The past 15 months have been particularly difficult for companies operating in the mortgage market. The Federal Reserve's rapid-fire interest rate increases depressed the value of mortgage-backed securities. Rising rates also negatively affected anyone in the business of originating mortgage loans, as the incentive to refinance for a lower rate disappeared.
Now that the Federal Reserve is getting close to wrapping up its tightening cycle, the mortgage real estate investment trusts (REITs) are getting a second look from investors attracted to their above-market dividend yields. Two popular mortgage REITs are Annaly Capital (NLY 1.02%) and PennyMac Mortgage Trust (PMT -0.28%). Which one is the better buy?
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Annaly originates a lot of business purpose mortgages
Annaly Capital is a mortgage REIT that focuses on mortgage-backed securities, which are guaranteed by the U.S. government. The company also originates mortgages that are not guaranteed by the government, which are typically geared toward professional real estate investors. Annaly also invests in mortgage servicing assets.
Mortgage servicing is an unusual asset. The servicer handles the administrative tasks of the mortgage on behalf of the ultimate mortgage investor. The servicer sends out the monthly bills, collects the payment, sends the principal and interest to the investor, and works with the borrower in the event of a default. The servicer is paid an annual fee of 0.25% on the balance outstanding on the mortgage. The right to perform this service has value, and it is capitalized on the balance sheet as an asset.
PennyMac originates a lot of government-guaranteed mortgages
PennyMac Mortgage Trust has a business model similar to Annaly's. PennyMac Mortgage Trust invests in mortgage-backed securities, mortgage servicing rights, and mortgages that are not guaranteed by the U.S. government. PennyMac Mortgage Trust is also a correspondent mortgage lender, which means it purchases mortgages that have already been funded by a different lender, and then flips them back into the market via a securitization. PennyMac Mortgage Trust also invests in credit risk transfer securities, which are sort of a reinsurance arrangement with Fannie Mae and Freddie Mac.
Both Annaly and PennyMac Mortgage originate mortgages, although PennyMac focuses much more on mortgages that are guaranteed by the U.S. government. Annaly mainly focuses on business-purpose loans like fix-and-flip and loans that are based on rental income. These loans tend to have higher interest rates, and borrowers who take out these loans usually can't get a government-guaranteed loan.
For a professional real estate investor, the decision to borrow is a function of interest rates, home price appreciation, and a whole host of other considerations. They are much less likely to see a burst of new borrowing if interest rates fall.
PennyMac's loans are more interest rate sensitive. If interest rates fall, homeowners should see improved housing affordability, which will spur purchase activity. Home sellers will be more amenable to moving if it means interest on a new home loan is less. Refinancing opportunities may increase as well, as borrowers extract home equity to pay off higher-interest-rate debt.
Both companies recently cut their dividends
Annaly recently cut its dividend from $0.88 a quarter to $0.65. At current levels, Annaly has a dividend yield of 12.7%. PennyMac cut its quarterly dividend from $0.47 to $0.40 in 2022. At current levels, PennyMac has a dividend yield of 12.2%. Both companies are in the servicing business, and servicing assets soared in 2022 on rising interest rates. Originators and mortgage REITs like to hold servicing because it is one of the few assets that increases in value as rates rise. If rates fall and delinquencies increase, servicing valuations are going to take a hit.
Ultimately, if interest rates are going down, which mortgage REIT will perform better? My sense is that falling rates will be good news for both companies' agency mortgage portfolio. It will be bad news for both companies' servicing portfolios. For the origination arms, I think falling rates will benefit PennyMac Mortgage Trust more. Falling rates will encourage more home sales, and refinancing activity might pick up at some point. I don't see a decline in rates mattering as much to professional real estate investors. So I think PennyMac might be better positioned to benefit from falling rates.
