- Jonathan Poyer
1st Half Real Estate Recap - A Dissection of the Sector
In real estate-backed structured credit, the best performing part of the market was floating-rate, senior Agency CRT bonds, which have ample credit enhancement and only declined marginally in price.
In legacy RMBS, prices were down in varying degrees depending on duration. Prices were unchanged for some limited duration, floating-rate legacy RMBS bonds while other more interest rate-sensitive mezzanine bonds were down as much as 25 points. Agency RMBS, CMBS, and Non-Agency CMBS were all down 8-10% as rising interest rates and widening credit spreads continued to weigh on prices.
Liquidity continued to feel challenged as fund outflows persisted (albeit in an orderly fashion) in 2Q 2022, and buyers with strong conviction were nowhere to be found.
In commercial real estate, property transaction volume continued to plummet, new issue CMBS appetite became scarce, and secondary CMBS bid/ask spreads remained wide.
Prices for corporate bonds of mortgage originators and servicers continued to be under pressure as fears of mortgage origination profitability continued to weigh on that market. Mortgage originators/servicers closed June with yields ranging anywhere from 8-20%. We believe this represents a significant buying opportunity for certain names that have a strong mortgage servicing component and can weather rising interest rates.
Total returns for equity REITs (REITs that own properties as opposed to debt) were also negative for the quarter and most major subsectors were down over 20% for 1H 2022. Healthcare REITs performed better than average and should continue to benefit from demographic trends and pandemic normalization.
Residential mortgage-related equities were not immune from the indiscriminate selling in the market. Mortgage REITs and servicers that have strong positions in mortgage servicing rights (MSRs) fared better versus mortgage REITs, which have less exposure to interest rate hedges. MSR holders get paid a servicing fee and benefit when interest rates rise, since refinancing activity slows down and the servicing fee stream extends. Given the fact that mortgage rates have almost doubled this year, a very large percentage of mortgages are now “out of the money” and have no economic incentive to refinance.
Q12022 earnings reports for mortgage REITs and servicers with large MSR positions showed that book values increased from the previous quarter. Some residential mortgage REITs ended June trading at 35%+ discounts to tangible book value. Some common shares of mortgage REITs are now yielding upwards of 15%.
The recent sharp sell-off in mortgage REITs and servicers is markedly different from the previous significant drawdowns that we witnessed in this sector in 2008 and 2020. In 2008 there were obvious credit issues in residential mortgages and in 2020 there was excessive use of short-term leverage by many market participants. We see neither of these issues in 2022 as residential mortgage underwriting has been relatively strict, the housing market is relatively stable on a national level, and leverage utilization by residential mortgage REITs is currently more long term (and less mark to market) in nature.
The bottom line is that the economy and financial markets remain highly uncertain. For this reason, we think it is especially important to focus on solid fundamentals, deep value opportunities, and securities with attractive yields. A cooling economy is also likely to assuage interest rate volatility, signs of which we have already seen in July, while not causing widespread mortgage and corporate defaults. We believe this environment would represent a relatively benign set of conditions for many real estate and mortgage investments which are currently trading at distressed prices.
We have already seen some signs of a housing “cool down” as mortgage rates have skyrocketed so far this year. We believe this is a healthy dynamic as it is a necessary disinflationary force and is likely to continue as the year progresses. While some parts of the country which experienced exorbitant home price appreciation will likely see some price declines, it is unlikely that widespread price declines will plague the market.
The primary reason the housing market is well supported for the short to medium-term is the historically low inventory in the market. While we saw a slight uptick in inventory at the end of 2Q 2022, several metrics show that we have a long way to go for inventory level normalization. This is an unfortunate dynamic for first-time home buyers but will likely be supportive for homeowners and investors in residential mortgages/real estate.
We believe that residential mortgage and real estate-related securities that have limited interest rate sensitivity could perform well for the remainder of the year. Given the drop in pricing for many income-producing securities, yields are historically high in many cases and should help to mitigate potential price declines from indiscriminate selling. Mortgage originators that have relatively small servicing businesses are likely to underperform mortgage originators and mortgage REITs that own a significant amount of MSRs. Mortgage companies that have some combination of attractive investment portfolios, origination capability, and off-balance sheet value should be able to achieve attractive returns for the remainder of the year. Equities trading at significant discounts to book value should also provide an additional defense as share buybacks are likely to accelerate. As we have said, the current investment environment in mortgage-related securities lacks the credit issues present in 2008 as well as financing deficiencies that characterized early 2020.
Although bond yields will likely stabilize in the coming quarters, we think it makes sense to limit obvious long duration securities – these include long term, fixed-rate bonds as well as unprofitable “growth” stocks. Long duration securities will also likely continue to suffer from poor liquidity. We think the Senior Credit Officer Opinion Survey on Dealer Financing is worth the attention of bond investors for the remainder of the year. The June report showed that three-fifths of dealers reported a deterioration in liquidity for Agency MBS with similar results for “off the run” Treasury bonds. Dealers also reported increased volume in collateral disputes for situations where they are financing certain securities. This trend is likely to continue as markets remain volatile and financing conditions become increasingly challenged.