By Art Gering

It wasn't too long ago that mortgage REITs were the darlings of the industry, handily outperforming their equity REIT peers. However, things turned in 2005 as mortgage REITs slumped, posting a negative total return of 23.2 percent, according to NAREIT data. How did the sector's fortunes shift so quickly?

For starters, non-prime mortgage banking and residential mortgage-backed securities (RMBS)—probably the two most prominent business models employed in the mortgage REIT universe—suffered "tremendous financial adversity" last year, explains C. Douglass Garrett, vice president in the Financial Institutions Group at Flagstone Securities.

"Specifically, non-prime mortgage banking suffered from weak whole loan pricing as originators chose not to pass higher financing costs along to borrowers," Garrett says. "Meanwhile, the agency RMBS spread investors suffered from substantial net interest margin erosion as Fed-driven financing costs increased more rapidly than yields on their RMBS assets."

"The performance is attributable to margin compression," adds Matthew Howlett, an analyst at investment bank Fox-Pitt, Kelton. During the prior few years when the Fed held rates at low levels, mortgage originators had the ability to generate significant margins, he explains. "For a lot of reasons, including the Fed ultimately raising rates, and excess capacity levels, the active originators could not deliver the same margins they delivered during the previous periods when conditions were significantly more favorable."

The diverse business models and operating platforms employed by individual mortgage REITs makes it difficult to generalize about the sector's prospects. Most broadly, mortgage REITs can be broken down into those companies that focus on commercial financing and those centered on home financing. Regardless, interest rate trends, changes in the property markets and the possibility of credit erosion are but a few factors that mortgage REITs will have to contend with in the months ahead.

Interest Rates Impact

At the beginning of 2006, the yield on the 10-year U.S. Treasury sat in a tight range from 4.50 percent to 4.59 percent, but began to rise in early March. Additionally, a strong employment report for February spurred speculation that the Federal Reserve would raise its short-term rate not just two more times, as has been widely presumed, but a third time in June.

What to Watch For: Mortgage REITs As 2006 unfolds, investors in mortgage REITs should be mindful of the following issues that could impact the sector's performance:

PROS: The sub-prime mortgage market continues to expand, providing more business opportunities to mortgage REITs with sub-prime origination platforms. Supply and demand fundamentals in the commercial property markets continue to strengthen, which should support a vigorous pace of investment sales volume. Mortgage REITs active in the commercial space should benefit from greater deal flow. With the time to make easy money passed, weaker firms will exit the residential mortgage business. Stronger firms, including many residential mortgage REITs, will be able to rebuild margins as the weaker firms disappear.

CONS: Mortgage originations are expected to decline as the single-family housing market slows. The decline is expected to adversely affect residential mortgage originators. Rising interest rates. The yield curve is flat, and was inverted for much of the early part of 2006. The current shape of the yield curve hurts those mortgage REITs that depend on favorable spreads between short-term and long-term rates. Erosion of credit quality may occur at the back end of 2006 or early 2007, as borrowers that used short-term, adjustable-rate financing confront higher monthly payments on their mortgages.

Higher short-term and long-term rates appear to be a virtual certainty in the months ahead, and mortgage REITs will be affected in several ways. For one, REITs that hold mortgage bonds could see the value of their portfolios diminish—a strong possibility in a rising rate environment. Mortgage REITs that use the public markets to raise capital for asset purchases may also face new challenges.

"One of the things that we look at very closely is a company's funding profile," says Matthew Gallino, a senior director with Fitch Ratings. "An issuer that is using financing that, for example, only goes out 90 days, has a lot more refinance risk than an issuer that has long-term funding through the use of CDOs, securitizations, or Trust Preferred Securities."

In a perfect world, a REIT's assets would match its liabilities from a duration perspective, according to Fitch managing director Tara Innes. "Some companies have been borrowing short-term because it has been cheaper than lending long-term. That is great for earnings in the near term, but in a rising rate environment, greater margin risk and, ultimately, refinance risk emerges," Innes says.

The outlook for capital raising by mortgage REITs also becomes a bit uncertain due to the pressure on performance exerted by higher interest rates. "To raise capital, the companies need to be trading at attractive price-to-book ratios," says Donald Fandetti, senior equity research analyst-specialty finance with Citigroup Investment Research. "The companies that have been executing well probably still have the window open. It is usually a function of investors supplying capital to these companies if they are good, attractive investments, and it is accretive."

Another outcome of rising interest rates is much lower prepayment of mortgage debt. For mortgage REITs, a lower rate of prepayment has a potential downside. "To the extent that mortgage REITs have strong assets, they're more likely to repay, whereas the assets that are more challenged are less likely to repay," Innes explains. The quality of a loan pool deteriorates in a rising rate environment, she concludes. Still, others see a lower prepayment rate as a minor positive for the mortgage REIT sector.

"When prepayments slow, that will help portfolio lenders," according to Bose George, REIT analyst with Keefe, Bruyette & Woods. "If the loan lasts longer, they essentially get more income."

Property Markets Shifting

The performance of mortgage REITs will also be affected by changing conditions in the property markets. Signs continue to emerge nearly every day indicating a slowdown in the single-family housing market. Meanwhile, supply and demand fundamentals for commercial properties are strengthening in most metro areas across the country. Fitch, for one, expects origination volume in the residential mortgage market and for most mortgage products to decline. Indeed, higher interest rates and diminished affordability in many metros are frequently cited as factors that will slow activity in the single-family housing market.

Howlett of Fox-Pitt, Kelton foresees a 20 percent drop in overall residential mortgage originations, but expects a relatively stronger non-prime loan market, which would be good news for the many mortgage REITs operating in that sector.

"We think the non-prime market will decline from 10 percent to 15 percent," Howlett says. "The decline in the overall market will be driven by a decline in rate-term refinancing, but the non-prime market is tied more to purchases and cash outs. While cash outs are expected to be down somewhat, we think purchases will be flat, and we think the non-prime market will see more rate-term refinancing activity."

One of the potential outcomes of slower origination volume will be a reduction in the number of firms operating in the residential mortgage sector. "There are simply too many originators," Howlett claims. "As a result, there has been a lack of pricing discipline. Many players entered this market when margins were extraordinarily wide, and business was very profitable. When conditions changed, pricing discipline was relaxed, and margins were squeezed." With origination volume slowing, Howlett expects some consolidation in the sector, providing an opportunity for the remaining firms to claim greater market share.

On the commercial side, vacancy in the major property types is forecast to decline, and rents are expected to increase, strengthening property cash flows. Mortgage REITs with origination platforms stand to benefit from improving fundamentals, but some potential downsides exist. For one, rising interest rates could initiate a readjustment of cap rates, leading to a wider spread between buyers' and sellers' expectations.

"A lot of companies on the commercial real estate side were seeing very strong origination volumes," particularly in the fourth quarter, Fandetti notes. "Should transaction velocity slow, that could potentially mean less deal flow."

Credit Erosion

Exotic residential mortgage products, including interest-only loans and option ARMs, have boosted home ownership rates during the past several quarters. But they have also permitted many suspect or under-qualified buyers to purchase homes, leading to an emerging concern for many mortgage REITs.

"One real clear area of concern for us would be with residential mortgage REITs operating on the sub-prime side, where there has been substantial erosion of lending standards recently," Innes says. "Now that interest rates are beginning to rise, we're perhaps going through uncharted waters as we observe the seasoning of these assets."

Mortgage
# of REITs	32
Market Cap. (in thousands)	$24,284,256
Industry Market Cap. (in thousands)	$379,057,790
% of industry	6.4%
Yield	10.0%
YTD Total Return	5.3%
One-Year Return	-7.3%
Three-Year Return	13.6%
Five-Year Return	23.3%
Average Daily Trading Volume (Shares)	69,452,900
Source: NAREIT. Data as of March 31, 2006

Fitch forecasts a 10 percent to 15 percent increase in delinquencies this year, assuming that rising interest rates decrease cash-out opportunities. Nonetheless, delinquencies remain at a very low level.

"Credit is not an issue yet," George says. "But we're assuming the credit will become more of an issue in the back half of 2006. It may get pushed back into 2007, but it is clearly an issue at some point."

Offsetting such concerns is a strengthening economy, especially a stronger labor market. On the surface, job growth and wage increases will bolster borrowers' ability to meet monthly mortgage obligations. The concern, though, becomes whether wage growth will be sufficient to counter the rate of interest rate increases.

The Outlook

The combination of declining mortgage originations, interest rate pressures and emerging concerns over credit quality do not provide the most hospitable environment for mortgage REITs. For these reasons, "we have a very negative outlook for 2006," George states. "We're looking for flat to down earnings across the board."

For those firms that are non-prime mortgage bankers and RMBS investors, early 2006 will be a fundamental inflection point, Garrett says. "Non-prime whole loan pricing is currently improving because originators finally started to increase loan coupons to borrowers in October," he states. "Net interest margins should trough in the second quarter for agency RMBS spread investors assuming the Fed stops at percent."

"With the fundamental bleeding halted," Garrett concludes, "and prospects for modest fundamental improvement in the back half of 2006, the stock group will begin to respond positively by late spring and early summer."