Last week I wrote an article titled "Don't Bet The Farm On Mortgage REITs... Unless You Want To End Up Milking Cows" that generated over 260 comments and some wide-ranging feedback.
Whenever I begin to write an article I always have a purpose in mind, and when I sat down to write this article, my goal was in fact to ruffle some feathers in an effort to call out the high-yielding residential mortgage REITs.
As most readers know, there are varied reasons for investing in higher-yielding stocks, but regardless of your risk profile, the cold hard facts remain, in the words of Frank J. Williams (If You Must Speculate, Learn The Rules):
The quick profits are just froth. They arouse a fever in the blood and don’t last. The worst thing that can happen to a new spectator is to make a lot of quick money on his first trade.
I have lived long enough to know precisely what Williams means by “the fever in the blood” and that’s what I mean when I describe a high-yielding stock as a “sucker yield”.
In that article I was referring to, I provided readers with historical evidence – going back to 1972 – that equity REITs are better stocks than mortgage REITs. Of course, I’m not talking about every year, but over the long haul, investors would be much better off building a portfolio of high-quality equity REITs that grow dividends instead of a basket of highly leveraged mortgage REITs that are prone to cut dividends.
In that same article I pointed out,
while we do not typically advocate mortgage REIT equities – aside from certain CRE mREITs – to conservative investors, we do believe that they can play a role in income-focused portfolios. Specifically, we believe that the preferred stock of mortgage REITs can be a good addition to a portfolio.
Since the end of the last recession, thanks in large part to the large number of bank failures (think: Lehman Brothers, Capmark Financial, BankUnited, Bear Stearns, etc.), the commercial mortgage REIT industry has mushroomed.
The last recession transformed the banking sector due to a dramatic expansion of regulation meant to safeguard the financial system, and the taxpayers who had to bail them out. These regulations had a profound effect on banks because it required them to hold more capital against the risks, forcing many of them to scale back and to change the nature of the risks they were taking.
However, over the last ten years, commercial mortgage REITs have become the mainstream vehicle for commercial real estate lending and they are much safer today due to lower leverage and lower loan-to-value (or LTV) ratios.
The commercial mortgage REIT sector can be further broken down into two categories: pure balance sheet lender and balance sheet/conduit lender.
Apure balance sheet lenderoriginates or purchases loans for their own balance sheet and holds these loans on their balance sheet (although they may sell participation units in the loans to diversify some of the risks). Blackstone Mortgage Trust (BXMT), TPG Real Estate (TRTX), and KKR Real Estate (KREF) are all examples of senior-secured lender.
A balance sheet/conduit lenderoriginates and/or purchases loans for its own account (balance sheet) or to be sold into a securitized vehicle such as CMBS (conduit). Ares Commercial Real Estate (ACRE), Ladder Capital (LADR) and Starwood Property Trust (STWD) are all conduit lenders.
There are differences between these two types as well and risk can be further diversified. Balance-sheet lenders originate loans with the intent of holding them on their books. Balance sheet/conduit lenders originate loans for both their own books and to sell into securitized markets such as CMBS.
The risk with balance sheet lenders is relatively straightforward – the risk that the loans don't perform as expected. Balance sheet/conduit lenders have the risk of non-performance as well as the risk that the conduit market experiences a disruption and cannot take as many loans as expected.
With a booming U.S. economy, most all of the private equity players have entered the space:
Also, a number of specialty commercial mortgage REITs have entered the sector:
Combined, our (iREIT) universe of commercial mREIT coverage comprises over $24 billion in market capitalization and $75 billion in enterprise value:
Yet, based on market capitalization, the commercial mortgage REIT sector is much smaller than many of the U.S. equity REIT sectors such healthcare, apartments, malls, industrial, office, triple net, lodging, data centers, and shopping centers.
Start with Performance
The outperformance of the CRE mREITs versus the residential mREITs is clear and significant: the commercial mREITs have returned 14.15% compared with the residential mREITs that have returned .81%.
Even with the double-digit dividends (averaging 12.67% at the end of May), the residential mREITs have become unstable due to recent dividend cuts. We prefer the stable dividends of the commercial mREIT sector and that’s the primary reason that we maintain around 11% exposure with our Durable Income Portfolio.
Commercial mREITs are unique, because you get two powerful forces of nature: (1) above market dividends (equity REITs yield 4.04% vs. cmREITs that yield 8.11%), and (2) capital appreciation (as evidenced by the 14.15% returns YTD). As illustrated below, the commercial mREITs have easily outperformed the rezi mREITs by double: cmREITs averaged 16.75% per year compared with 8.66% for rezi mREITs.
Now that we’ve set the record straight, so to speak, let’s take a look at our entire commercial mortgage REIT coverage spectrum to see where we find the best opportunities.
The Commercial Mortgage REIT Spectrum
Recognizing that many investors first consider yield, let’s take a look at the entire spectrum (average yield is 8.6%).
Now, one of the ways that we screen for safety within the commercial mREIT spectrum is to analyze credit quality. Since we don’t have the same transparency, we have with equity REITs (that provide property-level details) we must dig deeper into transcripts and investor presentations. Here is what we uncovered:
As s you can see, Blackstone Mortgage (BXMT) is the largest cmREIT with a loan portfolio of $16.1 billion and an average loan size of $130.8 million. Also, KKR Real Estate (KREF) has the largest average loan per property of $158 million.
We have avoided REITs like Colony Credit Real Estate (CLNC) and Apollo Real Estate (ARI) because they are taking on more risk by utilizing mezzanine financing, in an attempt to boost returns. Around 28% of CLNC’s loans are not senior secured and around 23% of ARI’s loans are not senior secured (first mortgages).
Another thing worth noting is that Starwood’s loan portfolio is just 83% senior secured and that may explain some of the volatility lately. Also, keep in mind that several of these REITs invest in other areas. For example, Starwood’s loan portfolio is $8.5 billion, but that represents just 54% of capital invested.
STWD also has its hands in a few other pies, such as Residential Lending (5%), Infrastructure Lending (12%), Property (19%), and CMBS (7%). This means the business model is much complex and that’s one of the reasons that shares are oftentimes more volatile.
Ladder (LADR) is another example, in that the company’s lending platform represents 55% of the business. The company also allocates capital and resources to the securities (25%) and property (19%) businesses. Keep in mind, LADR is also one of the few internally managed cmREITs and that’s one of the reasons that the company is able to generate very consistent ROE of 9% to 13% (in the last 12 months was 13.7%).
This next chart we put together is very useful because it highlights the top three property categories for each REIT:
Starting with Hannon Armstrong (HASI), you can see that the company has 61% invested in investment grade obligors. This means that the company has a very high-quality lending platform and that’s one of the reasons we often use the net lease REITs as peers (for analysis).
Many of the REITs have the office category as their number one property investment class and Granite Pointe (GPMT) has the highest (office) exposure at 48%, followed by KREF (45%) and BXMT (44%). Also, not that none of the cmREITs have retail in the top three categories.
I also want to point out that KREF has a total of 82.6% invested in office (45%) and multi-family (38%). Arguably, these two property sectors are the most defensive and I am sure that’s the reason the company is overweight.
One of the concerns that I have (and I have highlighted in yellow in the chart above) is the hotel sector. As you can see, many of the cmREITs have made loans in the hotel sector. BXMT has 23% deployed, STWD has 22% deployed, LADR has 22% deployed, GPMT has 15% deployed, and ACRE has 17% deployed. Notably, ARI and CLNC both list hotel as their top property lending category.
But, it's important to compare apples to apples. BXMT’s average loan size is around $140 million so this means that the company is making senior secured loans on properties like this one:
Source: $258 million floating rate, first mortgage loan secured by a full-service resort in Maui
It’s hard to obtain property details for the hotel loans that ARI and CLNC are making, but it’s likely that these companies are also making mezzanine loans on hotels and they aren’t the big trophies like BXMT is securing. Also, you can see that ARI is also making investments to residential properties for sale (another example of chasing yield).
Although the cmREITs don’t have the same lease contracts that equity REITs have to predict earnings and dividend growth, we can still reply on consensus data and the payout ratio to forecast future dividend growth. Here’s a chart we prepared using consensus numbers (highlighted the REITs in yellow that we like):
Most all cmREITs payout at least 100% of their core earnings, but we believe that LADR, BXMT, and ABR have excellent hopes for future dividend increases, as illustrated below:
As the title to my article suggests, I am providing you with five cmREITs that I like, and I just provided you with three (LADR, ABR, and BXMT). The final two that I will add to the list include KREF and TRTX.
I like HASI, and I always have, but shares are trading at premium levels and I recommend waiting on a pullback. I also like STWD but the complexity is troubling me and given the pricing momentum, I would recommend waiting on a pullback as well.
In closing, it’s clear (actually crystal clear) that commercial mREITs are superior investment alternatives than residential mREITs. Given the current cycle and demand for high-quality real estate lending, we believe investors would be well-served to maintain exposure to the commercial lending sector. Overall property-level fundamentals are sound as occupancies and rents continue to increase and cap rates remain favorable.
We cover a wide spectrum of REIT research and by staying close to the lending environment, we have demonstrated a superior competitive advantage that allows us to utilize cmREITs as a hybrid to equity and preferreds.
Author's note: Brad Thomas is a Wall Street writer, and that means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking.
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Disclosure: I am/we are long HASI, LADR, BXMT, STWD, KREF, TRTX. 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.