Mortgage REITs (real estate investment trusts) are usually a favorite of yield-hungry investors (and for good reason -- they often have yields eclipsing 10%), but lately they've fallen out of favor. The REITs borrow money to buy and hold mortgages and mortgage-backed securities (MBS).
In good times, they earn the spread (called the net interest margin) on the difference between the rates on the mortgages they hold and cost of the debt they use to finance the mortgages. But when rates go up, they can start to lose money fast and that can compromise their ability to pay out the mandatory 90% of their taxable earnings as dividends.
Mortgage REITs are vulnerable to rising interest rates for three key reasons:
- Rising rates decrease the net interest margin.
- When rates go up, the value of MBS goes down.
- Rising rates increase the possibility that mortgage payers with variable-rate mortgages won't be able to make payments.
Let's take a look at three of the biggest players in the mortgage REIT market, Annaly Capital Management (NLY 1.01%), Blackstone Mortgage Trust (BXMT -0.87%), and Arbor Realty Trust (ABR -0.20%), and evaluate the level of exposure each has to rising interest rates.
1. Annaly Capital Management
Annaly is the largest mortgage REIT, with an $89 billion portfolio, financed with $76 billion of debt. Its net interest margin in 2021 was just over 2%, and its current dividend yield is 11.9%.
That level of yield, plus a price-to-earnings multiple of just 4.7 and price-to-book of 0.94, shows just how little the market thinks of Annaly's future prospects. If the stock price stays at this level, investors would make more on its dividend than the average stock market return over the past 50 years.
Annaly has planned ahead for rate hikes and management mentioned in the most recent investor presentation that it expects three 0.25% hikes in 2022. The company is prepared because it has cut operating costs, focused on agency MBS (mortgage securities that are backed by the U.S. government), and proactively hedged 95% of its existing portfolio with derivatives that will go up when interest rates do.
Annaly followers know that its stock has suffered during interest rate hikes in the past. It fell 22% from mid-2017 to 2019 as interest rates rose. That level of performance is priced into the stock already. If the management team has adapted well enough with its existing hedge portfolio and can move quickly to keep its interest margin high enough as rates rise, the stock may rise even faster.
2. Blackstone Mortgage Trust
Blackstone Mortgage Trust is sponsored by Blackstone Group, an $880 billion alternative asset manager. The mortgage trust has a $24 billion loan portfolio and isn't quite as undervalued as Annaly, as it currently sports a P/E of 11.3, P/B of 1.15, and dividend yield of almost 8%.
Blackstone Mortgage trades at a premium because of its growth and portfolio mix. Its portfolio increased by $5.9 billion in 2021, representing about 20% growth. Its portfolio of mortgages (purchased from parent Blackstone Group) is mostly in the office and hospitality markets, with a little multifamily sprinkled in.
Those types of loans are considered corporate loans, not residential. Because of that, they have higher interest rates, and a larger portion have adjustable interest rates -- meaning if the Federal Reserve raises rates, Blackstone Mortgage will be paid more on its existing portfolio.
Focusing on corporate debt also allows Blackstone Mortgage to use less leverage. Just by way of comparison, Annaly financed over 85% of its portfolio, while Blackstone financed less than 65%. So rather than rate risk, credit risk is the issue here.
Corporate debt isn't guaranteed by the government like it is with agency MBSes. If one of Blackstone Mortgage's 189 mortgages defaults, it just has to write it off. Floating-rate debt is nice for the REIT's top line, but its borrowers have their own budget constraints. Rising rates could spell defaults or prepayment for borrowers who can't afford higher payments.
3. Arbor Realty Trust
Arbor Realty also looks cheap right now. Its P/E of 7.2 is below its five-year average of 9.83 and less than half of what it was in 2020. Its yield of 8.4% also reflects a nervous market.
Right now, 89% of Arbor's portfolio is in multifamily real estate loans, while 95% of its loans are classified as bridge loans. Bridge loans are short-term real estate loans made to investors who plan to fix up a property, either through better management or structural improvements, and then refinance after a couple years to a long-term note.
Arbor's weighted average loan term right now is just 22 months. That means if interest rates jump, Arbor just replaces the runoff of old loans with new, higher-rate loans. Unlike many mortgage REITs, Arbor could benefit from an increase in rates.
Additionally, Arbor has invested in $26 billion of mortgage-servicing rights. In this business, the REIT purchases the right to service mortgages (meaning it collects payments from customers and administers escrow accounts) from the financial institutions that originated the loan. Arbor generates about $120 million of annual income from servicing the loans (which usually have prepayment protection), with no interest rate exposure.
Each of the three mortgage REITs we've talked about have some level of exposure to interest rate risk. Annaly's net interest margin could fall, Blackstone Mortgage could see more defaults, and Arbor Realty might have a lag for a couple years before it can replace existing low-rate debt with loans bearing higher rates. The key for investors is figuring out whether enough (or too much) of that risk is priced into the stock. Right now it looks like each of the three may have too much risk priced in.