The entire real estate industry is holding its breath as the Federal Reserve prepares to further tighten the purse strings. But one sector is poised to take advantage of the rise in U.S. interest rates that could result: commercial mortgage REITs.
It’s already been a heady year for these businesses.
The FTSE NAREIT Commercial Financing REITs Index, which monitors the returns of 11 REITs lending to the commercial real estate market, moved up .75 percent from the previous quarter, and up 14.88 percent from the same period in 2013, as of Aug. 19. And those gains show no signs of slowing. In comparison, the S&P 500 index was up 8.62 percent from last year in the same period.
Commercial mortgage REITs have been increasing their share of the lending market since the downturn. In 2013, REITs originated 8 percent of total U.S. commercial mortgages—the same level as that of international banks—up from approximately 2 percent in 2009, according to the latest numbers from commercial real estate data provider Real Capital Analytics.
In the last few years, increased regulation for domestic and international banks alike has created barriers for much commercial lending, while opening up a space for non-traditional lenders such as REITs to take advantage of the growing demand for debt for development and large transactions in major U.S. cities that has accompanied the recovery.
Now, the REITs are shifting their strategies in anticipation of the end of quantitative easing— prepping to defend their positions in the market. While many analysts admit there are risks on the horizon, on the whole, these firms expect to win out when U.S. short-term interest rates, which have been near zero since the end of 2008, finally rise.
Commercial mortgage REITs recent performance has been “driven principally by good new origination, limited loan losses and the improvement of the economy in the U.S.,” said Steven Marks, a managing director at Fitch Ratings and head of its U.S. REITs group. Steady cash flow and higher occupancy levels have also helped.
Fallout From Fed’s Withdrawal
At the end of July 2014, the Fed reduced its bond buying program by a further $10 billion, to $25 billion a month, and announced plans to end the program in October. Minutes from the Fed’s July meeting released on Aug. 20 showed the agency has even considered moving the date up, due to the strength of the recovery, a review of the minutes by Mortgage Observer shows.
Of course, last time the agency shifted away from its post-Lehman monetary policy, things did not go well.
In June 2013, the Fed suggested a possible tapering of its quantitative easing program sooner than expected and investors interpreted it as a sign that short-term interest rates would rise. The real estate market trembled. The Dow Jones Equity All REIT index dropped 2.1 percent in the second quarter of 2013, which was its weakest quarterly return since the third quarter of 2011.
This time around similar effects on the market are anticipated. A recent analysis by CMBS and mortgage data provider Trepp shows that in case of an interest rate increase by 150 basis points, up to 20 percent of the approximately $330 billion in loans that are due to mature by the end of 2017 might face challenges refinancing, said Susan Persin, senior director of research for Trepp.
But analysts and market players suggest that higher interest rates might not necessarily prove a disadvantage for commercial mortgage REITs —as long as rates don’t rise too fast.
REITurn on Investments
Compared to agency-mortgage REITs that borrow money based on fixed short-term rates and use that money to buy long-term bonds, commercial mortgage REITs often have floating rates over Libor, which means that they invest in debt whose coupons change when interest rates change. Agency-mortgage REITs are more vulnerable to the spread between short-term and long-term interest rates, which could shrink if the Fed raises short-term interest rates.
But with rising rates, the floating rates of the loans provided by many REITs increase as well, and so do their returns.
“We get a benefit if rates rise gradually,” said Michael Nash, executive chairman of Blackstone Mortgage Trust, which since its IPO last year has moved aggressively in the market, originating loans for over $1 billion in the second quarter of 2014 and reporting net income for $33.5 million, or $0.70 per share.
Commercial mortgage REITs’ “balance sheets are not highly vulnerable to increase of interest rates,” said Calvin Schnure, a vice president for research at the National Association of Real Estate Investment Trusts. “The main business risk that commercial mortgage REITs manage is the credit risk,” connected with the quality of their assets, he told Mortgage Observer.
As the economy strengthens, the credit quality of assets is also expected to increase. With the growth of the economy accelerating and an increasing demand for commercial debt, commercial mortgage REITs will have more opportunities for profitable investments, said Mr. Schnure, “even if interest rates are getting higher,” because they will have more leverage.
“Given the high volume of our loan book that is floating rate, we should benefit from a rising rate environment,” said Rina Paniry, chief financial officer at Starwood Property Trust, the country’s largest commercial mortgage REIT, during the conference call reporting the firm’s earning results for the second quarter of 2014.
STWD’s results—net income rose to $0.52 per share in Q2 2014, up from $0.37 in the same period in 2013—are expected to remain strong even with a rise in interest rates.
“We continue to finance our floating-rate investments with floating-rate debt, and our fixed rate investments with either fixed rate debt or floating-rate debt hedged by interest rate swaps,” said Ms. Paniry during the call. “We estimate that 100 basis point increase in Libor would result in an increase to income of $14 million.”
Blackstone Mortgage Trust executives echoed that sentiment. “A 100-basis point increase in Libor at quarter end would result in an annual earnings increase of $ 11.8 million, or $0.24 per share,” said Mr. Nash.
“I don’t think there will be any credit impact for even 200 to 300 basis points of Libor uptick,” Stephen Plavin, president and chief executive officer of Blackstone Mortgage Trust, said during the second quarter’s conference call for his firm.
These REIT strategies should remain static, even in the new environment, sources said.
The most recently-listed REIT, Ladder Capital, which completed its $225 million IPO last February, originates both conduit first mortgage loans eligible for securitization, with fixed rates and five- to 10-year terms, and balance-sheet first mortgage loans with floating rates and terms. But it has decreased CMBS origination in anticipation of rising rates.
“We took an active role in reducing the duration of our securities portfolio since longer duration assets are more susceptible to price movements in a rising interest rate environment,” said Chief Executive Officer Brian Harris during Ladder’s second quarter call. Ladder reported net income of $30.2 million in that period and core earning per share was $0.38.
Potential troubles for commercial mortgage REITs might come from a slow down of the larger real estate market and problems for borrowers struggling to pay loans with higher interest rates.
In an analysis of the possible risks for STWD, Daniel Altscher, a research analyst and vice president at FBR Capital Markets & Co, wrote recently that “interest rate fluctuations could significantly decrease the company’s results of operations and cash flows, and the market value of its investments.”
But it’s more a matter of how much the market falls. Slightly higher rates could improve business, analysts say, while of course defaults would constrain deal flow and be detrimental to many market players.
FBR nonetheless rated the company as overperforming the market in February and remained positive on its outlook. “On the surface, higher interest rates are not a bad thing at all,” Mr. Altscher said to Mortgage Observer. And the strengthening of the sector in the last few years is seen as a positive signal.
“The cash flow has been growing and we expect that it will continue to grow,” said Blackstone Mortgage Trust’s Mr. Nash. “The industry is strong now and borrowers will be able to pay higher interest rates,” as long as they increase gradually, he added.
Boyd Fellows, director and president of STWD, pointed out that his REIT’s strategy has been relatively conservative, and their deals have an average loan-to-value ratio of 65 percent. This leaves the REIT in a safe place in case of a change in the market, he told Mortgage Observer.
With over 35 percent of equity set aside for every loan, STWD has “a big cushion against every decrease of value,” of assets that could happen in a high interest rate environment, Mr. Fellows said. There is also room for new opportunities, he said, because with higher interest rates, some borrowers might not be eligible for a mortgage from traditional lenders, and might potentially become new clients of the REIT.
STWD also benefits from last year’s acquisition of LNR Partners LLC, the world’s largest CMBS special servicer, which could find distinct advantages to a
higher interest rate environment. “If interest rates are high, there will be great
distress, and our fees will largely—likely—be larger,” Barry Sternlicht, chairman and chief executive officer of STWD, said on the earnings call.
But, despite the euphoria of the current moment in the real estate cycle, a factor other than interest rates spells uncertainty for commercial mortgage REITs: competition. With the strengthening economy, the market is becoming more competitive, representatives of both STWD and Blackstone Mortgage Trust confirmed in their recent calls. Aggressive competitors are offering lower yields and higher loan-to-value, and might create a more uncertain marketplace for REITs.
Interestingly, competition comes from those same banks that had slowed their lending after the crisis. In the last two years, banks’ CMBS business has bounced back. The Mortgage Brokers Association expects $100 billion in CMBS issuance in 2014, up from $86 billion in 2013 and $48 billion in 2012.
“The re-emergence of pooled, floating rate CMBS has compressed lending spreads for fully funded loans on more stable properties,” said Blackstone Mortgage Trust’s Mr. Plavin on the earnings call. “To address asset spread compression resulting from increased competition and to maintain the lowest possible cost of debt capital, we continue to actively manage our funding costs. During the quarter, we negotiated material pricing improvements for new credit facility borrowings and extended term with our initial credit facility providers,” he added.
“I think the toughest place in the credit complex is the conduit market,” said STWD’s Mr. Sternlicht. “I think the conduits are very aggressive, and very undisciplined.”
In general, though, the forecast remains positive for commercial mortgage REITs in the near—and possibly long-term—future.
“Everyone is aware of the potential of interest rates to rise in the next couple of years. If that’s not part of your business plan as a mortgage REIT, you are driving with your eyes closed,” Real Capital Analytics Managing Director Dan Fasulo told Mortgage Observer. “The bullish case,” he added, “is that the interest rates will go up because the economy has finally gone up, and so we are all in good shape.”