By Steve Bergsman

Different Strokes for Different REITs

When the dust settled after the April volatility in the REIT sector, mortgage REITs were at the bottom of the pile. On April 30, the NAREIT Composite REIT Index had dropped to -4.62 percent for the year, down 15.26 percent for the month, while mortgage REITs were at -7.85 percent, plummeting 23.74 percent for the month of April.

Clearly, investors, accurately or not, consider mortgage REIT pricing to be at a greater risk during a rising interest rate environment than equity REITs. When the Federal Reserve raised short-term interest rates a quarter of a point to 1.25 percent at the end of the second quarter, that theory had a chance to turn into fact—or not.

As with equity REITs, the mortgage REIT sector is divided into a number of different sub-sectors—all of which need to be considered separately when determining the impact of changing rates on their performance.

"There are a wide range of mortgage REITs and mortgage REIT models, everything from firms that invest in Fannie Mae and Freddie Mac mortgage-backed securities to firms that invest in sub-prime, single-family mortgages," says John Kriz, managing director of real estate finance with Moody's Investors Service. "As a result, the interest rate vulnerabilities of those businesses are markedly different and more variable than for equity REITs."

W. Coleman Bitting, an analyst with Flagstone Securities, groups mortgage REITs into three broad categories: commercial mortgage, including such firms as Anthracite Capital Inc. (NYSE: AHR); mortgage financiers, including Capstead Mortgage Corporation (NYSE: CMO), Thornburg Mortgage, Inc. (NYSE: TMA) and Annaly Mortgage Management, Inc. (NYSE: NLY); and miscellaneous mortgage REITs, including IMPAC Mortgage Holdings, Inc. (NYSE: IMH).

Generally speaking, Bitting is not very positive on any of the groups, and except for individual cases, he expects earnings per share to be erratic in 2004 and then to decline in 2005.

The most visible of Bitting's sub-sectors is the mortgage financiers, which includes most of the larger mortgage REITs such as Annaly and Thornburg. To which, he notes, "excluding Thornburg, the average agency financier mortgage REIT liability (difference in duration of liabilities compared to assets) has increased to seven months at fourth quarter 2003 from one month at fourth quarter 2000; managements are preparing for future rate hikes."

Thornburg was singled out because it pursues a duration neutral strategy; it aggressively hedges against interest rate risk by matching the durations of its assets and liabilities. For 2004 and 2005, Bitting suggests earnings per share for Thornburg will be positive.

One of the key points Bitting was making, says Larry Goldstone, president and chief operating officer at Thornburg, "is that when you are borrowing longer-term, you pay a higher rate of interest—meaning you should have a higher cost of funds."

Essentially, higher interest rates are bad news for mortgage REITs and that impacted the whole REIT market, notes Steven Brown, a managing director at Neuberger Berman LLC. "Mortgage REITs suffer a direct impact from rising rates because high rates increase their cost of funding," according to Brown. "Unfortunately, mortgage REITs unfairly color investors' views toward equity REITs."

Jeremy Diamond, executive vice president at Annaly Mortgage, says it is unfair to pin the blame for the weakness in REIT pricing on the mortgage sector. "While rising interest rates aren't a good thing, they are not necessarily bad either," he adds.

Diamond maintains the modifying effects built into some mortgage REITs are threefold: coupons on the floating and adjustable-rate mortgages in portfolios will reset upwards as rates rise; rising rates mean refinancing activity is slowing down, hence amortization expenses related to prepayments decline, and this increases yields on assets; some mortgage REITs have short-duration portfolios, which are less sensitive to swings in interest rates.

One really has to drill down into the corporate structures to see the difference among the mortgage REITs, notes William Ashmore, president and COO with IMPAC Mortgage. "As opposed to just being a mortgage REIT that essentially acquires mortgage instruments and puts them on the books like a fund, we are an origination company (an operating mortgage company)."

And that's a big difference, adds Ashmore, because "our mortgage production between the first quarters in 2000 and 2004 has doubled and it looks like the same thing will happen in the second quarter. Things aren't slowing down for us."

The boom for IMPAC Mortgage is due to the fact that it specializes in non-conforming loans, for which the demand is not as interest rate sensitive as it is for conforming loans that usually are sold to Fannie Mae and Freddie Mac.

"Our origination business will continue at record levels," Ashmore says, "but we are being painted with the same brush as everyone else."

While Brown suggests it's the mortgage REITs' fault for bringing down the composite REIT market in times of rising interest rates, Thornburg's Goldstone maintains the opposite is true.

"Equity REITs don't really have any way to re-price or change current earnings on their existing portfolios," Goldstone says. "It's possible equity REITs could raise rents, but that is going to be a slow process. Whereas mortgage REITs (particularly the adjustable-rate ones) have the opportunity to re-invest monthly principal and interest payments from mortgages into higher yielding instruments. That will have a more beneficial impact on earnings than might be true of an equity REIT owning a bunch of buildings with leases locked in."