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Mortgage REITs Industry Outlook: Rate Hike Appears Manageable

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The Zacks REIT and Equity Trust industry comprises mortgage REITs, also known as mREITs. Players in this industry provide financing for income-producing properties by investing in or originating mortgages and mortgage-backed securities (MBS). Typically, these companies focus on residential or commercial mortgage markets, although some invest in both the markets through respective asset-backed securities.

Residential mREITs mainly invest in low credit-risk agency RMBS — securities issued by government-sponsored enterprises. Nonetheless, companies may also hold non-agency or private-label RMBS and residential mortgage loans.

Commercial mREITs, on the other hand, invest in CMBS, mezzanine loans, subordinated securities or construction loans, and might participate in loan securitizations. These securities are not backed by the government, so carry higher risks.

Net interest margin (NIM) — spread between interest income on mortgage assets, and securities held and funding costs — is the key revenue metric for mREITs. These companies raise funds in both debt and equity markets through common and preferred equity, repurchase agreements, structured financing, convertible and long-term debt, and other credit facilities.

Let’s take a look at the industry’s three major themes:

  • Interest rate sensitivity: Managing the impact of changes in short- and long-term interest rates is at the core of mREIT operations. Since these companies borrow extensively at short-term rates and then purchase higher-yield long-term mortgage securities, unfavorable changes in interest rates can affect their NIMs. This may also hamper the value of mortgage assets, thereby, impacting corporate net worth. Moving ahead, with a possibility of another rate hike this year and three more anticipated for the next, NIMs and performance of mREITs are expected to be strained. Nonetheless, impact of escalating rates will likely be mitigated by economic growth and healthy consumer sentiment. Also, it will boost property fundamentals, benefiting real estate owners and reducing credit risk.
     
  • Commercial v/s agency mREITs: Agency mREITs borrow debts that carry fixed short-term rates, while commercial mREITs often use loans which have floating rates over Libor. Hence, agency mREITs are more vulnerable to rollover risk in a way that if short-term interest rate is raised, it will impact the NIM of these companies. Commercial mREITs, on the other hand, match duration of assets and liabilities on their balance sheet and thus, face lesser rollover risk.
     
  • Important source of funding for the housing sector: mREITs have historically played an important role in restructuring the housing finance market. As government sponsored entities (GSE) and Federal Reserve are reducing their investment activities, refinancing the mortgage loans, RMBS and funding new mortgage originations for homebuyers will require extensive capital. With the ability to provide the required capital and liquidity to the market, mREITs are now poised to play a greater role in the housing finance market. In fact, players in the industry have steadily increased their investments in agency MBS.

Zacks Industry Rank Indicates Solid Prospects

The Zacks REIT and Equity Trust industry is housed within the broader Zacks Finance sector. It carries a Zacks Industry Rank #43, which places it in the top 17% of 256 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates solid near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Our proprietary Heat Map shows that the industry’s rank has remained in the top half over the past seven weeks.



The industry’s positioning in the top 50% of the Zacks-ranked industries is a result of positive earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are gaining confidence in this group’s earnings growth potential. Over the past year, the industry’s earnings estimate for the current year has moved up by 1.9%.

Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Industry Outperforms Sector, Lags S&P 500

The Zacks REIT and Equity Trust industry has lagged the Zacks S&P 500 composite over the past year, though it has performed better than the broader Zacks Finance sector.

The industry has registered a fall of 5.3% during this period compared with the S&P 500’s decline of 1%. Meanwhile, the broader sector has registered a fall of roughly 10%.




Industry’s Current Valuation

On the basis of the trailing 12-month price-to-book ratio (P/BV), which is a commonly used multiple for valuing mREITs, the industry is currently trading at 1.12X compared with the S&P 500’s 3.74X. It is also below the sector’s trailing-12-month P/BV of 2.39X.




Over the last five years, the industry has traded as high as 1.28X, as low as 0.85X, and at the median of 1.09X.

Bottom Line

While rising interest rates have hindered mREITs’ performance in the past quarters, these companies are poised for a comeback on the strengthening U.S. economy. With accelerating growth of the economy, credit quality of assets will likely increase. Hence, commercial mRIETs will have more opportunities for accretive investments amid rising demand for commercial debt. In fact, employment growth in key homebuying demographic area will likely translate to higher household formation and purchase originations. Amid this backdrop, agency mREITs are anticipated to put up an impressive performance.

We are presenting one stock with a Zacks Rank #1 (Strong Buy) and two with a Zacks Rank #2 (Buy) that that investors may consider betting on.

You can see the complete list of today’s Zacks #1 Rank stocks here.

Altisource Portfolio Solutions S.A. : Together with its subsidiaries, this Zacks #1 Ranked company is engaged in provision of real estate mortgage portfolio management and related technology products, as well as asset recovery and customer relationship management services. The company’s Zacks Consensus Estimate for the current-year earnings per share (EPS) has been revised 5% upward over the past two months. Further, it outperformed the Zacks Consensus Estimate by an average of 7.6% in the trailing four quarters.




Cherry Hill Mortgage Investment Corporation (CHMI - Free Report) : This residential real estate finance company acquires, invests in and manages residential mortgage assets in the United States. The U.S.-based company currently carries a Zacks Rank of 2. The 2018 consensus EPS estimate for the company moved 3.5% north, over the last 60 days. Moreover, it surpassed the Zacks Consensus Estimate by an average of 2.09% in the last four quarters.




Ares Commercial Real Estate Corporation (ACRE - Free Report) : This Chicago, IL-based company carries a Zacks Rank of 2, at present. It focuses on originating, investing in and managing middle-market commercial real estate loans and other commercial real estate investments. Its 2018 consensus EPS estimate has been revised 3% upward, in 60 days’ time. Additionally, it outpaced the Zacks Consensus Estimate by an average of 11.09% in the preceding four quarters.




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