While broad stock market indices ended the first quarter in positive territory, many financial related equities posted substantial declines. The S&P Regional Banking Index lost 29% in March. An unprecedented amount of volatility also hit the Treasury bond market in March as the market was pulled back and forth between a full-fledged banking crisis and inflation-related interest rate hikes.
The mortgage REIT indices were down ~10% in March as investors undiscerningly sold financial stocks.
Although it’s widely publicized at this point, the following factors are responsible for stress across many banks:
Concentrated deposit bases
Ability to avoid mark to market adjustments on portions of their portfolio
General mismanagement of interest rate risk
On the contrary, the following factors characterize many non-bank mortgage REITs/companies:
Non deposit taking institutions
Substantially all of their portfolio marked to market each quarter
Hyper focus on interest rate hedges including interest rate swaps and mortgage servicing rights (MSRs)
Some non-Agency residential mortgage REITs and servicers ended the quarter trading at 35%+ discounts to tangible book value and double-digit dividend yields. Agency mortgage REITs also ended the quarter with double-digit dividend yields while some mortgage servicers were trading at even steeper discounts to tangible book value.
As we have previously written, we believe many investors have not fully recognized that many residential mortgage REITs are currently using less and longer-term non mark-to-market leverage (often securitization) than during the time leading up to the pandemic. Most mortgage REITs and servicers also have share buy-back programs in place, and we expect to see buybacks of various portions of capital structures continue over the next several quarters.
Short term corporate bonds issued by mortgage REITs/servicers (in our opinion, still the best opportunity in real estate-related bonds), held up better versus equities posting roughly flat performance for the quarter. This part of the market continues to offer high single-digit/low double-digit yields with what we believe to be low credit and duration risk.
Banks will likely be a challenging place to be invested over an extended period as increased regulation, depleted equity capital, and eventual asset quality issues will likely take the spotlight. Regional banks are the predominant funding source for commercial real estate, so we think bank troubles will likely spill over into commercial real estate—a part of the market that is already “on the ropes”.
Although it seems obvious from the name, over time it is also likely to become more evident to investors that non-bank mortgage REITs/related companies ARE NOT banks. Many banks have attempted to “paper over” bond and loan losses related to rising interest rates—non-bank mortgage REITs/related companies have been fighting this battle (and many have been winning) in plain sight as mark to market adjustments occur every quarter. We expect that over time, many mortgage REITs and mortgage servicers should maintain relatively stable book values and price to book ratios should normalize.
As we previously mentioned, we also believe that certain publicly traded REITs (and funds that own them) are poised to outperform private REITs and similarly structured investment funds. Private REITs, which primarily own illiquid assets, generally lagged the price declines of more readily traded public securities/funds in 2022.