Should Mortgage REITs Switch Strategies?

The tables and charts are at the top; the analysis is below.

The High Yielders

The charts compare the common shares from the following mortgage REITs and BDCs:

The Charts

The following charts cover the mortgage REITs, BDCs, baby bonds, and preferred shares. To create a more scalable system and reduce wasted bandwidth, I’m linking the charts here.

Definitions for Preferred Shares

• FTF stands for “fixed-to-floating.” It means the share is a fixed rate but will begin floating based on SOFR. We may still refer to LIBOR, but LIBOR simply means SOFR + 26.161 basis points.

• FTR stands for “fixed-to-reset.” These shares are currently fixed rate but will eventually reset their dividend rate based on the five-year Treasury rate plus a given spread. They typically continue to reset every five years thereafter. At least in theory. That’s pretty far away, but those are the terms.

• FTL is a special classification for the preferred shares from PMT. PMT-A and PMT-B began floating on 3/15/2024 and 6/15/2024. However, the actual dividend payments did not change. I went into more detail in this article on PMT’s preferred shares.

• Floating stands for a share that is floating. Pretty obvious, right? This is the adult version of “FTF.” The rate is typically updated every three months.

Key Supporting Articles

I wrote a few supporting articles over the years that may help investors understand the sector:

The guide to swapping is brand new. I hope you’ll enjoy it.

Commentary From The REIT Forum

Mortgage REITs have been a wild ride. While the preferred shares were generally pretty stable, the common shares can bounce around pretty hard. We still have AGNC trading somewhere around 1.3x book value. That’s incredible. That’s simply something you never expect to see. Some investors will point to that as proof of their brilliance. I would point to it as a sign of their great luck. The price-to-book is certainly capable of swinging around, but management of the REITs treats it as one of the most important variables in determining whether to issue shares. If the board of directors thinks it’s the right way to decide when shares are expensive enough to issue them, that should be an indication for investors.

That doesn’t mean it’s never a good idea to issue shares when the company is issuing or to buy shares when a company is repurchasing them. We wouldn’t want to suggest such absolutes. But it’s something you may want to consider.

What I find surprising is that so few REITs realized that this is the best time available to switch strategies.

Should They Switch Strategies?

A mortgage REIT can switch strategies by selling their assets and buying other assets. This would be a particularly good strategy for some of the REITs trading at much larger discounts to book value. If their assets are worth anywhere near what the REIT claims for book value, they could unload those assets and swap strategies.

There’s a huge disparity between agency mortgage REITs and the other mortgage REITs.

For a moment, ignore all of the agency mortgage REITs.

You’re only looking at the others.

Out of the 11 mortgage REITs we cover that are not agency mortgage REITs, there are only two trading above 80% of trailing book value. They are Ellington Financial (EFC), which is very close to trailing book value, and Adamas Trust (ADAM), which is trading around 0.89x trailing book value. No, these REITs are not all set to report devastating losses to book value. These are simply REITs where the market believes that it would not be wise to pay a value near trailing book value for their shares.

Yet how are the agency mortgage REITs doing? We can remove Two Harbors (TWO) from the comparison since they are set to be acquired on Aug. 3, 2026.

That leaves us with six agency mortgage REITs. Out of those six, there are four trading right around trailing book value or above.

The two that are not included are Orchid Island Capital (ORC) at .93x trailing book value (higher than 10 of the 11 non-agency mortgage REITs) and Cherry Hill Mortgage (CHMI). CHMI regularly gets one of the biggest discounts, and I don’t want to get into the microcap situation there, so let’s just say that even serial dividend cutter ORC is trading at a much higher price-to-book ratio than almost any of the non-agency mortgage REITs.

How Could They Switch?

It’s actually really easy. Dump your assets. Buy other assets.

Agency MBS are a highly liquid market, so getting into that market is not hard. Therefore, the bigger challenge is unloading the older assets at prices similar to the recorded values. In some cases, that should be much easier than others. But it doesn’t have to be done all at once. The mortgage REIT can simply begin unloading “assets” to free up equity and rotate that equity into the agency mortgage REIT strategy.

Is the agency mortgage REIT strategy particularly difficult? No, not really. There are three agency mortgage REITs that have done a pretty solid job of understanding how to position portfolios:

DX, NLY, and AGNC.

So if you were an overpaid executive with minimal knowledge about how to do this, you could just go copy the last disclosed positions for those mortgage REITs. That’s pretty simple.

What’s the agency mortgage REIT strategy?

Buy agency fixed-rate MBS and then hedge duration exposure by using Treasury Futures or SOFR swaps (used to be LIBOR swaps). Nice and easy.

What if Shareholders Really Want The Old Strategy

The company is not committed to maintaining the prior strategy. Their duty (though some seem pretty bad at it) is to generate returns for shareholders. If they switch to an agency mortgage REIT strategy, they should expect to be priced like one. That would be great for their current shareholders. If the current shareholders wanted the old strategy, they could sell their shares at the higher valuation given to agency mortgage REITs and buy one of the other mortgage REITs at a lower valuation. They would be better off in the exchange.

Why Don’t They Do It?

Lack of creativity? Laziness? Hoping things will get better? Lack of knowledge about how to run a simple agency MBS strategy? Take your pick.

In some cases, the assets may also be remarkably illiquid. That would make it harder. But if the assets can’t be moved and the market is already discounting them, maybe management needs to recognize that book value may be too high?

Another Suggestion

While I’m on a roll, I have another suggestion.

Many mortgage REITs are externally managed. For the externally managed mortgage REITs, consider a revision to the contract.

Management fees should be paid:

1. Using cash when the mortgage REIT trades above book value.

2. Using shares of common stock valued at book value when the market price is lower.

That way management cannot hold onto assets at inflated values to protect management fees when the market believes the asset should have a lower value. This should create better alignment.

Now you might think this would just encourage management to undervalue their own assets. However, those fees are typically based on the shareholder’s equity. Undervaluing the assets would result in a lower amount of equity, so the fee would be lower.

This strategy ensures that management is being properly incentivized. Could the external manager sell the shares of common stock it received in the management fee? Sure. Why not? They have actual operating expenses to pay. Requiring them to wait one year before they can sell would further align interests, but simply having fees paid using common stock would do a great deal.

Examples:

• The company owes $5 million in management fees over the course of the year. Book value is $5. The share price is $6. The company pays $5 million in cash.

• The company owes $5 million in management fees over the course of the year. Book value is $5. The share price is $3. The company issues the manager 1 million shares (market value $3 million).

• Alternatively, the manager could be paid in cash but have their fee reduced to $3 million based on the average share price.

BDCs Getting Rocked

We’ve seen a dramatic reduction in the price-to-book ratios for BDCs. The decline in share prices can overstate the negative performance because returns are primarily driven by dividends.

However, I think this chart will be pretty interesting for many investors:

The VanEck BDC Income ETF (BIZD) is packed with BDCs. The returns were much smaller than they were for the S&P 500 (SPY), but that wasn’t awful. The last stretch, however, has been a bit rough. That’s when shares took a big hit. There are concerns about the credit quality of underlying assets and about interest rates. However, interest rates have been trending up, not down. Looking at the FedWatch Tool, we can see that the market is pricing in a 65% probability of the Fed Funds rate going up:

Well, that’s what it’s pricing into the bond market. It hasn’t been pricing that into the equity market lately. Equities remain quite high. We’ve even seen equity REIT indexes go on a run while rates are ripping higher. I’ve been starting to increase my allocation to Treasury bills. I still really like trading preferred shares and baby bonds, but I’m becoming more cautious elsewhere. I closed out some of my equity REIT positions around 52-week highs.

Conclusion

Hope you have a great week! Let me know what you thought of the article in the comments.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.