2 high yield mortgage REITs with very different risk factors
Some mortgage real estate investment trusts (REITs) are very sensitive to fluctuations in interest rates, while others are not as vulnerable. The same goes for the risk of default of the underlying mortgages. In this fool live Video clip, recorded on December 10, Fool.com contributors Matt Frankel, CFP® and Marc Rapport discuss the different risk profiles of two mortgage REITs, Annaly Capital management (NYSE: NLY) and Broadmark Real Estate Capital (NYSE: BRMK), to illustrate these differences that investors should be aware of.
Marc Report: How would you compare the risk of default, say, between Broadmark and Annaly? If you go to [Broadmark] website, it’s really interesting. You can watch: they made $ 1.5 million for a special house in Utah; $ 2.8 million, something like that, for a bunch of townhouses, like four or five in Seattle.
Matt Frankel: Sure.
Marc Report: They said they wanted loans with a loan-to-value ratio over 65%. This leads to a risk there. But then you look at Broadmark – or you look at Annaly, which is 10 times the size of assets or something, and they mostly buy Fannie Mae, Freddie Mac, mortgages, and government guaranteed loans. Doesn’t that reduce the risk of default?
Matt Frankel: Remember I mentioned two big risk factors. One is interest rate risk, leverage risk if you will, and # 2 is default risk. The risk of default is why you’ve seen them dive in during COVID – the early stages of the COVID pandemic. Leverage risk is the reason you saw Annaly drop during the 2017-2019 rate hike cycle.
Annaly does not have much risk of default. As you mentioned, his mortgages are generally guaranteed by the government. I’m going to go ahead and set up the Annaly slide because I have this queued up. But Annaly’s portfolio is 92%, 92% of her portfolio is agency guaranteed mortgages, Fannie Mae, Freddie Mac, compliant mortgages, government guaranteed. Commercial loans and mortgage management rights make up the rest of their portfolio. They have no risk of default in this sense.
But, and that last bullet tells you where the risk is coming from. Annaly uses a leverage ratio of 5.8 to 1 to achieve her returns. This means that for every dollar of capital invested, they borrow $ 5.80 to help buy mortgages. That’s a pretty high leverage ratio. This is where their risk comes from, because if the interest rate they have to pay on that borrowed money goes up – and these mortgages are fixed rate, so they keep paying the same no matter what. Their mortgages continue to pay 3%.
If the cost of borrowing goes up to 2% or 3%, you can see where their profit margin will evaporate very quickly. That’s why they’ve been hit so hard in this last cycle of rate hikes and they’ve had to cut your dividend and things like that. To answer your question, they don’t have a lot of default risk, but they do have a lot of leverage risk.
Now Broadmark is the other story you just mentioned, and here’s the ticker symbol, BRMK, someone asked earlier. You’ve already mentioned a little bit about what they do. Broadmark specializes in hard money loans. Think of them as short term loans for construction projects. I think what you mentioned, a mall. You can give us an overview.
Marc Report: Even smaller than that. There was one, a $ 1.5 million house in Utah that a builder was building. Another was a few row houses in Seattle for a few million dollars. None of the ones they featured on their homepage or projects webpage were over a few million dollars. It all looked like a single builder or maybe little local builder-type loan syndicates.
Matt Frankel: These are short term loans.
Marc Report: Yes.
Matt Frankel: I think the typical hard money loan lasts between six and 24 months. As any real estate investor who has had the chance can tell you, hard money loans usually have higher interest rates. It is not uncommon, even in today’s environment of low interest rates, to find rates of 8%, 9%, 10% on hard money loans because they are designed for short term needs. , in situations like where you can add value to a property through a rehabilitation project, where it might be worth paying that money. But here’s the point, and that’s what Marc was also referring to.
Unlike most mortgage REITs, Broadmark does not use leverage. They don’t borrow money. If they have $ 1 billion in the bank, they will make $ 1 billion in loans. So he doesn’t have that risk of leverage when rates start to rise. So he can do it because these short term hard money loans have high interest rates but he has higher default risks. These are not government guaranteed loans. One of the reasons that hard money loans charge higher interest rates is that they are inherently riskier. Construction projects consistently go over budget. I can bring in a contractor, for example, who can tell you. We have projects that don’t work for one reason or another.
Often, short-term loans are based on the borrower’s ability to sell the property before the end of the term, which is not a guarantee. These have a higher risk of default, but they don’t have that leverage risk. That’s why if you’ve seen this graph, Broadmark held onto the best of these four REITs during the early days of COVID. It was precisely for this reason: because they didn’t have to worry about things like margin calls. As long as their borrowers kept paying off their loans, they didn’t really care. Now the market was obviously when you saw this price correction. But it’s Broadmark. So these are the first two I wanted to talk about. Then I add one more that I would put in my top three.
By the way, quality really matters when talking about a mortgage REIT. There are a bunch of them. Most of them are not worth seeing. So we’re trying to figure out if you’re going to use them to create a certain return. At least we’re trying to point you in the right direction. The two we’ve talked about so far are very different risk dynamics. These are two extremes which is good that you have both of them in your portfolio as one is like extreme default risk but not leverage risk. One is the risk of extreme leverage, but not the risk of default. It’s a nice compliment to each other, I guess you would say. If there was a diverse mortgage REIT portfolio, I think you are on the right track.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.