mREITs After The COVID-19 Apex

COVID-19 pandemic concerns, including the prospect of mortgage and rent payments not being made, have severely depressed the market prices of REITs. This includes mREITs and even agency mREITs. The payments of principal and interest by agency mortgage-backed securities held by the mREITs are guaranteed by the federal government or its agencies and instrumentalities. Thus, agency mortgage-backed securities have no credit risk. However, agency mREITs such as AGNC Investment Corp. (AGNC), ARMOUR Residential REIT Inc. (ARR) and Orchid Island Capital, Inc. (ORC) have declined drastically.

From February 20, 2020 to April 3, 2020, AGNC fell from $19.61 to $9.51, a decline of 51.5% on a closing price basis. Over that same period, ARR fell from $21.13 to $6.27, a decline of 70.3%. ORC fell from $6.60 to $2.36, a decline of 64.2% over that same period.

The VanEck Vectors Mortgage REIT Income ETF (MORT) and the iShares Mortgage Real Estate Capped ETF (REM) are funds comprised of both agency and non-agency mREITs. From February 20, 2020 to April 3, 2020, MORT fell from $25.93 to $7.46, a decline of 71.2% on a closing price basis. Over that same period, REM fell from $48.35 to $14.45, a decline of 70.1%. Those ETFs, which are based on indices of mREITs, did much worse than the S&P 500 (SPY),which fell 26.3% from $336.95 to $248.19 over that same period. REM and MORT even did worse than the ETF Series Solutions – the U.S. Global Jets ETF (JETS), which is an ETF comprised only of airline stocks. From February 20, 2020 to April 3, 2020, JETS fell from $30.82 to $12.30, a decline of 60.0% on a closing price basis.

The decline in agency mREITs AGNC, ARR and ORC may seem irrational when compared to the declines in the overall market and even to MORT and REM. The market prices of the agency mortgage-backed securities held in the portfolios of AGNC, ARR and ORC are higher now than on February 20, 2020. As I said in “Agency mREITs Set To Soar, But What About The 2X Leveraged ETN“:

… To put the agency mREITs’ in perspective, a portfolio consisting of only agency mortgage-backed securities would be at an all-time high now. If that portfolio was leveraged it would be even higher. However, agency mREITs whose portfolios consist of agency mortgage-backed securities are near all-time lows. The only reason the pure agency mREITs declined was their unfortunate hedges. The only reason the pure agency mREITs had any margin calls was related to their hedge positions…

The mREITs had no significant losses on any of the agency mortgage-backed securities that they held. However, even the “pure” agency mREITs suffered sharp declines in book value. Agency mREITs had their book values decline because of the severe basis moves against them that occurred as their losses on the hedges that utilized swaps, futures and short Treasuries far exceeded any gains they may have had on the agency mortgage-backed securities in their portfolios.

The agency mREITs lost significant book value when the Federal Reserve abruptly lowered interest rates by a full 100 basis points. This caused havoc with the mREITs hedges, which were premised on only relatively small 25-basis point movements in interest rates. Without the COVID-19 pandemic, it probably would have been a good assumption that the Federal Reserve would have continued limiting changes to increments of only 25 basis points for many years.

The damage to the mREITs resulting from the sudden extreme decline in interest rates is now over. The yields on treasury bills and notes cannot fall another 100+ basis points in a matter of days again for the foreseeable future. Three-month treasury bills are at 0.10% and 10-year treasury notes are at 0.6% now. Unless those rates go significantly negative, the hedges employed by the mREITs cannot blow up again in the way that they did in March 2020. Negative rates in the United States are not as unlikely as they were in the past, but are still very unlikely.

According to statements made by them, AGNC, ARR and ORC appear to have survived better than might have been expected, and their book values are now much higher than their market prices.

From AGNC’s press release:

AGNC today announced the following updates as of close of business on March 27, 2020:

  • Tangible net book value per common share is estimated to be between $12.35 and $13.25, after deductions for common and preferred dividends declared through March 31, 2020, a year-to-date decline of approximately 25 – 30%.
  • AGNC has had access to Agency MBS repurchase agreement (“repo”) funding without interruption and has timely met all margin calls received.

From ARR’s press release:

At the close of business on March 31, 2020:

  • Book value per common share is estimated to be above $11.00.
  • ARMOUR’s liquidity, including cash and unpledged agency-guaranteed MBS, exceeds $350 million (45% of stockholders’ equity).

The 12/31/2019 book value per share was $24.40. This suggests that the decline in ARR’s book value was less than $53.3%.

From ORC’s press release:

ORCHID ISLAND CAPITAL PROVIDES MARKET UPDATE IN LIGHT OF RECENT MARKET DISRUPTIONS STEMMING FROM THE CORONAVIRUS PANDEMIC

  • March 27, 2020 Estimated Book Value per share of approximately $4.54 to $4.58, a decrease of approximately 27% – 28% from December 31, 2019
  • March 27, 2020 Agency RMBS portfolio market value of approximately $2.94 billion, a decrease of approximately 18% from December 31, 2019
  • Estimated quarter to date economic loss as of March 27, 2020 of approximately 22.1% – 23.8%
  • Company paid February dividend of $0.08 per share of the Company’s common stock in cash on March 27, 2020 as originally declared
  • The Company has met every margin call since its inception approximately eight years ago
  • The Company has invested exclusively in Agency RMBS since its inception

There is always the possibility that the assertions those three agency mREITs about their recent book values are inaccurate. However, if accurate, they are a screaming buy. The only thing that I can be relatively sure of is that the agency mREITs will not be indefinitely trading at very steep discounts to book value. Either the book values will be much lower than what has currently been published, or the market prices of the mREITs will be much higher than they are now. When the first-quarter results are released, we should get much more information about the book values of the mREITs, including some that have been silent so far.

Unlike closed-end funds, mREITs generally trade at a premium to book value. At some point, the larger market participants will look to buy agency mREITs at deep discounts to their book values for arbitrage purposes. This could include acquiring control of them with the intent of liquidating them at book value and distributing the proceeds to shareholders.

A reasonable assumption would be that the future ongoing dividends paid by AGNC, ARR and ORC will be reduced in line with their book values. If so, their yields would still be compelling.

For AGNC, a 27.5% reduction in the current $0.16 monthly dividend would imply a $0.116 monthly dividend. This would be $1.392 annually. That would be a current yield of 14.6%.

For ARR, a 53.3% reduction in the current $0.17 monthly dividend would imply a $0.079 monthly dividend. This would be $0.953 annually. That would be a current yield of 15.2%.

For ORC, a 27.5% reduction in the current $0.08 monthly dividend would imply a $0.058 monthly dividend. This would be $0.696 annually. That would be a current yield of 29.5%.

What About the Rest of the mREITs?

The prospect of mortgage and rent payments not being made in a timely manner as a consequence of the COVID-19 shutdowns has severely depressed the market prices of the REITs. Now, during the mitigation period of the COVID-19 pandemic, in almost all jurisdictions, there is a moratorium on evictions for nonpayment of rent and a moratorium on foreclosures. Even where state and local governments have not formally imposed such moratoriums, the stay-at-home orders, which have closed the courts, effectively prevent most evictions and foreclosures. There is also a risk that some mortgage and rent payments due during the shutdowns may never be paid. The New York Times, on April 2, 2020, included an op-ed with the title “The Case for a Nationwide Rent Moratorium.” A definition of a moratorium is: a legally authorized period of delay in the performance of a legal obligation or the payment of a debt. However, the authors of The New York Times op-ed have something more permanent in mind. They are calling for some rents to be forgiven and, thus, never be paid. The op-ed includes:

The eviction moratorium in states like New York is a crucial start but only delays the inevitable. After June 20, when Gov. Andrew Cuomo’s 90-day stay will have lifted, renters will face unpayable debt of months of back-rent and fees, as well as damaged credit. Housing courts will swell with the backlog, and many people will be evicted…. In the New York State Senate, a group of Democrats led by Michael Gianaris of Queens have introduced a bill to offer rent and mortgage forgiveness for residential and commercial tenants affected by the pandemic.

The cost or the rent and mortgage forgiveness as envisioned by the authors of the op-ed would be borne, in part, by the federal government. However, regarding who would pay for the rent moratorium, they advocate the following:

… But owners of larger properties, the institutional investors, would bear part of the cost in proportion to their size. The largest landlords would absorb the cost entirely…

I think there is near-zero probability that courts in America would allow the type of abrogation of debts as advocated in the op-ed. Anything that allows renters and mortgage borrowers to permanently evade their obligations would severely impact future investment in the real estate sector. In any case, such an abrogation would result in years of litigation by affected landlords and mortgage lenders. Even Argentina eventually had to pay debts to bondholders.

A negative for the REIT sector is that even without any legally mandated forgiveness of rent and mortgage payments, some will never be collected. However, the impact on investors and landlords would be much more severe if tenants and homeowners were legally relived of the obligations. A positive is that some type of federal bailout for the real estate sector could actually occur. There is a precedent with the forgivable loans to small businesses and some favored industries contained in the recently passed COVID-19 legislation. Thus, there is a reasonable prospect that the federal government will be making mortgage and rent payments for some impacted by the COVID-19 pandemic. Probably such payments would be made directly to landlords and mortgage lenders.

A possible federal bailout of renters and mortgage borrowers is also a bailout of landlords and mortgage lenders. That, in turn, is a bailout of holders of mortgage-backed securities and entities such as Federal National Mortgage Association (OTCQB:FNMA) that guarantee some mortgage-backed securities.

The probability of a federal bailout of renters and mortgage borrowers depends on the length of the COVID-19 pandemic-related shutdowns. We are now in the mitigation phase of the pandemic. The mitigation shutdowns are necessary to “flatten the curve.” There is mostly universal agreement that drastic steps must be taken to avoid a situation where people are dying as a consequence of hospitals being overwhelmed by the number COVID-19 patients who need ventilators. However, at some point in time, after the peak or apex of infections, and when hospitals are able to accommodate the number of those requiring ventilators, the containment phase of the pandemic may begin.

During the containment phase, identification of those infected, tracing anyone they may been in contact with and then isolating everyone who may possibly spread the infection occurs. During the current COVID-19 pandemic mitigation phase, almost no resources can be spared for contact tracing and other aspects of containment. After the apex, that can change.

While there is some optimism that the apex is approaching in various areas, there is some misunderstanding regarding the extent that shutdowns may be relaxed or rather continue to be imposed after the apex has been reached. In order for containment and ultimately the eradication of the SARS-CoV-2 virus to succeed, shutdowns for an extended period may be necessary after the apex. Advancements in vaccines, testing or treatments could, of course, reduce the time that shutdowns could be required. However, the shutdowns could be required for a considerable period after the apex to limit the number SARS-CoV-2 virus infections to the levels where containment and eradication can be achieved.

Shutdowns after the apex will not be as universally accepted as the COVID-19 pandemic shutdowns imposed during the mitigation phase have been. Most people do not want go to work or operate their business if that means they are risk of literally causing the deaths of some of those who might have lived if the curve had been flattened enough. Especially when they could possibly be among those who die because the number patients needing ventilators exceeds the number of available ventilators. However, once there are enough ventilators available for all patients, either because of additional numbers manufactured or a reduction in the number of patients needing them, the willingness of some to forgo income by refraining from gainful activity may be reduced significantly.

In order to convince enough people to refrain from engaging in economic activity in the period after the apex, some financial incentives may be required. Having the federal government pay the rent or mortgages of those intentionally idled in furtherance of the SARS-CoV-2 virus containment effort could be supported by many politically powerful groups, including real estate and banking interests. Such a bailout could have a significantly favorable impact on many REITs.

Conclusions and Recommendations

The agency mREITs AGNC, ARR and ORC are trading at very deep discounts to their book value. This situation cannot persist indefinitely. The discount for AGNC is less than those for ARR and ORC. That is understandable given the relatively poor historical performance of ARR and ORC. Even though the discounts to book values for the agency mREITs may appear irrational, it’s always good to remember, as Keynes famously said: “The market can stay irrational longer than you can stay solvent.”

AGNC, ARR and ORC have disclosed their recent book values that reflect current market conditions. It is theoretically possible that those book values are fraudulent. However, assuming those book values are accurate, those three agency mREITs should be bought at these levels. Many industrial, retail and transportation stocks will likely cut or eliminate their dividends for COVID-19 pandemic reasons. Thus, agency mREITs’ double-digit yields, even with somewhat reduced dividends, will look more and more attractive. At some point, the larger market participants will look to buy agency mREITs at deep discounts to their book values for arbitrage purposes. This could include acquiring control of them with the intent of liquidating them at book value and distributing the proceeds to shareholders.

Regarding the non-agency mREITs or hybrids of agency and non-agency, they should be evaluated like any other stock in terms of how the COVID-19 pandemic will impact them. Many stocks now are vulnerable to the impact of the COVID-19 shutdowns on their customers, creditors, operations, lenders, supply chains or some combination of all of these. To a greater or lesser extent, that is true for all of the REITs and non-agency mREITs. However, the pure agency mREITs would not seem to be vulnerable to any direct impacts of the COVID-19 pandemic regarding customers, creditors, operations, lenders, supply chains or commodity prices.

Many of the mREITs seem to be mispriced at current levels given their high yields. For some of the mREITs, until the first-quarter results are available, we will not know their book values. Some of the mREITs could still go lower or even may not survive, either because of the prospect of mortgage and rent payments not being made, future actual defaults on non-agency mortgage-backed securities, issues involving mortgage servicing rights or as the result of unmet margin calls.

There are two remaining 2x leveraged ETNs that have significant numbers of mREITs in the indices upon which they are based: the Credit Suisse X-Links Monthly Pay 2x Leveraged Mortgage REIT ETN (REML), which contains only mREITs, and the ETRACS Monthly Pay 2xLeveraged US Small Cap High Dividend ETN (SMHB), which has some mREITs along with other small-cap high dividend stocks. The volatility and current yields of REML and SMHB are about double that of the mREITs because of the leverage and carry factors. There is a significant risk that REML and SMHB could be accelerated and become almost worthless if the market declines.

Nevertheless, I am still a tentative buyer and have still been buying REML and SMHB. I could be much more confident buying REML and SMHB after all the book values of the all mREITs in the indices upon which REML and SMHB is based become known. I am also somewhat leery of the relatively weak non-mREIT stocks in the index upon which SMHB is based.

The best day to be an owner of mREITs, REML and SMHB would be the day before the federal government announces that it will be making mortgage and rent payments for those impacted by the COVID-19 pandemic. Will that day ever occur? Possibly.

In “Opportunities In The Remaining High-Yield 2x Leveraged ETNs,” I described two High-Yield 2x Leveraged ETNs that I also have recently purchased. The ETRACS Monthly Pay 2xLeveraged US High Dividend Low Volatility ETN Series B (HDLB) and the ETRACS Monthly Pay 2xLeveraged Wells Fargo MLP Ex-Energy ETN Series B (LMLB).

The three largest components by weight, as of the most recent composition of the Solactive US High Dividend Low Volatility Index, upon which HDLB is based are: IBM Corp. (IBM), AT&T Inc. (T) and Exxon Mobil (XOM), which collectively comprise 33.86% of the index. The index comprises stocks with “High Forward Looking Distribution Yield and Low 12-Month Trailing Realized Volatility.” It seems appropriate that IBM, T and XOM are included as low-volatility stocks as of the recent composition of the index. However, mREITs including Annaly Capital Management Inc. (NLY), New Residential Investment Corp. (NRZ), Starwood Property Trust Inc. (STWD) and Two Harbors Investment Corp. (TWO) are also in the index. They are among the various REITs and other securities that arguably are no longer in the relatively low-volatility category as a result of COVID-19 concerns. I will be looking closely to see how the index will be changed to reflect the new market conditions.

The large MLPs in LMLB contain exposure to large swaths of the economy. For example, Icahn Enterprises LP (IEP), which is the largest component by weight in LMLB, has investments in various industries, including auto parts, energy, metals, rail cars, casinos, food packaging, real estate and home fashion. Some of those are being hurt significantly by COVID-19, others less so. For those who want to receive very high current yields, while trying to be in a position to benefit when the effects of the pandemic recede, and are willing to incur the risks of total loss, the 2x Leveraged ETNs could still be attractive.

At some point in the future, the COVID-19 pandemic will be over. Exogenous events such as the Great Depression, World War II and the 2008 financial crisis all provided tremendous buying opportunities for some investors. However, one does not know when the bottom in the financial markets will be. Generally, stock market bottoms occur before the economy or the crisis is at its worst. With the COVID-19 pandemic, uncertainty exists as to how much damage will be done by the virus and by the various measures taken by governments in response. This includes, but is not limited to, the trillions of dollars in debt that will be incurred. The announcement of a federal government bailout of the real estate sector could spur a rally in the REITs, mREITs and 2x Leveraged ETNs based in whole or in part on REITs.

Disclosure: I am/we are long AGNC, ARR, ORC, REML,REM, HDLB< TWO, LMLB, SMHB. 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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