Mortgage REITs Are Bad Long-Term Investments

• The average annualized NAV return since inception for 15 residential mortgage REITs is 3.5%
• The average annualized NAV return since inception for 10 commercial mortgage REITs is 2.7%
• Mortgage REITs have complexity, volatility, and high overhead, but many fail to  outperform unlevered bond portfolios.
• Large discounts may provide opportunities for short-term outperformance
• New Residential, AGNC, and Blackstone have produced the best results

The above numbers actually overstate the performance of mortgage REITs due to a survivorship bias.  The total return since 2007 inception of the iShares Mortgage Real Estate ETF (REM) is -56% compared to a +74% return for the Vanguard Total Bond Market Index Fund (VBMFX)

Mortgage REITs attract investors by paying high dividend yields, but the benefit has been offset over time by falling asset values.

Topics:

• Historical Returns
• Historical Volatility
• Expense Ratios
• Discounts
• Investment Considerations

HISTORICAL RETURNS

These tables measure NAV performance since IPO (or other launch) rather than share price return.  They include dividends, but do not assume reinvestment.  New Residential (NRZ) is the only one of 15 residential mortgage REITs that was able to sustain its initial value:

Blackstone (BXMT) is the only one of 10 commercial mortgage REITs that was able to sustain its initial value:

For comparison the return of the Vanguard Total Bond Market mutual fund (VBMFX) over 20, 10, and 5 years was:

Mortgage REITs take a lot of small risks (interest rates, spreads, prepayment behavior, liquidity, delinquencies and defaults) that are magnified by leverage occasionally leading to large losses.

HISTORICAL VOLATILITY

Even in normal times Mortgage REIT share prices are considerably more volatile than bond prices due to leverage and changing investor sentiment.

EXPENSE RATIOS

Mortgage REITs incur significant costs in managing their complex portfolios.  Comparisons between companies are imperfect because some hold only public securities while others have many employees originating and servicing loans.  These tables attempt to show only corporate overhead (salaries, management fees, professional services, general and administrative) excluding investment expenses (property operating costs, servicing fees, transaction costs etc…) but accounting treatments and disclosures vary from one REIT to another.

AGNC (AGNC) stands out for efficient operation which contributes to its better than average historical return.

DISCOUNTS

Falling asset values demonstrate that mortgage REIT earnings do not cover their dividends.  However market dislocations occasionally cause share prices to trade far below asset values.  At such times investors may profit from narrowing of the discount, return of capital through dividends, accretion resulting from share buyback, and the potential to realize fair value through a liquidation or merger.

One important factor to keep in mind when comparing current discounts is that almost all securities held by mortgage REITs are carried at “fair value” while some loans “held-for-investment” are carried at cost with a loss provision if management believes full recovery is in doubt.  The market value of a loan during a market panic such as we saw in March 2020 may be far below its carrying value.

INVESTMENT CONSIDERATIONS

Dividends simply transfer value rather than creating value.  Any change in the dividend does not affect the underlying value of the company and its assets so this article does not offer any detailed commentary about past present or future dividends.  Investor sentiment related to dividends contributes to volatility by pushing prices higher when payments are considered “safe” and lower when payments are at risk or cancelled.  Dividend payment returns a portion of the full NAV which investors may currently be able to acquire in the market at a significant discount.

Discounts occasionally provide opportunities to profit from the sector’s volatility.  Investors should support activists pushing companies to eliminate the discount through share buybacks, sale or liquidation because few of these companies have been creating value as going concerns.

Disclosures

At the time of publication the author held long positions in LADR NRZ NYMT and short positions in IVR and MITT.  These disclosures are not recommendations and these holdings could change at any time.  Investors should check all facts cited here before making any investment decision.