Housing prices are rising so rapidly in the U.S. that some people are talking about another housing bubble. While there is very little possibility of that happening right now (the necessary pieces of the puzzle simply aren't there), we are seeing home price appreciation and bidding wars similar to the housing bubble days of 2004-2006.
While mortgage real estate investment trusts (REITs) are mainly sensitive to movements in interest rates, increasing house prices are another benefit. How does this help companies like Annaly Capital Management (NLY 1.91%), New Residential (RITM 1.35%), or MFA Financial (MFA 2.50%)?
Home prices are rising at a double-digit clip
According to the National Association of Realtors, there were just over 1 million homes for sale in the United States at the end of February, which is a record low. As a result, the median home price rose 15.8% year over year. The S&P CoreLogic Case-Shiller Home Price Index reported a 10.4% gain in 2020. There is a massive supply and-demand imbalance in the single-family home market as professional investors compete with homebuyers fleeing the cities.
While people will start throwing around terms like "bubble" every time an asset price has a large gain, it pays to understand that such things are quite rare. Residential real estate bubbles occur every third or fourth generation (the previous one was in the 1920s), and they require all significant players -- investors, bankers, and government -- to believe an asset is "special" and cannot fall. The memories of 2008 are too recent for that to really happen. Real estate prices are rising because demand is greater than supply.
Mortgage REITs have a unique way to capitalize
Mortgage REITs are different than the traditional REIT, so it makes sense to take a minute to understand the differences. Most traditional REITs follow a tenant/landlord model, where a company builds an office building, apartment building, or shopping mall and rents out the units to individual tenants. Mortgage REITs don't invest in real property; they invest in real estate debt (i.e. mortgages). While traditional REITs earn rental income, mortgage REITs earn interest.
So mortgage REITs that have exposure to non-government-guaranteed mortgages will benefit from rising home prices. Let's take a closer look at the three I named above.
MFA Financial's portfolio is invested primarily in residential whole loans and real estate owned (REO). The company owns about $250 million worth of properties, as a result of foreclosures. Single-family rental vehicles are hot right now, and homebuilder Lennar recently raised capital to buy existing homes, which puts it in direct competition with American Homes 4 Rent and Invitation Homes. These companies get rental income along with asset price appreciation.
While Annaly Capital invests mainly in mortgage-backed securities that are guaranteed by the U.S. government, it also has a sizable portfolio of loans that are not guaranteed. As real estate prices rise, loan performance improves because borrowers are less likely to walk away from a property that's worth more than the mortgage owed. Second, these loans are carried on Annaly's balance sheet at 75% of face value, which means that increased refinancing activity will realize that discount quickly.
Another mortgage REIT that will benefit is New Residential, which has a large mortgage origination arm. New Residential is big in the non-qualified mortgage space, which contains mortgages that are not guaranteed by the U.S. government. These loans carry higher rates than traditional government mortgages and are often made to professional real estate investors. This is another case where improving real estate prices will encourage stronger credit performance. New Residential will also benefit from a recent change in the rules for Fannie Mae and Freddie Mac, which will present a wider lending opportunity for the company.
While mortgage REIT earnings are largely driven by changes in interest rates, these assets are at least somewhat sensitive to the underlying fundamentals in the real estate market. That said, these companies primarily trade on their dividend yields and book values. In an environment where we are seeing rapidly rising real estate prices, the REITs with the highest exposure to residential credit risk will benefit the most. This means that New Residential and MFA should fall in that category. That said, any mortgage REIT with exposure to real properties will reap benefits.