Interest rate concerns that forced mREITs to trade at the lowest valuation during the past few years will be less of an issue going forward, according to Keefe, Bruyette & Woods.
Most mREITs were caught off guard in the second quarter by a surprising rise in rates that damaged their bottom line, but that risk has abated, analysts wrote. “The likelihood of sharply and sustainably rising rates appears diminished.”
As a result, going forward, these REITs expect to have a reduced rate exposure and “a much more positive tone in 3Q reporting.”
During the quarter mREITs have been busy “rebalancing portfolios, adding hedges and taking down leverage,” analysts explain in a recent report, and now are looking forward to more compelling business opportunities.
However, due to a still shaky economic recovery the most promising opportunities appear to be in more effective hedging, analysts note, so equity investors are “looking for portfolio hedges of their own.”
Judging from recent conference presentations most mREITs now have better hedged portfolios, improving spreads, leverage off-peak levels, and book values that remain flat compared to their second quarter levels. And even though currently liquid asset portfolios are trading at 15% discounts to mark-to-market value the 3Q outlook is generally positive, analysts note.
For example, most dividends “were brought down to sustainable levels that appropriately reflect lower leverage and lower risk.”
These improvements are bound to lead to relatively stable book values and mark “a positive flip side of the coin” compared to the book value declines in the previous quarter.
Meanwhile, prepays have slowed dramatically to a level that should bring 3Q prepayment speeds down to the lowest level in over a year, according to the report, so these changes, which in turn, “will help net interest spreads.”
Analysts expect the effects of the debt debacle and government shutdown will weigh on consumption and consumers’ sentiment and further damage the market “for at least a few quarters,” even if it does not last much longer.
“At an extremely big-picture level, the mortgage REITs of today are resilient yet countercyclical,” analysts argue. “This broadly left-for-dead sector” is worthy of materially more interest because the market is only about halfway through a multi-decade economic growth challenge.