Mortgage REITs acquire mortgage-back-securities (MBS), purchase mortgages in the secondary market, and lend directly to real estate owners. Mortgage REITs do not buy commercial or residential real estate properties per se. They are in the business of purchasing real estate debt by borrowing from capital markets.
Interest income is about 95 percent of a mortgage REITs’ revenue. It is the interest income earned on securities and is accrued based on the outstanding principal balance and the contractual terms. As assumptions are plentiful, the income statement recognition of revenue is often an art rather than science. Assumptions include estimating prepayment schedule, projecting cash flow of the MBS securities, and recognizing a gain or loss based on subjective revenue recognition methods such as the Effective Yield Method.
With expenses such as interest expense, operating expenses, and swap-hedging costs, a mortgage REIT balance sheet, at a first glance, resembles the balance sheet of a bank. But its solvency is not guaranteed by a federal agency. Interest expense is the cost to service the debt. Operating expenses are wages, administrative costs, and loan servicing costs. A small portion of the operating expenses relate to hedging against interest rate movements.
Assets consist of MBS portfolio and residential loan portfolio. The MBS portfolio consists of Agency MBS and Non-Agency MBS. Agency MBS interest income is guaranteed by a federally chartered corporation such as Fannie Mae or an agency of the U.S. Government such as Ginnie Mae. MBS securities that are not guaranteed by any U.S. Government agency are Non-Agency MBS. Residential loan portfolios are a pool of fixed and adjustable rate residential mortgage loans acquired in secondary market transactions at discounted purchase prices.
Liabilities are the repurchase agreements. Under repurchase agreements, a mortgage REIT sells securities to a lender and agrees to purchase the same securities in the future for a price that is higher than the original sale price. The difference between the sale price that the mortgage REIT receives and the repurchase price that the mortgage REIT pays represents interest paid to the lender. The repurchase financing length ranges from one month to six months at inception.
Two things to watch for
Leverage, a bliss and a curse, affects the earnings of mortgage REITs. When a mortgage REIT earns a positive return on equity, leverage augments that return. But leverage augments losses as well. In the good and ugly of leverage, John otte succinctly demonstrates the effect of leverage.
In a rising interest rate environment, the health of a fixed rate loans balance sheet will deteriorate. The mortgage REIT interest expense will increase but interest income will remain unchanged. In a declining interest rate environment, as borrowers tend to refinance mortgages, a mortgage REIT assets decline, resulting in a reduction in interest rate income.