REITs Are Not Born Equal
In my most recent article, I've once again explained why I believe that mREITs (NYSEARCA:REM) are (still) better positioned than eREITs (NYSEARCA:VNQ) for the current environment, following the US elections.
I believe that the charts I've provided in the second episode of my very own "Back to the Future" version were so decisive and powerful that there's really no need to keep explaining (or pushing) the message I've delivered over the last couple of months: Buy BDCs (NYSEARCA:BDCS) and mREITs (the A-Team) and sell (or short) the overvalued eREITs (the H-Team and O-Team).
Nevertheless, I do wish to emphasize that many eREITs are not only (still) overvalued anymore. On top of the overvaluation - we now also witness a very uncompelling risk/reward profile when it comes to eREITs. Allow me to explain:
As far as I'm concerned, overvaluation still exists as long as eREITs won't pay 300bps (or 3%) above what the US 10-year Treasury ("UST10Y") is yielding. At the time of writing, the UST10Y is yielding 2.36% and that means that I expect eREITs to offer a dividend yield of 5.36% at the very minimum.
The problem of eREITs now isn't only overvaluation but a very unfriendly environment:
If equity markets keep marching higher, it would most probably be combined with yields keep marching higher too, perhaps in a stronger and faster pace. Rising yields and rates are eREITs' worst enemies (as we already witnessed over the last couple of months).
If, on the other hand, markets make a U-turn and pull back (up to 5%) or even fall (10%+) - that would most probably be combined with yields moving lower though in a slower pace due to investors' expectations of higher rates. Putting it differently, in a move down - it's likely that the negative effect of the lower markets would outweigh the positive effect of the lower yields.
As I always say: My strategy is not - and never is - about finding the most profitable bets but about finding the best risk/reward plays. In my view, eREITs are probably one of the worst risk/reward plays out there as I write.
This is my message when it comes to eREITs: They may currently look cheap but they aren't! They may currently look attractive but they have another 10%-20% to go down, even if yields remain more or less at these levels!
As for mREITs... I must make a few very important clarifications here too because I sense that my pro-mREITs message wasn't fully explained, and consequently, wasn't correctly understood.
A steepening curve - like the one we are facing these days - come with wider spreads, i.e. the more steepened the curve is - the wider the spreads are:
Therefore, if we assume that the UST10Y yield isn't only going to rise further but it's also going to rise more than the UST2Y yield - we may be de-facto assuming that the spreads will keep widening.
(*) The 10-2 spread is the most commonly used spread to reflect long term versus short-term rate difference.
Generally speaking, wider spreads are positive for mREITs (and BDCs) because these entities borrow short term (low rate) and invest/lend long term (high rate). They make money out of the spreads, and therefore, the wider the spread - the more profitable they are.
While I'm not going to explain what mREITs are doing - other authors are doing this on an ongoing basis - I wish to divide the mREITs arena into two main sub-segments:
- Traditional mREITs such as AGNC Investment Corp. (NASDAQ:AGNC) and Annaly (NYSE:NLY). They are heavily invested in (mortgage) securities (that they purchase for their own portfolio) and loans (that they give to borrowers to buy properties).
- Hybrid-Special mREITs such as New Residential Investment (NYSE:NRZ) and Starwood Property Trust (NYSE:STWD). While these types of mREITs aren't avoiding what traditional mREITs are doing - they are more diversified and less relying on/exposed to prices of (mortgage-debt) securities/assets.
When yields go up so sharply and so quickly, we get a wider spread (positive) on one hand but we also get much lower valuation of (mortgage-debt) securities/assets. Rising yields = decreasing prices. Since mREITs are running a mark-to-market ("MTM") valuation of their assets - the effect of the declining prices (of debt) is a significant and quick erosion of book value ("BV").
Sure, over time the wider spreads cause all mREITs to be more profitable, and consequently, to offer a better coverage of dividend. That is extremely positive and should be well noted for the long term. Nevertheless, the problem is that the negative may be so significant in the short term that it will overcome the long-term positive.
Think of it this way: Your mREITs are now in a much more favourable environment for (possibly) years to come but the cost (to take advantage of these better prospects) is that you see a much lower BV today. You pay an immediate price at present to benefit from better long-term prospects.
Now, you'll probably ask me what should investors be more minded to - the better future prospects or the immediate BV erosion. Honestly, I don't (and nobody may) have a good answer for this. I do know, however, that whenever an mREIT records a significant BV erosion - the market tends to punish it.
I believe that there will be more than a few mREITs that (if yields won't ease back soon) are in danger of showing a BV decrease of 5%-10%! How will the market react to such a decline? I guess that not in a too friendly way...
My message when it comes to mREITs is, therefore, not one-sided. There are mixed effects on mREITs and there, for sure, will be mixed results and outcomes. NRZ is perhaps the ultimate example of a "good" mREIT. Not only that the rising rates/yields are positive to it but its BV may (though this is not certain!) actually go up because the arenas it operates in are actually benefiting from what is currently happening.
A Chart Worth a Thousand Words
In order to make my points very clear, I went back to the last period of time through which the UST10Y yield almost doubled itself - exactly what we're experiencing these days. Such a sharp move occurred during May-December 2013 when the UST10Y yield went from ~1.6% to ~3% (the chart doesn't capture the peak and through because I've used the period of 5/1/13-12/31/13).
Take a look for yourself and let me know what you see:
What I see is very clear:
1. eREITs went down over 10%. This is a total return, i.e. the net result including dividend. Now you can better understand why eREITs may fall an additional 10-20% in price. Even with the current poor 4%-5% annual dividend yield of most overvalued (H-Team) members, this is still a potential double-digit decline.
2. Surprisingly (or not), mREITs fell even more than eREITs! Nonetheless, there was a dramatic difference between traditional mREITs, such as AGNC and NLY, to hybrid-special mREITs, such as NRZ and STWD. While the former recorded very nice positive total returns, the latter have lost more than 30%!!!
3. Unsurprisingly, BDCs have held up very firmly as a group, returning 8.72% over this period. This is exactly the reason why in my last article - as well as in a couple of comments - I've made it clear that among the three groups - eREITs, mREITs and BDCs - the latter is the best group to hold onto right now.
All components of the A-Team were picked also based on their positive reaction to higher yields/rates. Bear in mind though that positive reaction refer to the earnings not to BV!
The mREITs within the A-Team - NRZ (see here), STWD (see here), Ladder Capital (NYSE:LADR) (see here) and Apollo Commercial (NYSE:ARI) (see here) - are all my sons but you must be minded of the specific risks that each one holds and make your own decisions. I believe that those who don't care about short-term swings should not be too worried while those who can't afford possibly seeing prices going down (even temporarily) should be more minded of what the end of year earnings and BVs may look like.
Don't get me wrong: This is not a call to sell anything. As a matter of fact, this is a call to hold into what you have. Nevertheless, those who are more trading-oriented and like to "play" the in-and-out game may find this point in time to be attractive.
Disclosure: I am/we are long NRZ, STWD, ARI, LADR.
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.