3 mREIT stock picks poised to weather rising interest rates – June 29, 2022

The Zacks REIT and Equity Trust industry has not been immune to the impacts of rising interest rates, high inflation and the Federal Reserve’s balance sheet reduction measures. Mortgage originators and servicers are seeing low origination volume amid declining refinance demand and compressing gain-on-sale margins. Unfavorable valuations in agency mortgage-backed securities (MBS) and widening spreads in agency MBS and credit-sensitive residential mortgages are further headwinds. As a result, mortgage MREITs will continue to experience book value pressure in the period ahead. Nonetheless, lower prepayment spreads provide respite for industry players by supporting asset yields and margins, while business diversification offers support in volatile conditions. We view rising mortgage rates as a positive for mortgage servicers who are seeing fair value mark-ups on mortgage servicing fees. These create an encouraging backdrop for players like Starwood Realty Trust (STWD free report), Arbor Real Estate Trust (ABR free report) and Invesco Mortgage Capital Inc. (IVR free report).

About the industry

The Zacks REIT and Equity Trust segment includes mortgage REITs, also known as mREITs. Industry players invest in and create mortgages and MBS, providing mortgage credit to homeowners and businesses. Typically, these companies focus on the residential or commercial mortgage markets, although some invest in both markets through the respective asset-backed securities. Agency securities are backed by the federal government, making them a safer bet and limiting credit risk. In addition, these REITs raise funds in the debt and equity markets through common and preferred shares, repurchase agreements, structured financing, convertible and long-term debt and other credit facilities. . Net interest margin (NIM), split between interest income on mortgage assets and securities held as well as funding costs, is the primary revenue measure for mREITs.

What is shaping the future of the mREIT industry?

Challenging mortgage production environment to hurt earnings: With labor markets tight and annual inflation consistently above 8%, the Federal Reserve is shifting from quantitative easing to tightening, with balance sheet cuts and interest rate hikes short-term interest. This has led to a significant increase in mortgage rates over the past six months, resulting in lower origination volumes (especially refinance demand). Additionally, excess capacity has presented additional challenges for mortgage servicers and originators, and could hamper origination gain on sales and revenue growth as competition increases in the origination market. .

Net interest spread and declining book values: The acceleration of the timing of monetary policy tightening and the end of net purchases are affecting the valuations of agency mortgage-backed securities. Industry players are not immune to widening spreads in agency MBS and credit-sensitive residential mortgages. As a result, mortgage MREITs will continue to experience book value pressure in the period ahead. Additionally, mortgage REITs, which benefited from higher net interest spreads on low borrowing costs, are expected to see their profitability deteriorate as rates rise. This may discourage mREIT investors and lead to capital outflows from the industry, which could lead to even greater declines in the book value of industry players in the period ahead. Alongside this, the majority of commercial MREITs tend to have floating rate liabilities, which implies an increase in interest charges when rates rise.

Conservative approach to limiting returns: Recognizing the growing concerns in today’s financial markets, mREITs have resorted to adjustments in their investment portfolio. In a context of increased volatility, companies have reduced their investment portfolios and reduced their leverage. While such measures can help offset fluctuations in interest rates, they are not designed to protect companies against fluctuations in tangible net book value due to changes in the spread between investments and other rates. benchmarks such as swap and cash rates. This exposes companies to the risk of adverse changes in spreads. Moreover, as companies prioritize risk and liquidity management over incremental returns in today’s volatile market environment, at least in the near term, robust returns are likely to remain elusive.

Zacks’ industry rankings point to bleak outlook

The Zacks REIT and Equity Trust industry is housed within the broader Zacks Finance sector. It carries a Zacks industry ranking of #157, which places it in the bottom 37% of over 250 Zacks industries.

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

The industry’s positioning in the bottom 50% of industries ranked by Zacks is the result of the negative earnings outlook for the constituent companies. Looking at revisions to aggregate earnings estimates, it appears analysts are gradually losing confidence in the earnings growth potential of this group. The industry’s profit estimate for the current year is down 14.1% from June last year.

Before outlining a few stocks you might consider for your portfolio, let’s take a look at recent stock market performance and the industry valuation picture.

The industry is lagging the sector and the S&P 500

The Zacks REIT and Equity Trust industry has lagged the broader Zacks Finance sector and the S&P 500 composite over the past year.

The industry fell by 25.4% during the aforementioned period, compared to a decline of 12.4% for the whole sector. The S&P index has fallen 9.8% over the past year.

Year-over-year price performance

Image source: Zacks Investment Research

Current industry assessment

Based on the 12-month price-to-book (P/BV) ratio, which is a multiple commonly used to value mREITs, the sector is currently trading at 1.18X versus the S&P 500’s 5.86X. also below the sector’s last 12-month P/BV of 2.99X. Over the past five years, the industry has traded as low as 1.41X, as low as 0.49X and at the median of 1.19X.

TTM of price per book

Zacks Investment Research
Image source: Zacks Investment Research

Three mREIT stocks worth investing in

Invesco Mortgage: IVR is primarily focused on investing, financing and managing MBS and other mortgage-related assets. Amid headwinds for agency MBS, the company is actively managing its portfolio. He reduced exposure to these stocks as the current macroeconomic situation continues to weigh on agency RMBS valuations. IVR has reduced its leverage and is moving its agency RMBS portfolio towards higher coupons by selling 2.0% and 2.5% coupons over 30 years and buying 4.0% coupons, 4 .5% and 5.0%.

As of June 17, its $5.2 billion investment portfolio included $4.4 billion in agency RMBS and $628 million in futures on securities to be announced. It had unrestricted cash and unencumbered investments totaling approximately $623 million.

Additionally, IVR estimates a leverage ratio of 4.1X and book value per common share of $15.94 to $16.60.

The company currently sports a Zacks rating of 1 (Strong Buy). The Zacks consensus estimate for IVR revenue in 2022 has been revised up 1.1% over the past month to $3.84. Additionally, the company has an impressive track record of earnings surprises, having topped the Zacks consensus estimate for the past four quarters.

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

Pricing and Consensus: IVR

Zacks Investment Research
Image source: Zacks Investment Research

Arbor Real Estate: mREIT, headquartered in New York, focuses primarily on originating and servicing loans for multi-family, single-family and other commercial real estate assets. Arbor Realty’s focus on diversified investments in commercial real estate investments, mortgage servicing and commercial mortgage-backed securities should allow it to generate stable revenues in the coming quarters despite the difficult economic environment.

In addition, securitization and multi-family mortgage originations are expected to expand ABR’s portfolio of fee-based services, thereby generating service revenue.

The company currently carries a Zacks Rank #2 (Buy). The Zacks consensus estimate for ABR’s earnings in 2022 has been revised up 4.5% to $1.86 in the past two months. Additionally, NII estimates for 2022 of $773.7 million indicate a 66% year-over-year increase.

Pricing and Consensus: ABR

Zacks Investment Research
Image source: Zacks Investment Research

Starwood Property: STWD, based in Greenwich, Conn., operates through four segments: commercial and residential lending, infrastructure lending, real estate and investment, and maintenance segments.

Starwood Property had a diversified loan portfolio of $16.2 billion as of March 31, 2022, including $14.1 million in the commercial and residential loan segment. Of these, 27% of the loans were backed by office buildings, 32% by apartment buildings and 17% by hotels. Additionally, 11% of its loans were backed by mixed-use, 6% industrial, 2% residential, 2% retail, and 3% in other property types. This positions it well to navigate the current environment.

Zacks’ consensus estimate for the company’s 2022 earnings has been revised up 12.2% to $2.30 in the past two months. Additionally, STWD’s 2022 NII is pegged at $1.29 billion, indicating a 9.9% year-over-year increase. Starwood Property carries a Zacks rank of #2 at present.

Pricing and Consensus: STWD

Zacks Investment Research
Image source: Zacks Investment Research

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