Last year’s precipitous drop in short-term interest rates - the yield on three-month Treasury bills fell from 5.7 percent at the end of 2000 to 1.7 percent a year later - and the much smaller decline in long-term rates - from 5.12 percent to 5.03 percent for ten-year Treasuries - were a godsend to mortgage real estate investment trusts. That’s because their liabilities (the obligations of their adjustable-rate mortgages) reflect long-term rates while their assets (their own borrowing costs) reflect the movement of short-term rates. In addition, mortgage REITs reprice their borrowing costs every 30 days, whereas they reprice their ARMs every 12 to 24 months.
The result? Last year mortgage REIT profits soared between 50 and 100 percent for most of the 25 publicly traded companies, including four non-REIT mortgage companies, estimates W. Coleman Bitting, mortgage finance analyst at St. Louis-based Flagstone Securities.
The profit surge ignited the performance of the National Association of Real Estate Investment Trusts mortgage REIT index. In 2001 it produced a 77.3 percent total return, compared with the 13.9 percent return of the association’s equity REIT index. Some residential mortgage REITs, including Annaly Mortgage Management and Thornburg Mortgage, generated returns of 100 percent or more last year.
Such commercial mortgage REITs as Anthracite Capital and iStar Financial gained a more modest 45 to 60 percent. Unlike residential mortgage REITs, which primarily invest in implied government-guaranteed Fannie Mae and Freddie Mac mortgages, commercial mortgage REITs carry credit risk as well as interest risk.
Still, the gains represent a nice recovery from the disastrous late 1998 to early 1999 period, when total returns for the sector fell 50 to 60 percent and a major commercial mortgage REIT - Rockville, Maryland-based Criimi Mae - filed for bankruptcy protection (the firm emerged from Chapter 11 last year). Those devastating losses reflected the bond market turmoil that followed the collapse of the Russian ruble and the meltdown of Long-Term Capital Management. During this painful stretch, interest rates for any bond that wasn’t stamped “U.S. Treasury” spiked suddenly and dramatically. Says Flagstone’s Bitting, “Anyone who owned leveraged fixed-income assets suffered.”
One company that avoided the profit margin squeeze: industry leader Annaly. It boasts a market capitalization of $830 million, out of a total industry equity capitalization of $3.49 billion. Says CEO Michael Farrell, “We are in the most defensive stance in the five-year history of our company.”
Of course, rising interest rates could hurt mortgage REITs’ profits, but the damage need not be fatal. Says UBS PaineWebber mortgage analyst Gary Gordon, “Earnings won’t collapse unless there’s a very big jump in rates, which now doesn’t appear likely.”
At seven to eight times earnings and yields of 12 to 13 percent, the stocks are not expensive, Gordon feels. “There’s still some reason to buy them,” he says. Why are they so cheap? “Investors haven’t accepted these much higher earnings. People believe they won’t last.”
Gordon figures Annaly will produce total returns of 10 to 12 percent a year over the next three years. The analyst believes commercial mortage lenders Anthracite Capital and iStar have a chance at greater appreciation, as they remain less vulnerable than their residential counterparts to interest rate changes.
Flagstone’s Bitting, though, is more bullish on the residential mortgage REITs, especially Impac Mortgage Holdings and Redwood Trust, as well as a non-REIT, NovaStar Mortgage. The group racks up impressive mortgage origination fees. He predicts total returns for the group of 20 to 30 percent over the next 12 months. That would make them lucky lenders indeed.
