NEW YORK CITY—Analysts at Keefe, Bruyette & Woods are scaling back their earnings estimates for mortgage REITs by an average of 4% heading into 2017. KBW says most companies in the sector will be pressured by increases in short-term interest rates: not the one that the Federal Reserve's Federal Open Markets Committee is widely expected to announce at its meeting this week, but four more that the firm's analysts are predicting will occur over the next two years.

Prior to “the unexpected results of the presidential election,” KBW had a slightly different view of mortgage REITs' near-term future. “Heading into November, we expected the Fed to take a gradual policy approach and that the impact on mREITs would be fairly benign,” KBW analysts write.

Since the election, though, “interest rates have moved meaningfully,” and KBW's economic baseline now assumes five increases in the federal funds rate, up from one predicted just two months earlier and not occurring until sometime in 2018. “So, while valuations are not high, we think it will be difficult for the sector to outperform as interest rates trend higher.”

That being said, NAREIT said earlier this week that post-election, total returns on the FTSE NAREIT Mortgage REITs Index gained 1.7%, while those of the FTSE/NAREIT All Equity Index fell 2.4% during November. Year to date, the NAREIT mREIT index has posted total returns of 20.01%, compared to 7.06% for the FTSE NAREIT All REITs Index and 5.87% for the S&P 500.

The impact of the rate hikes will be more pronounced for companies that have greater exposure to agency MBS. Typically, mREITs fare best when the yield curve grows steeper, as usually happens following a tightening cycle. “While the yield curve has steepened and spreads have widened recently, we expect some of this benefit to be offset as the Fed raises rates next year,” according to KBW.

Book values for mREITs have slipped by an average of 3.3% in the current quarter, KBW says, although New Residential Investment Corp. and PennyMac Mortgage Investment Trust have seen modest gains in book value since the fourth quarter began. “Companies with higher leverage and wider duration gaps have tended to get hit the hardest, as generic 30-year agency MBS pools are down between 2% and 5% in price, depending on coupon and vintage,” according to KBW.

“Prices for 'specified' MBS pools, which are widely held by REITs because of their more predictable cash flow characteristics, have been hit even harder, as pay-up premiums over generic pools have collapsed given the reduced interest in obtaining prepayment protection,” according to KBW. For the coming year, KBW is establishing new price targets that reflect between 0.90x and 0.95x of book value for most of the companies in its sphere of coverage.

Accordingly, with book values lower, leverage levels are forecast to increase, and “that will make it difficult for companies to take leverage even higher in order to support earnings,” says KBW. “Our earnings estimates revisions reflect this outlook.”

Given its 0.90x book value on average, the mREIT sector “is not expensive and we continue to expect double-digit dividends,” according to KBW's analysts. “However, we think that if book values and earnings remain under pressure because of rates and increased volatility, it will likely be difficult for the sector to outperform.”

Instant Insights /

Future Rate Hikes Will Challenge mREITs

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