2024-01-15 07:00:00 ET
Summary
- REITs, including mortgage REITs, may begin to recover in 2024 as the Federal Reserve hints at lowering interest rates.
- Economic uncertainty has negatively impacted REIT share prices, but signs of recovery have been seen since November 2023.
- Dynex Capital is well positioned to benefit from the strong US economy, a potential recovery in the housing market in 2024, and the potential for lower interest rates.
While the past couple of years have not been kind to the real estate sector of the stock market, 2024 may be the year that REITs, and mortgage REITs in particular, begin to recover as the Federal Reserve hints at lowering interest rates. According to Nareit , recovery for REITs could be on the horizon for 2024 due to a number of factors, including the potential end to the Fed tightening cycle.
Economic uncertainty, which began in 2022 and created a difficult environment for REIT share prices, will likely be an ongoing theme in 2024. For example, as the 10-year Treasury yield increased nearly 3% and REIT implied cap rates rose from 4.5% to nearly 6.5%, REIT share prices fell by 21.4% from the beginning of 2022 through Dec. 1, 2023.
History has shown that REITs often outperform after the end of a Fed tightening cycle as illustrated in this chart from Nareit.
In my recent article discussing Ellington Financial ( EFC ), I discussed how that REIT already started to show signs of recovery since the beginning of November when the Fed first hinted that interest rates could be lowered in 2024. The real estate sector as of the second week of January is the top performing market sector since the October low.
In fact, several REITs have begun to show signs of recovery and strong performance since the end of October including other mREITs that had very poor performance since January 2022. One of those is Dynex Capital ( DX ), which is well positioned in my opinion to benefit from the strong US economy and the disinflationary trend that could lead to lower interest rates later this year.
Is Dynex Capital a Buy?
While several REITs offer a high yield dividend that is attractive to income investors, including DX, EFC, AGNC Investment ( AGNC ), Annaly Capital ( NLY ), and PennyMac Mortgage Investment Trust ( PMT ), not all of them have been able to navigate the rapidly changing rise in interest rates effectively. One or more of these REITs may be forced to cut their dividend soon. In fact, PMT reduced their dividend payout in December 2022 and NLY cut their dividend in March 2023, while DX, EFC, and AGNC have thus far maintained the same dividend payout for the past 3 years.
Comparing 3-year total returns for these five REITs it appears that EFC has performed the best, with PMT catching up over the past couple of months and DX holding steady, while AGNC and NLY have lagged the others.
However, past performance is no guarantee of future results as each of the five has different opportunities and risks. DX has a market cap of about $725M, is basically a pure play mortgage REIT (with some investments in securitized loans in both single-family residential and commercial) and offers investors a yield of about 12% at the current market price. I rate DX a Hold at the current market price pending news of any future interest rate cuts.
Q3 Results and Long-Term Outlook
With interest rates rising quickly over the summer and fall of 2023 and the housing market remaining flat due to higher mortgage rates, the impact to Dynex was reported in the poor quarterly earnings results that included a drop in book value from $14.20 in Q2 to $12.25 in Q3. A comprehensive loss of -$1.59 was reported as compared to a gain of $0.79 in Q2 and the total economic return (including dividends declared and the change in book value) was -11% compared to 5.7% in Q2. The leverage level increased from 7.7x to 8.5x during the quarter. Average earning assets increased from $6.6B to $7.5B, inclusive of TBAs .
Gains from rate hedges are not included in the reported numbers but do have an impact on the dividend coverage. As explained on the Q3 earnings call by CFO Rob Colligan:
In the third quarter, Dynex had net hedge gains of $217 million and have unamortized net hedge gains of $830 million at quarter end. These hedge gains help to offset increase in financing costs. For the third quarter, we recognized $18 million of hedge gain amortization for tax purposes, or approximately $0.33.
As of now, we're projecting the fourth quarter to have hedge gains of $24 million, or $0.41 per share. The total amount of gain to amortize and to REIT taxable income can go up or down, depending on the hedge position and movement in rates in the future. Dynex ended the third quarter with an unrealized gain on its hedges.
While the report for Q3 was not encouraging, Dynex management reminds investors that they have a long-term view of the market, and the company is well positioned to take advantage of opportunities. As CEO Byron Boston summarized in the Q3 earnings call:
As I lead Dynex, my focus remains on generating long-term sustainable returns. In that regard, our past performance provides a strong foundation to work from as we navigate what is clearly an unpredictable and evolving environment. I see a compelling business opportunity in agency mortgage-backed securities to earn above average returns adjusted for the risk. We have positioned our shareholders to benefit from this in the long-term.
Although the quarterly results were disappointing, Dynex management maintains an optimistic long-term perspective that is based on changes in the financing of MBS due to a shift over the past several years from government agency backed securities to more privatized financing. This macro level shift is further explained by President and Co-Chief Investment Officer Smriti Popenoe:
For much of the last 15-years the U.S. Federal Reserve was the largest holder of agency RMBS and before that the GSEs retained portfolios with the largest holders. These entities crowded out private capital and removed a risk premium from the asset class.
Private capital must now replace these government balance sheets. And in agency RMBS, that risk premium has now returned. Spreads are historically wide and they compensate private capital appropriately for the risk. This is why I have been saying we are in the middle of a persistent investment opportunity for our shareholders.
This macro level view of the long-term opportunity in RMBS is further illustrated in this slide from the Q3 earnings presentation.
One way that the company is preparing themselves for the long haul is by maintaining a large amount of liquidity. They ended the quarter with $450 million in cash and unencumbered assets. Another aspect of their long-term strategy involves additional gains from hedging. In fact, according to CFO Colligan the company has realized over $100 million in hedge gains since quarter end. This slide from the Q3 presentation illustrates some of the changes made in the hedge positions from Q2 to Q3.
Those hedge positions change frequently and are adjusted using a combination of options and futures, so the strategy is flexible allowing them to adjust to a steepening curve. Again, further detail is provided by Smitri on the earnings call regarding their approach:
So let me give you some fundamental observations about the mortgage market here. The Fed is basically coming out and telling us that they're pretty much done raising rates. The second thing is the biggest bank selling that we had, you know, this year is done right? The third thing that's happened here at this time which is really important is the yield curve is substantially steeper and for the first time now you actually have agency mortgage yields at a positive yield spread versus Fed funds. So the yield on current coupon mortgages is around 6.5%, 7%. Fed funds is at 5.5%, that's a lot of carry in mortgages.
Summary and Conclusion
Although Dynex has experienced a rough two years and an unprofitable Q3 in 2023, the company is well positioned for the long term with a strong management team, a highly liquid balance sheet with an effective hedging strategy, opportunities to leverage widening (or tightening) spreads to incrementally manage assets, and strong long-term returns with a stock price trading at a discount to book value which could close as the market realizes the benefits provided by the REIT model. In essence, the company finds themselves in a position to take advantage of a potential historic opportunity in the asset class as summarized by Smitri in the Q&A in response to a question about the possibility of needing to raise capital:
This asset class is cheap, period. It's the cheapest asset class out there. It's the asset class that every astute investor should be looking at, because the forward returns are extremely compelling. So if we're out there raising capital, the story we're telling is, number one, this is the asset class that's gotten the cheapest. We know why it's here. We know why it's cheap. We know why we're getting to earn this incremental spread, because private capital now can earn a risk premium that wasn't previously there to earn.
The current macro environment is still in flux and risks remain while interest rates continue to be elevated and the housing market remains stagnant. If the Fed does indeed follow through with rate cuts this year and if mortgage lending activity begins to pick up again as most are expecting, then Dynex is in a good position to take advantage of the widening spreads and should see greatly improved returns. The strong balance sheet and realized gains from hedging activity should help to support the continued dividend payout without the need for a cut, however, if losses continue to pile up beyond Q1 2024 then I believe that a dividend cut may be inevitable.
I rate DX stock a Hold mainly because of the current uncertainty with respect to interest rates, inflation, and the housing market which is seasonally slow during the winter months. By the time that DX reports Q4 results, we may have a clearer picture of the future, but for now I would caution investors to hold off on initiating a new position. If you already own shares of DX I would continue to hold and collect the income. There may be an opportunity in the coming weeks to buy shares at even cheaper prices depending on what happens with the overall market, which is ripe for a correction in my opinion.
For further details see:
Dynex Capital: This REIT Yields 12% And Is Poised To Outperform In 2024