Any ideas why REITS seem to be headed to zero?

Question

Being old I have/had much of my 401 K in REITS for income. I specifically avoided mall and retail. Most imply that they are mostly residential mortgages. All are down substantially more than market averages. I am hoping they can still pay some, if not all, dividends as an offset to the capital losses. What may happen?

Answer 1

Mortgage-REITs are highly leveraged. They are much more leveraged than closed-end-funds. Well, take a look at ticker BKT and it's only down about 8%. But mortgage investments in general are down on mortgage refinancings but also down on de-leveraging by institutional investors due to impending recession. In other words, institutional investors had to sell to raise cash and make margin calls.

Property-REITs are just leveraged by ordinary bank loans. But also property-REITs partially run on short-term credit such that they benefit from low short-term interest rates. But now property-REITs are down on de-leveraging by institutional investors due to impending recession.

The good news is that the FRB just took steps to alleviate a credit-freeze.

Another point is that a diversified stock portfolio has about as much bounce-back potential as anything else. So consider taking the capital loss on the taxes and putting the funds into a diversified stock portfolio.

Oh, a capital loss in a 401K is limited on the taxes. So possibly just stay with the current holdings. Then more investment put-in, if possible and if risked, averages the cost basis downward.

And now mortgage defaults are in the news as a fundamental that could grow with recession. So that's leveraged mortgage-REITs, leveraged institutional investors holding the leveraged mortgage-REITs, previous mortgage refinancings, and soon-to-be growing mortgage defaults.

Answer 2

This article gives a good explanation of what a Mortgage REIT is:

Mortgage REITs are essentially leveraged bond or loan funds that invest primarily in real estate debt, making them more similar to fixed-income funds than to standard REITs, which own properties such as shopping malls, office towers and apartment buildings.

Mortgage REITs use short-term financing to buy commercial and residential mortgage securities, then add borrowed money -- typically about three to nine times the amount of their own capital -- to boost returns. Like other REITs, they must pay out at least 90% of their taxable earnings to shareholders as dividends and, in exchange, don’t have to pay federal income taxes on those earnings.

The fact that they borrow money in several multiples of their initial capital makes them leveraged. Leveraging means that they start with, say, $1 million, and then borrow another $9 million, then investing the resulting $10 million in mortgage notes (to simplify, this is basically like them buying up the rights to collect on mortgage debt).

This leverage means they're able to make more money per dollar invested - for example, if they're able to make 2% annual return (net) on each dollar invested, then on $10 million they will make $200k per year. However, that's not a 2% return on your investment - it's a 20% return, because they only capitalized $1 million!

However, leverage means they also take a bigger hit in a recession. It doesn't take too long for that $10MM to drop by far more than $1 million, when the market crashes. That means not only are they moving up by more than the market, but they're also moving down by more than the market - and can easily be forced into selling at lower prices due to that leverage, due to margin calls.

The Wall Street Journal has a good explanation of what's happening there right now (no paywall, at least for me); for example:

Mortgage REITs, which typically use borrowed money to juice their returns, have been particularly susceptible investments as mortgage-backed securities sold off in recent weeks. Analysts at JPMorgan estimate that mortgage REITs need to sell between $40 billion and $80 billion of mortgage-backed securities to reduce leverage, or nearly one-quarter of their holdings. Their share prices have in some cases dropped more than double the broader market, with some down more than 60% so far this year.

From the same article, it looks like some Mortgage REITs are not going to be able to make those margin calls even by selling significant amounts:

On Friday evening, the company “notified its financing counterparties that it doesn’t expect to be in a position to fund the anticipated volume of future margin calls under its financing arrangements in the near term,” AG Mortgage said in its statement, which added the company is in discussions with its lenders “with regard to entering into forbearance agreements.”

Over the weekend, hedge funds, insurance companies and private-equity firms examined AG’s holdings, according to people close to the matter. It isn’t clear if a sale of any assets will take place. The firm’s market capital, above $700 million before the coronavirus crisis, is down to $150 million.

That significant of a drop will have impacts on other funds as well, of course.

Some investors believe this is temporary, and will rebound; certainly lower leveraged Mortgage REITs with safer securities will likely do better, relatively speaking, than more leveraged REITs. However, as with anything in this market, it largely depends on how long the current recession (or whatever this turns out to be) lasts. The higher the unemployment rate and the longer the stay-at-home orders last, the harder it will be for any fund to be productive.