Residential Mortgage REITs: Poor Total Return, High Volatility, and Uncertain Dividends … As Usual

  • Residential mortgage securities performed well this year due to massive government support and a strong housing market in most of the country.
  • Residential mortgage REITs produced an average year-to-date total NAV return of -25% to 9/30 and a ytd total price return of -28% to 12/23.
  • Deeply discounted valuations created short-term opportunities earlier this year, but the average discount has shrunk to 9%
  • Ellington Residential, and Dynex were the only REITs to provide positive NAV and price returns in 2020.
Residential Mortgage REIT Shareholder Meeting

The ishares Mortgage Real Estate ETF (REM) has delivered a negative total return since its 2007 inception due to value destruction during market downturns:

Equity and bond markets staged an impressive recovery in 2020 and home prices (the backing for residential mortgage credit) are at all-time highs, yet residential mortgage REITs have delivered an average YTD return of -28%, roughly in line with the -25% decline in their NAV.

Mortgage REITs attract investors by paying high dividend yields, but the benefit has been offset over time by falling asset values. It has been difficult to deliver the yields that investors expect without taking the risks that lead to permanent capital losses during market panics.

Topics:

  • Historical Returns
  • Selling Assets At The Bottom
  • Dividend Reductions
  • High Volatility
  • Investment Considerations

HISTORICAL RETURNS

Mortgage REITs have provided a wide range of historical returns although direct comparison is imperfect because each REIT has a different inception date.

The average of the REITs in the table is much higher than the the sector (represented by the REM fund) due to a survivorship bias. Poor performers disappear through bankruptcy, liquidation, and acquisition. AGNC stands out for having a superior long-term record, although it has generated a modest NAV and price loss in 2020.

SELLING ASSETS AT THE BOTTOM

In order to generate the high yields expected by investors, mortgage REITs managers feel pressured to add leverage and credit risk in calm markets. Use of convenient low cost financing from secured repurchase facilities is very common, but during market panics these margin loans can be subject to increased haircuts and decreased availability resulting in forced portfolio liquidation at low prices. The ytd average change in total assets for 18 residential mortgage REITs has been -43% and most of the decline took place at the worst possible time, in March and April.

DIVIDEND REDUCTIONS

Mortgage REITs that sold assets at low prices locked in permanent losses and suffered permanent reduction of potential earnings and dividends.

On average and in aggregate, residential mortgage REITs do not provide investors with stable income.

HIGH VOLATILITY

Mortgage REIT’s high leverage and complexity lead to volatile share prices. This chart compares a Vanguard agency mortgage fund (VMBSX) against the 8 largest residential mortgage REITs.

The REITs have significantly higher price risk, but do not provide a higher return. However, the chart does show two broad opportunities for investors who were willing to make the volatility work in their favor by buying at discounted prices in early 2016 and early 2020.

INVESTMENT CONSIDERATIONS

Share prices of residential mortgage REITs have recovered to modest discounts to their underlying asset values. Stocks could rise further, but 2020 revealed once again the inherent risks of the high leverage + high dividend business model.

Observations about a few individual REITs:

  • AGNC has delivered the best long-term return, significantly helped by its much lower than average overhead (2020 operating expenses running at 0.8% of equity). The company lost money in 2020, but was not a disaster. Returns for REITs which hold only portfolios of securities, such as AGNC and this years gainers (EARN and DX) are hard to forecast because they depend on the managers judgments about risk and hedging.
  • NRZ was forced to sharply reduce in assets in March and raise financing on dilutive terms, but has more remaining recovery potential than peers. The company filed for a public offering of its mortgage origination business and estimates it could be worth $5.58-$7.66/share in excess of current book value. The company also estimates that the value of its MSR assets could rise by $3.60/share if valuations normalize. These segments balance each other so it’s unlikely that full value would be realized from both. If mortgage rates remain low then origination earnings will be high, but MSR values will be low due to faster amortization. If rates rise then origination earnings will be weaker, but MSR values will rise due to slower amortization. In contrast to the REITs which hold only securities portfolios, NRZ has a large operating business with 5105 employees and licenses to operate in all 50 states.

Disclosures

At the time of publication the author held a long position in NRZ.  This disclosure is not a recommendation and the holding could change at any time.  Investors should check all facts cited here before making any investment decision.

My prior article (Mortgage REITs are Bad Long-Term Investments) calculated total return for each REIT with dividends held in cash rather than reinvested. Either approach is valid as long as it is applied consistently across REITs and benchmarks. Reinvestment makes the strong performers look better and poor performers look worse.

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