been a tailwind here, and MFA sold about $270 million of properties above their carrying value on the balance sheet. MFA's portfolio of reperforming loans has seen an increase in delinquencies due to COVID, but 81% of the book is less than 60 days delinquent.
Low rates mean a dearth of cheap investment assets
MFA characterized the investment climate as one with very few cheap assets. Despite the recent increase in interest rates, they are still extremely low by historical standards, and credit spreads are very tight. When rates are super-low, the most value can be found by managing the liability side of the ledger, and MFA has substantially lowered its cost of funds. Luckily, the non-QM origination business is beginning to wake up again, as rising rates have eliminated some of the low-hanging refinancing activity for originators. Going forward, this business should continue to grow, and the securitization market has returned.
MFA Financial pays a $0.075 per share quarterly dividend, which works out to a 7.5% dividend yield. The company also trades at a substantial discount to its book value of $4.54 per share. As the COVID-19 pandemic fades economically, credit-exposed mortgage assets should outperform government-guaranteed assets as rates rise. That said, MFA's dividend yield is below those of the big agency REITs like AGNC Investment (8.9% yield) and Annaly Capital (10.5% yield). On the other hand, its discount to book is larger. MFA is probably fairly valued at this stage, but the worst is definitely over.
