mREIT Preferreds

Several preferred stock issues of different mortgage Real Estate Investment Trusts (“mREITs”) appear attractive. mREITs had a very difficult 2022 because mortgage spreads widened significantly. Mortgage spreads widened because the Federal Reserve stopped buying mortgage-backed securities (“MBS”) as part of their Quantitative Easing Program. Since mREITs own MBS on a leveraged basis, when mortgage to-Treasury spreads widen, the book value of mREITs decline. Also, higher interest rates are a headwind for mREITs and their related preferred issues.

In September 2022, mortgage spreads gapped out. Investors in mREIT preferreds became worried that the losses would cause book values to decline and possibly impair the value of the preferreds. For the preferred to be impaired, it would mean 100% of the book values were wiped out. When mREITs reported their book value declines for the September quarter, they were only down 15-20% across the industry, so no mREIT preferred issues were impaired. Since September 30th, mortgage spreads have tightened (or declined), which has been positive for book values. Now, the mREIT preferreds have more equity protecting them. But, the preferred values only marginally recovered through year-end.

Another interesting aspect of the mREIT preferreds is the market seems to be ignoring the upcoming Fixed-to-Floating resets. Most mREIT preferreds are structured with an initial 5-year fixed rate term. Then, the coupon resets to a floating rate such as the 3-month Secured Overnight Financing Rate (“SOFR”) plus a spread. On mREIT preferreds, the spread is usually around 5%. With 3-month SOFR at 4.7%, these mREITs are going to reset to a coupon around 9.7%. To me, it looks like the market is ignoring the upcoming resets. Instead, the market is pricing these mREIT preferred issues based on the yield on the fixed rate coupon because most of them are trading at a similar current yield of 9%. But, if we look at the yield after the reset, they are trading with yields between 10% and 13%. Some of the resets are within the next two years, while others are still more than 4 years away. We note that the mREIT issues that have already gone from fixed to floating trade close to their par value.

We like the total return potential on the mREIT preferred issues as they approach their fixed-to-floating reset dates.