Mortgage Real Estate Capped ETF: A Revival On The Way

Summary

• REM is a fund that closely tracks the FTSE NAREIT All Mortgage Capped Index.
• After an initial recovery, there has been a resistance due to volatility in the mortgage industry.
• The fund comprises undervalued shares offering a very high yield.
• I do much more than just articles at The Lead-Lag Report: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

Don’t wait to buy real estate, buy real estate and wait. – T. Harv Eker

The mortgage industry has been one of the hardest-hit sectors since the coronavirus outbreak reached American shores. This is despite the 30-year mortgage rates dropping, with May recording the lowest rate historically, since 1971. Homebuyers have taken advantage of the drop in rates, as the sale in newly built homes increased by nearly 1% in April compared to March. This may be a promising sign for the industry that has yet to recover from its lows, as reflected in the price of shares of some of the popular ETFs. The iShares Mortgage Real Estate Capped ETF (BATS:REM) is one such fund that tracks the FTSE NAREIT All Mortgage Capped Index and is composed of US REITs.

Source: Seeking Alpha

Trading at almost half the value of its 52-week high, the fund has a trailing twelve-month dividend yield of 16.05%. This attractive yield has still not lured investors into this fund, as it continues to remain flat after a short stint upwards. Though it is fraught with multiple risks, the opportunity that the fund provides should be analyzed in depth before considering it as an investment option for your portfolio.

Expect a further drop in mortgage rates

The fall in the mortgage rates is expected to continue in the near future. In terms of the monthly payments, it is estimated that the amount would be equivalent to what was paid back in 2015 or 2016. This would surely give homebuyers the incentive to carry out additional purchases in normal circumstances. Hopefully, as the economy reopens, there is a return to some normalcy.

Another indicator of the activity picking up is that the price of houses has not witnessed any sharp drop recently. The Fed's involvement in the Mortgage-Backed Securities market also ensured that there was enough liquidity and contributed to the prevailing low rates.

Rates falling further seems to be a high probability as well. The spread has been considerably higher compared to the 10-year US Treasury rates recently. A fall in rates, coupled with a marginal increase in demand, would affect the MBS segment and is something to look out for directly impacting the Mortgage Real Estate Capped ETF (REM).

Breaking down the ETF

The iShares Mortgage Real Estate Capped ETF concentrates its holdings in the Real Estate sector with 75% of its top 10 shares. Diversification is low for this ETF.

Source: Seeking Alpha

These companies also have high exposure to Agency MBS. For example, Annaly Capital Management (NLY) has 93% of its funds invested in these MBS, while AGNC Investment Corp. (AGNC) is almost entirely invested in Residential MBS backed up by Freddie Mac and Ginnie Mae. While there have been pressures on the margin due to the falling rates, the fact that most of their portfolio is covered should prevent these companies from going bust. As far as valuation is concerned, coining the portfolio as undervalued would be an understatement.

Source: Yahoo Finance

The P/B figure illustrates that the share is trading even below its book value, and the P/E is significantly lower than the average S&P 500 figure. Though the companies have had a tough quarter due to subdued interest margins, there is every reason to believe that margins could significantly improve once the rates stabilize in the longer term. Once the economy opens up, and the mortgage industry demand gains momentum, we could see the profits going up again.

Another important point that needs to be considered is that many of the constituent companies have managed to provide high dividend yields even during the pandemic. The latest dividends of Annaly, AGNC, and Starwood (STWD) this year were $0.25, $0.16, and $0.48, respectively. This can be considered significant in the context of their share price that continues to remain at a low level.

So why not other Mortgage ETFs?

A comparison of the fund with its two peers the VanEck Vectors Mortgage REIT Income ETF (MORT) and the Vanguard Global ex-U.S. Real Estate ETF (VNQI) should give a clear picture of why REM stands out.

	REM	MORT	VNQI
P/B	0.57	0.55	0.82
P/E	5.69	5.72	9.22
P/S	3.8	3.95	1.82
Dividend yield	17.00%	15.38%	9.91%

Click to enlarge

Source: Yahoo Finance

REM and MORT are very alike in terms of their portfolio composition, and both are undiversified funds. In terms of valuation of constituent stocks, REM seems marginally cheaper considering P/S. Dividend yield, too, is higher for REM.

VNQI, on the other hand, is a much more diversified fund. With the top 10 holdings only accounting for 20% of the portfolio value, it does not compare. The dividend yield is much lower, and the valuations are also not as cheap as REM.

Risks to watch

Given the level of uncertainty in the mortgage industry, there are undoubtedly high risks involved. But with higher risk may come higher reward. Investors should take into consideration the following:

1. High level of concentration risk: Looking at the sectorial breakdown and constituent holdings, the company relies heavily on its top 10 holdings. The high dividend yield should not be a motivating factor for people having a lower tolerance towards risk
2. Mortgage rates: So far, the intervention of the Fed has been able to sustain activity in the MBS market. It would be interesting to see how the industry fares once the support dwindles. The companies within the fund have suffered a significant contraction in interest rate margins due to lower rates. How the rates move will be an essential factor in the performance of the ETF.

REM offers a higher level of return for assuming a higher risk. The portfolio of undervalued stocks with a high yield has certainly been missed by investors. The optimism brewing in the mortgage industry could be the harbinger of better times for this fund. Many would-be homeowners may have been priced out of the market before the coronavirus hit and are looking to take advantage of a dip in activity (although not in prices yet). Mortgage demand should stay healthy in the future, especially if the economy begins to recover.

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Analyst’s 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.

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