Mortgage Real Estate Investment Trusts (mREITs) are currently occupying an attractive place. Record refinancing rates and demand for new loans due to a low mortgage rate environment have helped to increase mREIT income at all levels over the past year. Yet at the same time, 2.6 million Americans are in abstention, 5.02% of all residential mortgages are in arrears, and millions of Americans are still unemployed. With forbearance protections expiring at the end of June 2021, this means mortgage REITs, particularly residential REITs like ARMOR Residential REIT inc. (NYSE: ARR), could be in trouble.
ARMOR’s business model
Unlike other mREITs, ARMOR Residential does not originate mortgage loans. Instead, he uses his brokerage firm, BUCKLER Securities, to invest in mortgage backed securities (MBS). MBSs are issued and / or guaranteed by US government entities such as Fannie Mae, Freddie Mac or Ginnie Mae, which allows the company to not only earn money on the interest received on loans, but also to participate in credit swaps. Credit swaps, also known as interest rate swaps, are an important part of ARMOR’s business model, accounting for around 19% of its revenue in the first quarter of 2021.
Credit default swaps (CDS) are common practice in financial markets and help large banks, lenders and mREITs protect themselves against fluctuations in market interest rates and potential borrower defaults while providing cash to sellers now. ARMOR buys and sells pools of government guaranteed loans in the repo market, earning a spread between variable interest rates over the interest rate associated with the company’s bonds. In the first quarter of 2021, credit swaps generated income of $ 182.4 million and held a total swap notional amount of $ 6.0 billion as of May 2021.
Prepayments on loans are also hurting the bottom line of mREITs, especially in a lower interest rate environment like the one we see today. Fortunately, ARMOR’s portfolio covers itself against this:
- 25% of loans have prepayment penalties.
- 8% of loans are in geographic areas that charge additional fees for refinancing.
The company’s prepayments declined in the first quarter of the year.
Is ARMOR in trouble?
MREITs are known for their volatility and risk. Although this investment model has significant upside potential, it also comes with significant market exposure in the event of a financial or economic crisis. The rise in defaults is putting more pressure on companies like ARMOR, especially since their primary investment strategy is government-insured loans like Fannie Mae and Freddie Mac, which are currently among the largest numbers. of borrowers in abstention. In March 2021, a report by Black Knight estimated that 1.69 million FHA, VA, Fannie Mae and Freddie Mac loans were withheld. One percent of the loans in ARMOR’s portfolio have loan-to-value ratios above 95% and FICO scores below 700, which is a plus. Low credit scores and high loan-to-value ratios mean less equity and greater risk for the creditor in the event of default.
Uncertainty in financial markets also translates into reduced transactions in the repo market and an increased likelihood that swap buyers will not be able to maintain their debt securities in the event of a credit default. Considering the number of transactions made by ARMOR in the repo market, the current environment, especially as the abstentions expire, means that the company is quite exposed to declining income and volatility in the repo market. However, given the amount of government intervention that the repo market has received over the past year, the government is unlikely to allow too much volatility or risk its collapse.
Its basic income per share in the first quarter of 2021 was $ 0.23, which puts the company’s current dividend payout ratio at 130%, which is high for REIT’s equity lines but not uncommon in the world of mREIT. In the first quarter of 2021, the company’s leverage ratio was 7.1x, with a leverage ratio of 4.1x. The company has $ 687 million in cash and cash equivalents, which is not enough to settle the current total liability of $ 4.5 billion. However, since mREITs operate on debt, the amount of debt the company currently holds is not out of the norm.
Right now, the business seems to be doing well. But if the market were to suddenly turn around or if the State’s intervention in pensions or financial markets was reduced, ARMOR Résidentiel could find itself in a difficult situation and unable to maintain its dividend distribution ratios. Investors in mREITs are often drawn to the higher returns, which are currently around 10%, but there is significant risk and volatility in these markets. Investors should understand that ARMOR Residential may not be struggling right now, but a rapid move in the market and it could very well be.