RWT - Mortgage REITs Ranked By Quality (And Some Words Of Caution)

2023-04-19 15:14:08 ET

Summary

• Most mREITs are likely to continue to underperform in a high-rate environment.
• Some observers are already predicting an end to fed funds rate hikes, but I suspect those predictions could be premature.
• Over most time periods, even mREIT gainers have underperformed SP500 even as measured by total return.
• 37 mReits were evaluated using a quality matrix with factors including: Price/Book, EPS MRFQ/Price, Return on Equity, Forward Yield, and Payout Ratio TTM.
• Those readers who are still feeling sporty might first consider those mREITs with the highest matrix score and low payout ratios.

mReit Funding Costs and Rising Rates

Mortgage Real Estate Investment Trusts (mREITs) focus on real estate financing and often profit on net interest margin, the spread between interest income generated by mREITs' mortgage assets, and their funding costs. An mREIT's funding costs are largely dependent on Federal Funds Effective Rate. The following plot reflects the Federal Reserve's most recent 0.25% hike.

Federal Funds Effective Rate, Consumer Price Index Monthly Rate of Change (inflation), and Currency in Circulation are plotted from 1980 forward. Some observers are already predicting an end to fed funds rate hikes, but I suspect those predictions could be premature. Inflation is still at a 40 year high while the fed funds rate remains below its highest rates in this millennium. Further, the Fed's quantitative tightening efforts have not and (based on history) are unlikely to reduce currency in circulation.

Most mReits Have Painfully Underperformed Over Most Time Periods

The performance of 37 mReits covered by Seeking Alpha is summarized in the plot below.

mREIT Performance

Over most time periods, even mREIT gainers have underperformed SP500 even as measured by total return. One exception is 3Y performance, where 28 mReits gainers' average total return was 59% vs SP500 total return of 54%. However, the average 3Y total return of all mReits underperformed SP500 total return by over 5%. If teardrops were diamonds, many mREIT investors would already be fabulously wealthy. However, for those investors who are still feeling sporty, I will rank mReits by quality.

Relative Quality Evaluation

The 37 mReits covered by Seeking Alpha were compared using a quality matrix with factors including: Price/Book, EPS MRFQ/Price, Return on Equity, Forward Yield, and Payout Ratio TTM. The values for each company's factors were normalized by means of statistical percent ranking with relation to the group. The quality matrix was calculated as the sum of the percent ranks of the factors.

Quality Matrix Chart

The above chart is sorted in descending order of the best value (highest matrix score) to the poorest value (lowest matrix score). Note payout ratios over 95% are highlighted in red. Some companies reported negative earnings over the previous 12 months. In those cases, a payout ratio could not be calculated in a meaningful way and "NE" was tabulated instead.

Quality Matrix Plot

The quality matrix is presented graphically in the stacked bar chart above with cumulative inputs for each factor. Based on this analysis, the most favorable investments in the group are likely to include:

1. Ready Capital Corporation ( RC )
2. Arbor Realty Trust, Inc ( ABR )
3. Rithm Capital Corp. ( RITM )
4. Apollo Commercial Real Estate Finance, Inc. ( ARI )
5. Blackstone Mortgage Trust, Inc. ( BXMT ).

Based on this analysis, the least favorable investments in the group are likely to include:

1. Angel Oak Mortgage REIT, Inc. ( AOMR )
2. Redwood Trust, Inc. ( RWT )
3. PennyMac Mortgage Investment Trust ( PMT )
4. Broadmark Realty Capital Inc. ( BRMK )
5. Orchid Island Capital, Inc. ( ORC ).

A note on payout ratios: Stocks with higher forward yields can be great investments. However, high yield stocks are risky when dividends are not supported by revenue. If the payout ratio is consistently high over time, the dividend is unsupported by earnings and is at high risk of a cut with a resulting price decline.

Quality Matrix Limitations

Investors should consider the value matrix a screen only. The matrix and its factors, normalization method, and weights could all be adjusted and yield different results. Further, the matrix is based on the most readily available and common metrics. These metrics can change rapidly with share price or as new company reports are released. The value matrix does not include company-specific data available in quarterly reports and presentations.

The value matrix is a blunt instrument; finesse, judgement and discernment are left to investors. Investors are advised to consider the value matrix as nothing more than a starting point for their own due diligence. Nonetheless, a higher value matrix score indicates an investment with a favorable combination of the factors considered.

Conclusions and Recommendations

The 37 mREITs evaluated have a total market cap of $51.7B and most of these mREITs are likely to continue to underperform in a high rate environment. In fact most have been a poor investment over most time frames. I don't doubt that some traders with excellent timing have realized past returns and some will profit going forward. However, I would advise most investors stay clear of the sector and further advise investors with current positions to carefully review those positions.

Those readers who are still feeling sporty might first consider those mREITs with the highest matrix score and low payout ratios. Investors are once again cautioned to consider every investment carefully and on its own merits.

Information is a source of learning. But unless it is organized, processed, and available to the right people in a format for decision making, it is a burden, not a benefit. - William Pollard (Physicist and Theologian).

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