The performance of mortgage REITs this year has been abysmal. Total returns are down more than 44% as of Oct. 17, reports the National Association of Real Estate Investment Trusts (NAREIT). But after a much-improved September — a month in which total returns actually rose 5.29% but are still mired in negative territory for the year — some analysts say the worst may be over. A few gutsy investors are again dabbling in the mortgage REIT market. Others, however, aren't ready to give the industry a clean bill of health.

“The mortgage REIT market isn't rosy, and it's not like investors are rushing back into mortgage REITs, but the bad news may be mostly behind us,” says Brad Case, vice president of research and industry information at NAREIT based in Washington, D.C. “Everybody involved in the credit markets is still suffering, but finally investors are starting to say the mortgage REIT sector has been beaten down more than it should have been.”

Not so fast, says Chris Carwile, senior analyst at SNL Financial in Charlottesville, Va. He's still cautious about mortgage REITs. “Commercial mortgage REITs seem to have more solid fundamentals, but I personally think we still have some rough times ahead,” he says. “A lot of people are predicting that we haven't seen the bottom yet. It could get worse before it gets better, and we won't know for the next 12-15 months.”

A market in turmoil

Mortgage REITs invest in loans secured by real estate, including residential and commercial mortgages and mortgage-backed securities. Some also borrow from banks to lend money to investors, profiting from the spread between the two rates. Though performance is painful year-to-date, in September commercial and residential mortgage REITs posted gains. Residential mortgage REITs were booming with a 7.98% return, while commercial mortgage REITs eked out a positive 1.31% return.

But October is again seeing declines. Commercial mortgage REITs posted a negative 2.87% return during the first 17 days of the month, while residential mortgage REITs recorded a negative 4.47% return, according to NAREIT.

Investors' response to the subprime meltdown has been typical, says Michael Straneva, head of Ernst & Young's real estate transactions group in Phoenix. “There's been a reaction and an overreaction; there's been fear and greed. Before the Federal Reserve's Sept. 18 short-term interest rate cut, the markets were in a fear mode. After the Fed's cut, cooler heads prevailed.

“That caused returns to come more in line and people to put more money back into REITs,” says Straneva. “REIT stocks in general and mortgage REITs have recovered. There's more liquidity than there was in August.”

But investors are still uneasy because the subprime crisis hasn't been resolved. “People are being overly cautious because no one can pinpoint where these subprime loans are anymore,” says SNL's Carwile, “and they're afraid adjustable-rate mortgage resets will cause defaults, even though a large portion of the portfolios are safe.”

Testing the waters

NAREIT's Case says that mortgage REIT investing today isn't for the faint of heart. “It takes an investor with some cold blood — with guts — to look at mortgage REITs and say this is a real buying opportunity,” he says. “That's what happened to a small degree in September.”

One of those cold-blooded investors is Joe Betlej, portfolio manager at Advantus Capital Management in St. Paul, Minn., which manages real estate securities portfolios. During the summer, Betlej backed away from commercial mortgage REITs, but he's testing the waters again. “We've dipped our toe in the market,” he says. “We've dabbled when we're confident there isn't any balance sheet issue.”

Several factors have caused Betlej to wade back in the market. “The inventory of mortgage loans to be securitized is starting to be sold, so you have some liquidity being brought into this market,” he says. Pricing has also stabilized. Loans are still expensive, but not as pricey as in the early fall, and there's been a boost in loan quality. Typical loans now have lower loan-to-value ratios, says Betlej, and they no longer have extended interest-only periods.

Those signs are encouraging to Betlej. “The market is repricing to a level where you're starting to be compensated adequately for the risk you're taking. In six months, if things are still improving, we'll have increased our investment because commercial mortgage REITs are a great source of dividend for our clients. You look at the huge dividends, and you can't pass those up.”
— G.M. Filisko