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Zacks Industry Outlook Highlights Starwood Property, Arbor Realty, and Invesco Mortgage Capital

For Immediate Release

Chicago, IL – June 30, 2022 – Today, Zacks Equity Research discusses Starwood Property Trust STWD, Arbor Realty Trust ABR and Invesco Mortgage Capital Inc. IVR.

Industry: REIT and Equity Trust

Link: https://www.zacks.com/commentary/1945543/3-mreit-stock-picks-poised-to-navigate-rising-interest-rates

The Zacks REIT and Equity Trust industry has not been immune to the impacts of rising interest rates, high inflation and the Federal Reserve's balance sheet reduction moves. Mortgage originators and servicers are seeing low origination volume amid a decrease in the refinance demand and gain on sale margin compression.

Unfavorable valuations of Agency mortgage-backed securities (MBS) and spread widening in the Agency MBS and credit-sensitive residential mortgage space are other headwinds. Hence, mortgage mREITs will continue to see book value pressure in the upcoming period.

Nevertheless, receding prepayment spreads offer respite to the industry players by supporting asset yields and margins, whereas business diversification offers support amid volatile conditions. We view the increase in mortgage rates as a positive for mortgage servicers witnessing fair value mark-ups on mortgage service rights. These create an encouraging backdrop for players like Starwood Property Trust, Arbor Realty Trust and Invesco Mortgage Capital Inc..

About the Industry

The Zacks REIT and Equity Trust industry comprises mortgage REITs, also known as mREITs. Industry players invest in and originate mortgages and MBS, thereby providing mortgage credit for homeowners and businesses. Typically, these companies focus on residential or commercial mortgage markets, although some invest in both markets through the respective asset-backed securities.

Agency securities are backed by the federal government, making it a safer bet and limiting credit risk. Also, such REITs raise funds in both debt and equity markets through common and preferred equity, repurchase agreements, structured financing, convertible and long-term debt, and other credit facilities. Net interest margin (NIM), spread between interest income on mortgage assets and securities held as well as funding costs, is the key revenue metric for mREITs.

What's Shaping the Future of the mREIT Industry?

Challenging Mortgage Production Environment to Hurt Revenues: Amid the tight labor markets and annual inflation persistently being above 8%, the Federal Reserve is in the midst of a shift from quantitative easing to tightening, with balance-sheet reductions and rising short-term interest rates. This has driven a significant increase in mortgage rates over the past six months, leading to lower origination volumes (especially refinancing demand). Also, excess capacity has presented additional challenges for mortgage servicers and originators, and might impede origination gain on sale and revenue growth as competition increases in the origination market.

Net Interest Spread & Book Values to Decline: The accelerated timeline for monetary policy tightening and an end to net purchases are affecting valuations of Agency mortgage-backed securities. Industry players are not immune to widening in the Agency MBS and credit-sensitive residential mortgage space. Hence, mortgage mREITs will continue to see book value pressure in the upcoming period.

Also, mortgage REITs, which had been enjoying higher net interest spreads on low borrowing costs, are expected to see profitability deterioration as rates rise. This may discourage mREIT investors and result in capital outflows from the industry, potentially resulting in even greater book value declines for the industry players in the upcoming period. Beside this, the majority of commercial mREITs tends to have floating-rate liabilities, implying an increase in interest expenses when rates go up.

Conservative Approach to Limit Returns: Recognizing the growing concerns in the current financial markets, mREITs have resorted to adjustments in their investment portfolio. Amid higher volatility, the companies have been trimming investment portfolios and reducing leverage.

Although such moves might help offset interest rate fluctuations, these are not designed to shield companies against fluctuations in tangible net book value due to changes in the spread between investments and other benchmark rates like swap and treasury rates. This exposes companies to the risk of adverse spread changes. Moreover, as companies prioritize risk and liquidity management over incremental returns amid the volatility in the current market, at least in the short term, robust returns are expected to remain elusive.

Zacks Industry Rank Indicates Dismal Prospects

The Zacks REIT and Equity Trust industry is housed within the broader Zacks Finance sector. It carries a Zacks Industry Rank #157, which places it in the bottom 37% of more than 250 Zacks industries.

The group's Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates bright near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry's positioning in the bottom 50% of the Zacks-ranked industries is an outcome of the negative earnings outlook for the constituent companies. Looking at the aggregate earnings estimate revisions, it appears that analysts are gradually losing confidence in this group's earnings growth potential. The industry's current-year earnings estimate has moved 14.1% down since June last year.

Before we present a few stocks that you may want to consider for your portfolio, let's take a look at the industry's recent stock-market performance and valuation picture.

Industry Lags Sector and S&P 500

The Zacks REIT and Equity Trust industry has lagged the broader Zacks Finance sector and the S&P 500 composite in the past year.

The industry has slipped 25.4% in the above-mentioned period against the broader sector's decline of 12.4%. The S&P Index has dipped 9.8% over the past year.

Industry's Current Valuation

On the basis of the trailing 12-month price-to-book (P/BV), which is a commonly used multiple for valuing mREITs, the industry is currently trading at 1.18X compared with the S&P 500's 5.86X. It is also below the sector's trailing-12-month P/BV of 2.99X. Over the past five years, the industry has traded as high as 1.41X, as low as 0.49X and at the median of 1.19X.

Three mREIT Stocks Worth Betting On

Invesco Mortgage: IVR primarily focuses on investing in, financing, and managing MBSs and other mortgage-related assets. Amid headwinds for Agency MBSs, the company has been actively managing its portfolio. It has reduced exposure to such securities, as the current macro situation continues to weigh on Agency RMBS valuations. IVR has reduced leverage and is shifting its Agency RMBS portfolio to higher coupons by selling 30-year 2.0% and 2.5% coupons, and buying 4.0%, 4.5% and 5.0% coupons.

As of Jun 17, its investment portfolio of $5.2 billion included $4.4 billion of Agency RMBS and $628 million of to-be-announced securities forward contracts. It had unrestricted cash and unencumbered investments aggregating around $623 million.

Moreover, IVR estimates a debt-to-equity ratio of 4.1X and book value per common share of $15.94-$16.60.

The company sports a Zacks Rank of 1 (Strong Buy) at present. The Zacks Consensus Estimate for IVR's 2022 earnings has been revised 1.1% upward over the past month to $3.84. Also, the company has an impressive earnings surprise history, having surpassed the Zacks Consensus Estimate in all four trailing quarters.

You can see the complete list of today's Zacks #1 Rank stocks here.

Arbor Realty: The New York-headquartered mREIT primarily focuses on originating and servicing loans for multi-family, single-family and other commercial real estate assets. Arbor Realty's diversified investment focus on commercial real estate debt investments, mortgage servicing and commercial mortgage-backed securities is likely to enable it to generate stable income in the upcoming quarters despite the challenging economic environment.

Further, multi-family mortgage loan securitization and originations are expected to expand ABR's fee-based servicing portfolio, driving servicing revenues.

The company currently carries a Zacks Rank #2 (Buy). The Zacks Consensus Estimate for ABR's 2022 earnings has been revised 4.5% upward to $1.86 in the past two months. Moreover, 2022 NII estimates of $773.7 million indicate a year-over-year uptick of 66%.

Starwood Property: Greenwich, CT-based STWD operates through four segments — Commercial and Residential Lending, Infrastructure Lending, Property and Investing, and Servicing segments.

Starwood Property had a $16.2-billion diverse loan portfolio as of Mar 31, 2022, with $14.1 million in the commercial and residential lending segment. Of this, 27% of loans were backed by office properties, 32% multi-family and 17% hotel. Also, 11% of its loans were backed by mixed-use, 6% industrial, 2% residential, 2% retail, and 3% in other property types. This positions it well to navigate the current environment.

The Zacks Consensus Estimate for the company's 2022 earnings has been revised 12.2% upward to $2.30 over the past two months. Moreover, STWD's 2022 NII is pegged at $1.29 billion, indicating a year-over-year uptick of 9.9%. Starwood Property carries a Zacks Rank of #2 at present.

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Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Zacks Investment Research does not engage in investment banking, market making or asset management activities of any securities. These returns are from hypothetical portfolios consisting of stocks with Zacks Rank = 1 that were rebalanced monthly with zero transaction costs. These are not the returns of actual portfolios of stocks. The S&P 500 is an unmanaged index. Visit https://www.zacks.com/performance  for information about the performance numbers displayed in this press release.

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