When assessing the risk of a mortgage real estate investment trust (mREIT), it pays to understand not only the risks involved in the assets themselves, but also to the amount of leverage (or borrowed money) the REIT employs.
Portfolios full of government-guaranteed mortgage-backed securities (MBS) may look conservative at first glance, but dangers can lurk under the surface. We saw that last year when pretty much every mortgage REIT was slammed in the early days of COVID-19. Invesco Mortgage Capital (NYSE: IVR) had a near-death experience, and the company that emerged from the crisis was vastly different from the company that entered it. So what does Invesco Mortgage Capital’s profile look like now?
Mortgage REITs look more like banks than real estate companies
Mortgage REITs are an unusual subset of the REIT space. While most REITs follow a landlord/tenant model, mortgage REITs look more like banks. The typical office or retail REIT develops a property and then leases out the space. It's a simple-to-understand model. Mortgage REITs don’t buy real estate assets; they buy real estate debt. Instead of charging rent, they earn interest.
Mortgage REITs are counter-cyclicals
This difference in business models means that mortgage REITs will march to a different cycle than the typical REIT. A retail REIT or office REIT will perform more or less in line with the overall economy and the credit cycle. When the economy is going strong, these REITs will do well. During recessions, they will struggle. Some REITs are more defensive than others, but they tend to be cyclicals overall.
Invesco Mortgage Capital is an agency REIT, which means it invests in government-guaranteed mortgage-backed securities. These companies tend to behave in a counter-cyclical manner. When the economy begins to weaken, investors will tend to eschew riskier debt and swap into safer credit profiles. Government-guaranteed mortgage-backed securities become an attractive place for pension funds and other bond funds to wait out the storm.
As we've seen in the past two recessions, the Federal Reserve bought agency mortgage-backed securities to boost the economy, which translates into good news for agency mortgage REITs.
Invesco Mortgage REIT almost died of COVID
Last year, the typical mREIT script didn’t play out as usual, which was due to a freeze in the mortgage-backed securities market. When COVID first struck, liquidity dried up in many financial markets, including the MBS market.
Mortgage REITs tend to use repurchase agreements to borrow money cheaply. Repurchase agreements are basically secured loans, and if the value of the collateral falls below the loan amount, the bank will demand the REIT post additional cash to make up for the drop in asset values. Mortgage REITs hold very little cash as a general rule, so the only way to come up with additional cash is to sell assets. If everyone is in the same boat, prices can fall in a hurry.
Even government-guaranteed paper can collapse if sellers overwhelm buyers. That happened last year, and every stock in the mREIT space reported losses and cut its dividend. Invesco Mortgage was forced to enter into forbearance with its creditors, but it sold assets, raised capital, and eventually brought back the dividend.
Mortgage REIT investors have to keep an eye on the overall economy and remember that these stocks are counter-cyclicals. They tend to struggle when the economy heats up. Why is that?
First of all, mortgage-backed securities are bonds, and when rates rise, bonds fall. While the Fed is nowhere near hiking rates, the Fed Funds Futures see a better-than-70% chance of a rate increase by the end of next year.
Second, the Fed is currently buying mortgage-backed securities to support the economy. That will end at some point, which means the biggest buyer of mortgage-backed securities will exit the market. This will push mortgage-backed securities prices lower as well.
We have seen this movie before in 2013, during the “taper tantrum,” which caused MBS to underperform Treasuries. In industry parlance, MBS spreads “widened.” It was a tough period for mortgage REITs. Mortgage REITs are financials, and financial stocks go through crisis periods every decade or so. That's why they tend to trade with low multiples and higher dividend yields.
Not super-risky, but the sector will be subject to Fed fears
So where does this put Invesco Mortgage Capital on the risk scale? Well, the company just reported a second-quarter loss, and book value per share fell from $3.65 in the first quarter to $3.21. The entire mREIT sector has had a similar experience, and MBS spreads have a long way to go to reach 2013 levels. This will be a cloud over the head of the entire sector for the next couple of years.
Invesco Mortgage Capital’s portfolio is almost entirely invested in agency MBS, although it does have a minor credit portfolio. The company’s performance will be driven almost entirely by the behavior of MBS spreads, and those will be a function of the market’s perception of upcoming Fed policy changes.
Invesco Mortgage Capital is trading right around book value per share, which is about normal. The company pays a quarterly dividend of $0.09 per share, which gives it a fat 11.4% dividend yield. To put that dividend into perspective, Invesco Mortgage Capital paid a quarterly dividend of $0.50 until COVID hit.
The Millionacres bottom line
Invesco Mortgage Capital simply won't return to pre-COVID levels. It sold many of its underperforming assets at the bottom, and the pre-COVID book values in the teens are irrelevant. Investors hoping for a rebound and thinking they are buying dented merchandise on the cheap should rethink that theory.
Invesco Mortgage Capital is fairly valued at these levels -- those high-teens pre-COVID prices are a pipe dream. Assuming that Invesco can manage its portfolio by opportunistically switching between cheap and expensive agency MBS, the dividend is probably safe. Unless we hit another liquidity pocket like last year, the stock should be looked at as a garden-variety agency mortgage REIT, suitable for an income investor looking for yield.