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June 25, 2021

What you need to consider when investing in REITs

Investing in REITs

I don’t recommend REITs; their returns aren’t that impressive and I would rather buy and flip the property myself, BUT they’ve dropped very low and the fundamentals do not support this drop.  The selling panic of Covid-19 is affecting all areas and some REITs have dropped over 60%.  The beauty of REITs is their value is maintained by real estate, which is REAL.  People need and want housing, so even in a down market, these properties will have value even if it’s not as much as the owners hope.

Let’s look at a mortgage REIT. There are two major parts to a mortgage REIT (mREIT):

1) Book value

This is likely down for every mREIT in this quarter, how much is the question.  The book value is incredibly important to a mREIT. It's a measure of the value of their assets minus their debts.

  • Two Harbors recently indicated that book value per share was down 6% quarter to date.
  • NRZ recently indicated book value per share was down around 3% quarter to date.
  • Annaly Capital Management (NLY) indicated that book value was down around 10% to 11% quarter to date.  NLY takes into account the recent drop of 7-8% in the last few weeks.

However, the decline in value seem more accurately aligned with a book value that would be down by around 20% over the first two months and fallen another 20% in the last few weeks.

The discounts to book value are so large now that many of the mREITs focused on Agency RMBS (residential mortgage-backed securities) could:

  1. Sell all of their assets
  2. Close their hedges
  3. Repurchase their stock
  4. Repurchase their preferred stock
  5. And have an enormous volume of leftover cash

Of course, it isn’t practical to repurchase all of your shares. We understand that. However, it's telling that the mREITs’ asset value, net of debts, outweighs the total market capitalization by an enormous amount.

2) Earnings

The drop would be expected if earnings were headed to zero, but that is not going to happen.

Mortgage REITs generally have access to extremely cheap financing for agency positions so if they were short on cash and short on buyers, they could still get by.

Given the enormous plunge in the sector, investors have to be asking why the market would drop shares so dramatically if the fundamentals are still viable. It seems ironic that book value could be down 10% to 20% with share prices down 60% to 80%.

It’s possible that such a drop could be due to home prices collapsing, but we do not see that.  Of course there could be dramatic moves in housing prices in the upcoming months, but even a moderate decline would not be enough to justify such declines.  However, with the buildup of the market and the fear of it crashing has led to overselling which has affected mREITs and why they are an extremely attractive investment.

Investors could be looking at the balance sheets and see that mREITs use a substantial amount of leverage, their balance sheet shows an enormous amount of debt. While leverage can be an issue, the levels of debt for mREITs are not worthy of this panic.  Many have even reduced their leverage to reduce their risk. If you were financing physical real estate with this much debt, you would have a problem. Physical real estate is not this liquid, but mREITs are.

The mREITs trade at staggering discounts to the net value of their assets. While many mREITs have not provided new updates to the market, the updates we have seen support our research. These executives have explicitly told shareholders where they see current book value and potential earnings. They have indicated that they still have access to repo markets.

The market is pricing shares for bankruptcy, but that reality is not reality. The market appears to be following extremely simplistic analysis which simply focuses on high levels of debt and difficulties with credit exposure from the Great Recession. There seems to be a massive panic in the market, without the fundamentals justifying this level of decline.

If you want to invest in real estate without actually owning the real estate, now is a great time.

Source: https://seekingalpha.com/amp/article/4332856-why-mortgage-reits-plunged-30-to-60-today

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Manly Danh
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