Implications for mortgage REITs
Until consumption demand and jobs return, the Fed will keep interest rates as low as it can. It has already backed away from the numeric target for unemployment (6.5%) before it will consider raising interest rates. The Fed is undoubtedly sensitive to the effect that increasing interest rates will have on consumer debt.
The net effect on REITs like American Capital (AGNC), Annaly (NLY), MFA Financial (MFA), Capstead (CMO), or Hatteras (HTS) will be low interest rates and higher prepayments. Low interest rates mean mortgage REITs will have to use more leverage than usual to generate acceptable returns. As long as there’s stability in the financial markets, their borrowing rates will remain low. They’ll benefit from having steady or rising prices for the assets on their balance sheet. The downside will be prepayments and delinquencies. For agency REITs, prepayment risk is their biggest worry. Prepayment risk occurs when borrowers refinance their mortgage, which removes high-yielding assets from the REIT’s portfolio and replaces them with lower-yielding assets. This lowers net returns.
Implications for commercial REITs
The biggest beneficiaries of an improving consumer balance sheet are mall REITs like Simon Property Group (SPG) and General Growth Properties (GGP). While mall REITs do have a secular (long-term) issue to deal with, primarily the demographic challenges of an aging population, there’s a tremendous amount of pent-up demand in the U.S. right now. The average car is now 11.5 years—a record. People have deferred consumption as long as they could, but they can only do that for so long. Eventually, clothes wear out, durable goods break, and the car becomes too expensive to keep fixing. This is how recessions end—consumers spend because the have to, not because they necessarily want to. This pent-up demand leaves mall REITs in a good position when consumption finally turns.
To learn more about investing in REITs, check out the Market Realist series Must-know releases driving bonds, homebuilders, and REITs.