With: Greg Mason, Managing Director, Ares Management Portfolio Manager, Litman Gregory Masters High Income Alternatives Fund
Date: November 14, 2019
Greg Mason: On the mortgage real estate market, a lot of people think of REITs and they think of private-equity REITs. Right? Where you own a building and you get the rental income off the building. Almost all of those buildings have some kind of mortgage-debt on those. The mortgage REITs that we invest in provide the first-lien mortgages to real estate.
Now there are lots of sub-categories in mortgage REITs. We have commercial mortgage REITs. We have agency mortgage REITs. Hybrid residential credit mortgage REITs. Those all have different factors. Maybe we can get into that, if you want to, during the q-and-a.
But it allows us to kind of play different risks and different options within the mortgage REIT market. If you look again, through the statistics of what we have exposure to in the Litman Gregory fund, over $17 billion of commercial mortgages and over 500 individual commercial mortgage loans. Over a million residential mortgages with $150 billion of residential mortgage exposure.
Our portfolio today is about 50% floating-rate and 50% fixed-rate. On valuation, the mortgage REITs are getting close to book-value. A little bit of a premium to where they have been historically. But they’re generating significant income right now. The average dividend yield on our mortgage REIT market is 10%, and they’re covering that dividend about 110%. So we feel very confident in the dividend coverage there.
What’s interesting – when people think about REIT exposure – and passive flows into REITs – they’re not flowing into the mortgage REIT market. When S&P created the real estate sub-category a couple of years ago, they actually excluded the mortgage REITs from that.
This group is not getting a lot of the institutional flows that happened. Particularly with the passive flows that we’re seeing.
Jason Steuerwalt: Could you – maybe for people who aren’t as familiar with this space – go into the differences between the agency, the hybrid and the commercial? And why you might favor one versus another in those subsectors?
Greg: Yes. They actually move very differently. Commercial mortgage REITs are exactly what you’d think. If you’ve got a commercial property –
Let’s say somebody owns an office building here in San Francisco. Maybe they’re at 75% occupancy. But they know if they put $50 million into the building and improve the lobby and improve the office space, they can drive that occupancy up to 95%. What they’ll do is look to the commercial mortgage REITs to make a 3-to-4-year loan that helps them with that capital to lease up the building. That’s what the commercial mortgage REITs do. They’re typically 3-to-4-year loans. They’re floating-rate. Typically with an interest rate of LIBOR-plus-3% or 3.50%. And they’re all first-lien mortgages. When we look at the commercial mortgage REIT space, they typically on their balance sheet will use 2.5-to-3.5-times leverage. They generate an 8% to 9% dividend yield, and it’s steady and consistent. Average loan-to-value is 65% in their portfolios.
We feel really confident about the cashflows and dividends from those portfolios.
The agency REITs are almost the exact opposite. What agency REITs do is, they buy a portfolio of residential Fannie-Freddie-Ginnie-Mae government-backed 15-and-30-year bonds. Then what they do is borrow on one-month and three-month repo. They’re just trying to make a spread between the long-end of the yield curve and the short-end of the yield curve.
In our view, that’s a model that sometimes you want to be in and sometimes you don’t. Actually, from 2006 to 2008, the first three years we were invested in the strategy, we owned zero agency mortgage REITs. The Fed was raising interest rates. They were unwinding their MBS (mortgage-backed security) portfolio. That’s going to do two things. It’s going to negatively impact the value of the long bonds. So you’ve got book-value going down. And it’s increasing the short-term interest rates that they’re borrowing at.
So you’ve got a spread-comparison. It’s a horrible environment for the agency REITs. We owned none of them.
Fast-forward to this year. With the Fed (Federal Reserve) now starting to change and starting to lower interest rates, we think that that improves book-value. Increases yield on the portfolio. And if we do go into recession, agency REITs have historically been a hiding place, because there’s no credit-risk. Right? It’s all government-backed assets. They become a kind of safe haven.
We actually have 7% of the portfolio in agency REITs today versus zero for the first three years we were investing in the strategy.
Finally, residential credit. That’s kind of a hodgepodge of things. But these are typically if you have jumbo or non-conforming loans or fix-and-flip loans. Residential mortgages that don’t fit within the GSEs (government-sponsored enterprises). They actually own the whole loans. Or they might be a mortgage-servicer. So they actually send your monthly mortgage statement and take your check. They get paid 25 bps (basis points) to service that. Then you have a mortgage-servicing right that has a value there.
Those MSRs typically do badly if interest rates fall, and do well if interest rates rise.
You can put all of these different kinds of investments together that move in different ways, based on what’s going on with the economy and the interest rate. It’s a pretty interesting industry to build a portfolio around, and move tactically within it.