Most real estate funds continue to take predominantly commercial real estate risk by virtue of their extensive holdings of common shares in equity REITs. We are focused on finding deep value investment opportunities in the market for publicly traded real estate related securities. We broadly define this segment of the investing universe as equity and debt investments in REITs and other real estate-related companies, as well as structured credit securities (backed by real estate or mortgages).
Mortgage REITs performed well during 2Q2023 as the index increased by ~8%. This subsector outperformed the broader REIT index, the Russell 2000, and the DJIA. Although the second quarter provided some relief, non-bank mortgage stocks continued to be weighed down by issues in the banking sector that have little to do with the fundamentals in non-bank mortgage servicers and REITs.
As we stated in our 1Q2023 update, the three factors that have led to fundamental problems for banks are the following:
Concentrated Bank Deposits
Ability to avoid mark to market adjustments on positions of their portfolios
General mismanagement of interest rate risk
On the contrary, the following factors characterize many non-bank mortgage REITs/companies:
Non deposit taking institutions (and have been reducing forms of short-term funding since 2020)
Substantially all of their portfolio marked to market every quarter
Hyper focus on interest rate hedges including interest rate swaps and mortgage servicing rights (MSRs)
Despite an uptick in performance, some non-Agency residential mortgage REITs and servicers still ended the quarter trading at sizeable discounts to tangible book value and double-digit dividend yields. As we have previously communicated, we believe many investors have not fully recognized that many residential mortgage REITs are currently using more prudent leverage than during the time leading up to the pandemic. We continue to believe that this subsector could be an area of outperformance over the coming quarters.
We continued to pay close attention to the 11 trillion-dollar RMBS market. Non-Agency RMBS spreads have tightened slightly across various sub-sectors. Spreads for AAA senior bonds tightened by approximately 20 basis points (bps) while spread tightening was more pronounced for mezzanine CRT, non-QM, and legacy RMBS. Broker-dealers’ commentary noted that in legacy RMBS, net customer buying in June drove dealer inventory lower by the end of quarter. There also continued to be a positive technical dynamic in the Non-Agency RMBS market with only ~30bn of new issuance year-to-date – well off the pace of last year. On the Agency (government guaranteed) MBS side, the basis (or spread over Treasury bonds) ended the quarter roughly 12 bps wider than the first quarter. Despite the weakness, the quarter ended on a strong note as spreads tightened significantly from the wides seen at the end of May.
Short term corporate bonds issued by mortgage REITs/servicers (still the best opportunity we see in real estate-related bonds), saw a slight uptick in pricing later in the quarter. In our opinion, this part of the market continues to offer high single digit/low double-digit yields with low credit and duration risk.
Housing data continued to support our view that home prices could be stable in 2023. The S&P CoreLogic 20 City Index posted a 0.91% month over month increase at the end of June. The following factors continue to be supportive forces for home prices:
Low inventory driven by a long-term underproduction of housing
A record amount of borrower equity due to appreciation and a lack of "cash-out" refis"
Borrower "lock-in effect" as mortgage rates have climbed significantly
Demographic trends supportive of household formation and baby-boomers "aging in place
We believe investors could benefit from owning securities that have solid/ relatively predictable fundamentals, above-average income, and double-digit return potential. We continue to see plenty of opportunities to achieve return objectives without taking undue risk. In addition, fund managers who have the flexibility to invest in debt as well as equity should make use of the extra arrows in their quiver as the year progresses.
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