The VanEck Vector Mortgage REIT Income ETF (MORT) offers targeted exposure to “mREITs” that invest in the debt financing side of real estate through mortgages or mortgage-backed securities. While mREITs are recognized as attractive income investments, this year’s pandemic has represented a historic challenge considering many properties faced delinquencies amid broader disruptions to the real estate sector. Indeed, MORT is down by 25% year to date further pressured by a collapse in yield spreads limiting cash flow and earnings. That being said, we highlight more recent positive momentum with MORT up 18% over the past month benefiting from an improving economic outlook. We like MORT for its 9.4% yield and see upside as the operating and financial environment for mREITs improve going forward.
The MORT ETF with an expense ratio of 0.41% and $217 million in total assets tracks the underlying ‘MVIS US Mortgage REITs Index’ which contains only REITs that derive at least 50% of their revenues from mortgages. From this group, REITs invest across commercial and residential loans or related structured securities. The fund follows a market capitalization-based weighting methodology and currently only includes 25 holdings.
Keep in mind that this is a concentrated portfolio based on the relatively unique market segment that represents an overall small portion of the broader REIT universe. Annaly Capital Management Inc (NLY) with a 15.4% weighting in the fund is the largest holding consistent with its market cap of $11.5 billion. AGNC Investment Corp (AGNC) with a 12.2% weighting and Starwood Property Trust Inc (STWD) at 6.6% of the portfolio round out the top-3 positions.
Overall, the top-10 holdings represent 67% of the total exposure. While most mREITs share in common a similar exposure to market interest rate spread dynamics and general real estate market trends, there is some diversification in terms of the type of properties being financed and deals pursued including agency debt and middle-market lending. Some mREITs target their credit exposure to particular industries and have varying levels of credit quality.
Mortgage REITs tend to benefit from wider spreads between their borrowing costs and the yield on their mortgages. The trend this year of collapsing yields across the entire curve and all types of interest rates based on the FED’s quantitative easing measures have represented a bearish headwind for mREITs and also help explain the poor performance of the segment.
MORT is down 25% in 2020 and also underperformed to the broader real estate sector considering the benchmark Vanguard Real Estate ETF (VNQ) is down by a more moderate 6%. Generally, significant disruptions this year from the pandemic forcing retail businesses to close along with ongoing themes like work-from-home limiting demand for office space have significantly impacted the operating and financial environment for the underlying REITs in the sector.
As it relates to mREITs, data showing residential mortgage rates remaining at historical lows with the 30-year fixed at 2.72% over the past week continue to challenge the outlook for earnings. Ideally, the companies want to borrow at low rates and lend at high yield. In their week mortgage market survey, Freddie Mac (OTCQB:FMCC) explains that a boom in refinancing along with low inventory for homes continues to keep rates down.
On the other hand, there are some reasons to believe the environment is improving and mortgage rates could begin to climb higher going forward representing a more supportive environment for the underlying mREITs within the MORT portfolio. First, long term Treasury rates are well-off their lows and have climbed higher in recent months. The 10-year Treasury currently at 0.88% has climbed from a low of 0.51% back in early and now at nearly the highest level since early March. While long-term Treasuries and mortgage rates are not directly related, the climbing yield here can be viewed as a potential leading indicator in our opinion. Also, a more stable interest rate environment is positive for mREITs because this reduces prepayment risk.
Secondly, one of the weakest trends for the industry this year which was a surge in mortgage delinquencies appears to be improving. Even as the aggregate number is nearly double from the level in 2019, signs are that the worst is over and the market from the residential side is already recovering. According to the industry group ‘Mortgage Bankers Association’, the delinquency rate for residential properties improved in Q3 to 7.67% down from 8.24% in Q2. From the report:
“Consistent with the improving labor market and the overall economic rebound, homeowners’ ability to make their mortgage payments improved in the third quarter,” said Marina Walsh, CMB, MBA’s Vice President of Industry Analysis. “The decrease in the mortgage delinquency rate was driven by a sharp decline in newer 30-day delinquencies and 60-day delinquencies.
While this metric remains of particular concern for the sector, the expectation is that continued economic improvements along with a firming labor market through 2021 will allow borrowers on aggregate to remain current. More importantly, coupled with recent developments suggesting a COVID-19 vaccine is on the horizon and may effectively end the pandemic by next year supports a view the outlook is now better than previously expected.
The table below highlights the performance of the underlying mREITs within the MORT ETF. Notice that over the past month shares have rallied impressively with MORT up 18% over the period with every holding presenting a positive return over the period. Colony Credit Real Estate Inc (CLNC) is a big winner up 57.7% in the last month. A general trend here is that the most beaten-down names have outperformed more recently. This is in the context of an extreme level of volatility considering most holdings are down significantly year to date with even larger losses from their 52-week high.
(source: data by YCharts/ table by BOOX Research)
The other point to note is the impressive dividend yields offered across the universe of mREITs. Invesco Mortgage Capital Inc (IVR) is an outlier with a massive 30.7% stated yield based on its quarterly distribution of $0.05. While this rate may not be sustainable indefinitely, the company last declared a payment in September. Colony Credit Real Estate Inc with a yield of 0% expects to reinstate a payout in Q1 2021.
The result here is that the MORT ETF currently yields approximately 9.4%, or technically 10.2% on the 30-Day SEC Yield. This level reflects the still depressed stock prices while there could still be some cuts by individual names down the line. The quarterly payments are variable based on the underlying portfolio income. The last payment for the ETF in October at $0.34 per share was down from $0.38 in 2019. Even as there were many suspensions or distribution cuts this year given the challenging financial environment, most of the companies have already adjusted their payouts to the new economic reality and we expect the dividend rates to be relatively stable from the current level. The income potential here is attractive considering the MORT ETF yield was under 7% before the pandemic selloff.
As mentioned, the recent development of several candidate COVID-19 vaccines expected to be approved for distribution in the coming months is fueling a wave of market excitement towards a strong economic rebound in 2021. While the pandemic remains a reality with a record number of cases globally, the consensus now is that there is light at the end of the tunnel and investors are looking ahead at the operating and earnings outlook beyond this year.
As it relates to mREITs, a gradual normalization for key sub-industries like offices and hospitality that were particularly impacted over the past year can support new growth opportunities for lenders. A stronger than expected economic environment into 2021 can drive mortgage rates higher which would be bullish for the sector.
While real estate still faces significant concerns regarding certain types of properties or trends in lease rates, we believe there is room for MORT to climb as the sector gets repriced with a more positive outlook. Even as the highs for the ETF from early Q1 near $26.00 per share may be out of reach for the foreseeable future, we below upside towards $20.00 per share implying 20% upside from the current level is achievable.
The risk here is that operating and financial conditions for the underlying mREITs within the MORT ETF deteriorate and underperform expectations. There is a concern that as COVID relief efforts expire, the economic recovery could lose traction and again force a new wave of weakness in real estate. We believe a new round of economic stimulus efforts on the fiscal side over the coming months possibly in a new Biden administration could act as a stop-gap for vulnerabilities in real estate through the end of the pandemic.
We are bullish on the VanEck Vector Mortgage REIT Income ETF as a high-quality fund that still offers value at the current level. We believe an allocation by investors into MORT can act as a portfolio diversifier and add an attractive income component considering the 9.4% yield.
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Disclosure: I am/we are long MORT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.