One common question that Capital Markets staff receives is, “Do you ever sell loans to REITs (real estate investment trusts), or do you use their prices on your rate sheet?” Mortgage REITS (aka, mREITs) are definitely involved in the demand for mortgage products, and therefore determine the price of many mortgage products indirectly. And although there are typically few, if any, direct links between a lender and an mREIT, it is important for capital markets personnel to know what mREITs are doing in the current market.
First off, as a reminder, a REIT is a company that owns and, in most cases, operates income-producing real estate (commercial real estate, such as office and apartment buildings, warehouses, hospitals, shopping centers, hotels and even timberlands) but also engage in financing real estate. There are tax advantages to the REIT structure, but broadly speaking mREITs were designed to provide a real estate investment structure similar to the structure mutual funds provide for investment in stocks.
Many mREITs trade up and down with the stock market. With the broader market heading toward official “correction” territory and mortgage REITs off to a strong start in 2014, they are attracting the attention of investors. And if mREITs are doing well, price-wise, that will impact their demand for mortgage product, with, in theory and simply stated, the demand for mortgages increasing the price and dropping the rates to borrowers.
Current mREIT pricing, broadly speaking, is about a 10% discount to book value. So analysts believe downside risk seems fairly limited (barring a surprising economic turnaround and change of heart from the Fed). In a turbulent market where “value” is suddenly replacing growth, investors and analysts alike are bullish on mREITs.
Slower mortgage refi activity tends to be a positive for mREITs, so banks reporting mortgage production down quarter over quarter, and year over year, is positive for mREITs. But the case analysts make for owning mREITs doesn’t depend on bad economic data or global central bankers deciding to fill in the gap that Fed tapering has left in QE. Continued economic growth, even at a moderately better pace than the past four years, is also friend to the mREITs. That’s because what’s “priced in” is some kind of sharp uptick in growth, or surprise Fed tightening, which is what would be required to send book values plummeting again and dividends being cut.
Investors believe that discounts to book value averaging 10% offer downside protection. It’s important to recognize book value is a fully marked-to-market net asset value of each company’s assets and hedges. An mREIT at a 10% discount to book can be viewed similarly to a closed end bond fund at a 10% discount to book: it’s effectively a statement by equity investors that bond investors are mispricing bonds to the high side. Perhaps that made sense a few months ago, when enthusiasm was high that the economy was poised for strong acceleration in 2014. With economic and earnings data disappointing, bonds firmly in rally mode, and bond yields back below their 200 day moving average this implicit expectation of bond market collapse looks increasingly misplaced.
What does all of this have to do with the rates borrowers see when they obtain a loan from a lender? Sure the Fed controls rates – but typically short term rates. Long-term rates are controlled by supply and demand (the reason why QE has been effective through increasing the demand). And if there is increased demand by mREITs for residential mortgage product, that will help push prices higher and rates lower. And that is easy for someone in Capital Markets to explain to an LO.