Some REITs are highly vulnerable to interest rate fluctuations, while others are not. The same can be said about the risk of default in primary mortgages. In this Lie Live Video, Registered on December 10, Fool.com contributors Matt Frankel, CFP®, and Marc Rapport, discuss the different risk profiles of two REITs, Annali Capital Management (NYSE: NLY) And Broadmark Realty Capital (NYSE: BRMK)To clarify these differences investors need to know.
Mark’s report: How does default risk compare, for example, between Broadmark and Annaly? If you go to [Broadmark] Website, it’s really fun. You can look: They did $1.5 million for a specialist home in Utah; $2.8 million, something like that, for a bunch of homes, like four or five in Seattle.
Matt Frankel: surely.
Mark’s report: They said they wanted loans over 65% of the loan value. This leads to risk there. But then you look at Broadmark — or you look at Annaly, who’s 10 times the size of assets or something, and they’re basically buying Fannie Mae and Freddie Mac and mortgages and government-guaranteed loans. Doesn’t that reduce the risk of default?
Matt Frankel: Remember that I mentioned two major risk factors. The first is interest rate risk, leverage risk if you will, and then the second is default risk. Hypothetical danger is why you’ve seen them go down during COVID – the early stages of the COVID pandemic. Leverage risk is the reason why you saw me go down during the 2017-2019 interest rate hike cycle.
Annali doesn’t have much of a default risk. As I mentioned, her real estate loans are generally guaranteed by the government. I’ll go ahead and put Annaly’s slide because I’ve been put on hold. But Annaly’s portfolio is 92%, 92% of her portfolio is made up of agency backed mortgages, Fannie Mae, Freddie Mac, matching mortgages, government guaranteed. Commercial loans and mortgage servicing rights make up the rest of their portfolio. They have no risk of default in this sense.
But, this last bullet tells you where the risks come from. Annaly uses a leverage ratio of 5.8 to 1 to generate its returns. This means that for every dollar of invested capital, they borrow $5.80 to help buy mortgages. This is a very high leverage ratio. This is the source of their risk, because if the interest rate they have to pay on that borrowed money goes up – And these are fixed rate mortgages, so they keep paying it no matter what. Their mortgages keep paying 3%.
If the cost of borrowing goes up to 2% or 3%, you can see where their profit margin will evaporate very quickly. That’s why they got hit so hard during the last price hike cycle and they had to cut your profits and things like that. To answer your question, they don’t have a lot of default risk, but they do have a lot of leverage risk.
Now, Broadmark is the other story I just mentioned, and here’s the ticker code, BRMK, someone asked that earlier. I already mentioned what they do a little bit. Broadmark Corporation specializes in hard money loans. Think of these as short-term loans for construction projects. I think what you mentioned, mall. You can give us an overview.
Mark’s report: Even smaller than that. There was a $1.5 million custom home in Utah that a builder was building. Another one was a few homes in Seattle for a few million dollars. None of the ones they were showing on their homepage or on their Projects webpage exceeded a few million dollars. These were all like a single builder or perhaps small local associations of building type loans.
Matt Frankel: These are short-term loans in nature.
Mark’s report: Yes.
Matt Frankel: I think the typical term of a hard money loan is six to 24 months. As any real estate investor who has used them can tell you, hard money loans generally have higher interest rates. It is not uncommon even in the current low interest rate environment to find rates of 8%, 9%, 10% on difficult loans, because they are designed for short-term needs, in situations such as where you can add value to a property through a rehabilitation project, where it may be It pays to pay that money. But here’s the point, and that’s what Mark was hinting at as well.
Unlike most mortgage funds, Broadmark doesn’t use any leverage at all. They don’t borrow any money. If they had $1 billion in the bank, they would make $1 billion in loans. Therefore, it does not have the risk of leverage when prices start to rise. Therefore, it can do this because these short-term hard money loans have high interest rates, but they have a higher risk of default. These are not government-guaranteed loans. One of the reasons hard money loans charge higher interest rates is because they are inherently riskier. Construction projects exceed budget all the time. I can bring in a contractor, for example, who can tell you that. Our projects are not working for one reason or another.
Often, short-term loans depend on the borrower’s ability to sell the property before the end of the term, and this is not a guarantee. These have a higher risk of default, but they don’t have that leverage risk. Which is why if you see this graph, Broadmark holds these 4 best REITs through the early days of COVID. Precisely for this reason: because they didn’t have to worry about things like margin calls. As long as the borrowers kept paying their loans, they weren’t worried about it. Now it was clear to the market when I saw this price correction. But this is Broadmark. Those are the first two I wanted to talk about. Then I add another one that I’d like to put in the top three.
Quality really matters when you’re talking about a mortgage REIT, by the way. There are a bunch of them. Most of them are not worth looking at. So we are trying to get rid of if you are going to use it to produce some crop. We are at least trying to point you in the right direction. The two we’ve talked about so far are completely different risk dynamics. They are opposites, which is great to have both in your portfolio because one is similar to severe default risk, but no leverage risk. The first is the high risk of leverage, but there is no risk of default. It’s a nice compliment to each other, I think you’d say. If there is such a thing as a diversified portfolio of REITs, I think you are on the right track.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of the Motley Fool Premium Consulting Service. We are diverse! Asking about an investment thesis — even if it’s our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.