Home prices are rising at a torrid pace, as we have seen in popular real estate indices like the Case-Shiller Home Price Index or the FHFA House Price Index. These two indices recently reported that in May, home prices rose 17% and 18% year over year, respectively. While the prices of a year ago (during the lockdown) are possibly distorted by small sample sizes, the housing market is red-hot.
Given the rapid rise in home prices, investors are starting to wonder whether we have another real estate bubble on our hands. If we do, the one real estate investment trust (REIT) that stands the best chance of surviving is AGNC Investment Corp. (NASDAQ: AGNC).
However, it is unlikely that we have a housing bubble in the first place. Residential real estate bubbles are rare events that happen once or twice a century. For a bubble to exist, everyone -- investors, lenders, regulators -- has to believe an asset is "special" and can only go up in price. The memories of 2008 are still too fresh in everyone's minds. We will probably never see another real estate bubble in our lifetimes, but perhaps our grandkids or great-grandkids will.
The other thing to keep in mind about real estate bubbles is that they tend to be the Hurricane Katrinas of banking. Residential real estate is a highly leveraged asset in general: A "conservative" homeowner who puts 20% down on a home purchase is still leveraged 4:1. So, if a real estate bubble bursts, it will throw off a ton of financial shrapnel, which can still catch someone who, theoretically, has no exposure to real estate prices.
Counterparty risk can be just as deadly as asset price risk. Real estate prices can fall even without a bubble, and some mortgage REITs, or mREITs, will perform better than others in that scenario.
Not all mortgage-backed securities are the same
The most common assets that mortgage REITs hold are agency mortgage-backed securities (MBS). Agency mortgage-backed securities hold loans backed by Fannie Mae and Freddie Mac, which are ultimately guaranteed by the government. If the borrower defaults on the loan, the MBS holder will still be paid the principal and interest owed. That means if real estate prices fall, agency MBS should be largely unaffected.
Other assets that mortgage REITs hold include whole loans and securities backed by loans that are not guaranteed by the government. Typically, these loans are either too big to get a guarantee (also called jumbo loans) or fall outside the government's qualified mortgage parameters (also called non-qualified mortgages).
These assets will be sensitive to real estate prices, and if the value of the underlying collateral falls, they will decrease as well. Most mortgage REITs will own a combination of agency (government-guaranteed mortgages) and non-agency paper.
AGNC has the highest percentage of its assets in agency paper, compared with competitors such as Annaly Capital Management, MFA Financial, New Residential Investment Corp., and Redwood Trust. AGNC just reported second-quarter earnings and disclosed that they held an $87.5 billion portfolio, of which $85.5 billion comprised agency mortgage-backed securities and their derivatives.
While AGNC bears very little credit risk, that doesn't mean it bears no risk -- book value per share fell 7.5% during the quarter as mortgage-backed securities underperformed Treasuries. The underperformance was due to market fears that the Fed will curtail purchases of MBS in the near future.
Beware of the Fed
AGNC Investment Corp. is trading right around its book value per share of $16.39 and has a dividend yield of 8.9%. The entire mortgage REIT space will be under a cloud while the Fed contemplates reducing or suspending its MBS purchases. In this environment, it makes sense to wait for these stocks to trade at a significant discount to book value (7% to 10%) before stepping in.
I like mortgage REITs in general, and I had AGNC as one of my CAPS picks not too long ago. But the prospect of MBS spreads widening further ahead of any Fed tapering warrants caution in the mREIT space.