Clash Of The Titans - eREITs Vs. BDCs Vs. mREITs Vs. The Markets

| About: iShares Mortgage (REM)


On one corner of the boxing ring, representing the overvalued equity REITs: VNQ.

On one corner of the boxing ring, representing the undervalued BDCs: BDCS.

On one corner of the boxing ring, representing the high risk-reward mortgage REITs: REM.

On one corner of the boxing ring, representing the markets: SPY.

The Clash of the Titans - May the Best Man Win!

Following my "Mortgage REITs In 3 Charts And One Healthy Headache" I've decided to dive into this mREITs debate a little bit further.

There are Pros & Cons to almost anything in life and mREITs are no different. On one hand, mREITs are not immune to risk and there are many moving parts that affect those instruments. On the other hand, where there is risk there's also a potential-higher reward.

The key is, therefore, to measure and decide how attractive is the reward compared to the risk. Putting it differently, how undervalued or overvalued is a certain asset class based on very simple parameters.

I'll stick to the recent "a picture is better than a thousand words" theme and will use four charts to demonstrate and prove my thesis.

Although I believe that eREITs are overvalued and should not be bought at current prices, I wish to make it clear that the message I'm trying to communicate is not "avoid eREITs" rather "prefer mREITs". While there's no doubt that mREITs are riskier than eREITs, I believe that at this point of time mREITs are more attractive than eREITs.

Those who follow me already know that I'm a big fan of interest-rate sensitive instruments since the beginning of 2016, simply because I don't expect short interest rates to move up in a meaningful way anytime soon. That doesn't mean that the Fed can't/won't raise rates at all and, more importantly, that doesn't mean that spreads can't/won't widen.

The Fed has very little room to do anything right now, while everything seems dark and gloomy. June, starting with the disastrous NFP numbers at the beginning of the month and ending with the Brexit last week, make it impossible for the Fed to tighten. For now...

If I am the Fed with almost no room to maneuver, I would seriously consider to do the unthinkable: Start selling the tons of long-term debt that are held in the Fed's balance sheet. By doing so the long-end of the curve would rise significantly, the curve as a whole would steepened and most of all, the curve that is currently screaming out loud "Recession!" would suddenly become/look normal.

Do I think the Fed will do such a thing? No; it's too crazy/bold for them and, admittedly, there are costs/implications to such a move too. Nonetheless, such a new, "out of the box", way of thinking is perhaps what is needed. The "more of the same" approach clearly hasn't worked for the economy.

Think for a moment how powerful such an action might be and what a strong message it would send to the markets. The curve would then seem as normal as it can gets and while we all know it to be a false/misleading message, sometimes creating a perception is the first step in (subsequently) turning this perception into reality...

Chart 1: While VNQ has outperformed the SPY, both BDCS and REMhave significantly underperformed the marketVNQ Total Return Price Chart

While over the last couple of months, BDCs and mREITs outperformed both the SPY and VNQ, there's a potential for plenty more catch up to do.

Chart 2: The yields that are being offered by the BDCS and REM are way higher than the ones offered by the VNQ and SPY

VNQ Dividend Yield (a href=

High yield for itself is not a reason to buy an asset class otherwise we would only buy the assets with the higher yields and, obviously, the higher risks. Having said that, it's the combination of the higher yield and the low valuation that make mREITs and BDCs attractive from a risk/reward view.

Chart 3: Contrary to most people perception, mREITs and BDCs aren't more volatile than eREITs or the market as a whole these days

VNQ 30-Day Rolling Volatility Chart

While, historically, mREITs and BDCs have been more volatile than eREITs and the market, the picture is definitely not one-sided; there were times that it actually was the VNQ more volatile than anything else. Even more stunning, though not so surprising, is the fact that the market as a whole is more volatile than interest-rate sensitive instruments over the past couple of weeks.

Chart 4: VNQ has never been so expensive/overvalued compare to REM while volatility is almost identical these daysFundamental Chart Chart

The last and most important chart clearly shows that from a pure pricing perspective, mREITs have never been so cheap compare to eREITs. Furthermore, for the same volatility (and sometimes for lower volatility), mREITs buy you a higher yield than eREITs (as chart 2 shows).

Once again, I wish to emphasize that this article does not attempt to undermine the overvalued eREITs but to highlight the attractiveness of the undervalued mREITs.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.