The current interest rate environment has some investors taking a closer look at mortgage REITs (mREITs) right now, and for good reason. Mortgage REITs that have maintained a strong portfolio of debt assets through the pandemic are positioned to enjoy a nice boost in earnings over the next couple of years. Two such mREITs are Starwood Property Trust (NYSE: STWD) and Annaly Capital Management (NYSE: NLY). Buying these two mREITs will give you exposure to both the commercial and residential mortgage markets.
Starwood Property Trust
Starwood Property Trust is a mREIT that primarily invests in commercial mortgages. Its high exposure to hotel and office properties does make it a higher-risk REIT investment. However, with the hospitality industry showing strong signs of improvement and the office market not being in as much trouble as people feared, it looks like it's already seen the worst of its pandemic-related defaults in these areas.
Despite its exposure to these property types, 98% of its loans were current as of the end of 2020, and the company's interest income from commercial and residential loans was up over 9% for 2020 compared to 2019.
Besides that, the REIT reduced the LTV on its loans from 64.9% to 60.4% since the end of 2019. Additionally, the portion of its loan portfolio with an LTV between 0% and 50% has increased to 79% from 73% over the same time period. As a lender, this provides it with a lot of added protection against losses in case of default.
Starwood also has added stability through its real estate investments. The company has a $2.3 billion real estate portfolio made up of multifamily and medical office buildings. The real estate portfolio accounted for over $255 million in revenue in 2020.
The company also has additional recurring revenue through its loan servicing. In fact, Starwood Property Trust is one of the largest commercial mortgage-backed securities (CMBS) special services in the United States. This segment of the company accounted for over $183 million of its revenue in 2020.
The company is currently sitting on a relatively safe portfolio of loans and real estate, which should prevent any further disruptions in the near future. For the upside, the increasing interest rates on long-term debt will increase the company's yield on its debt investments, which should mean a boost in earnings over the next couple of years.
With an already attractive dividend yield of 7.87%, Starwood Property Trust should make a great income investment.
Annaly Capital Management
On the residential side of mortgages is Annaly Capital Management, an mREIT that mainly invests in agency mortgage-backed securities (MBS). MBS assets are low-risk investments, since they're guaranteed by Fannie Mae (OTCMKTS: FNMA) or Freddie Mac (OTCMKTS: FMCC).
These guarantees give agency MBS the same AAA credit rating as the U.S. government, making these assets easy to borrow against at the lowest rate available. This means Annaly is able to use short-term loans at extremely low interest rates to fund these agency MBS assets and profit from the difference between the short-term and long-term rates.
Since the Fed has made it clear it intends to keep short-term rates low for the foreseeable future and long-term rates are showing a steady increase, Annaly's earnings will continue to grow as the spread between the interest it's paying and the interest it's receiving continues to widen.
The mREIT is now putting more of its eggs in this agency MBS basket with its recent announcement that it's selling its $2.33 billion commercial loan portfolio. The company plans to invest in more agency MBS assets with the proceeds of the sale after paying off debt related to its commercial portfolio.
The loss of risk is minimal with the Fannie Mae and Freddie Mac guarantees, and the upside potential is significant. With its dividend yield already at 10.16% and its share price still down 16.3% from the pre-COVID-19 price, Annaly is a smart income play right now.
The Millionacres bottom line
These mortgage REITs have the potential to provide a significant amount of income to investors over the next couple of years, but mREITs have to be watched closely. They're extremely sensitive to interest rates, so as short-term rates eventually start to increase, the margins will begin to tighten again. Make your money off of mREITs while you can, but be cautious about keeping them as a long-term investment.