Recommendation: Think about upcoming mortgage REIT earnings (Part 4)

Market Realist

Continued from Part 3

Which component should you focus on?

All companies have certain metrics that drive their valuation, and often, different sectors have different metrics that matter. Financials trade on book value. Tech stocks do not. REITs trade on their dividend yield. Biotechs do not. So you need to look at what particular things matter to a REIT. The relevant components are:

  • Asset type
    Many REITs are somewhat flexible in the interest rate risk they choose to take. Some of the adjustable-rate mortgage REITs don’t have the discretion to go into 30-year fixed-rate loans, but the big hybrid ones can rotate between adjustable-rate mortgages and fixed-rate mortgages based on their view of the economy and interest rates. Make sure that when you do your analysis, they’re holding the right assets for your view.
  • Book value per share
    This component is the equity value, or the value of the assets less the liabilities. Theoretically, this means that if you liquidated the entire portfolio and paid off all the creditors, what would you have left? For levered REITs, this is an important value. Analysts will look hard to see what sort of methodology they’re using to mark (that is, value) their assets. Are the assets liquid (able to quickly turn to cash with minimal losses), like agency mortgage-backed securities (MBS)? Or are they illiquid (unable to quickly turn to cash with minimal losses), like distressed MBS? As a general rule, book value can provide a bit of a floor, but remember that book value is a moving target.
  • Leverage (A tutorial on leverage is available here)
    This component relates to book value, and it’s generally the debt-to-equity ratio. The higher the leverage ratio, the more sensitive the REIT will be to changes in the value of its assets. REITs as a general rule despise bond market volatility. This is due to negative convexity. So if you think we’re going into a stable interest rate environment where not much is going to happen one way or the other, you might be fine with a more levered REIT. If you think rates could move big—especially down—the more levered the REIT, the more it’s going to suffer, as a general rule

This analysis continues in Recommendation: Think about upcoming mortgage REIT earnings (Part 5).

More From Market Realist

View Comments (0)