Some mortgage real estate investment trusts (REITs) are highly susceptible to interest rate fluctuations, while others aren’t nearly as vulnerable. The same can be said for default risk in the underlying mortgages. In this Fool Live video clip, recorded on Dec. 10, Fool.com contributors Matt Frankel, CFP®, and Marc Rapport discuss the different risk profiles of two mortgage REITs, Annaly Capital Management (NYSE:NLY) and Broadmark Realty Capital (NYSE:BRMK), to illustrate these differences that investors need to be aware of.
Marc Rapport: How would you compare the default risk, say, between Broadmark and Annaly? If you go to the [Broadmark] website, it’s really interesting. You can look: They did $1.5 million for a spec house in Utah; $2.8 million, something like that, for a bunch of townhouses, like four or five in Seattle.
Matt Frankel: Sure.
Marc Rapport: They said they want loans over 65% loan-to-value. That leads to risk there. But then you look at Broadmark — or you look at Annaly, which is 10 times the size in assets or something like that, and they’re primarily buying Fannie Mae, Freddie Mac, mortgage, and government-guaranteed loans. Doesn’t that lower the default risk?
Matt Frankel: Remember that I mentioned two big risk factors. One is that interest rate risk, the leverage risk if you will, and then No. 2 is the default risk. Default risk is why you saw them plunge during the COVID — the early stages of the COVID pandemic. The leverage risk is why you saw Annaly go down during the rate-hike cycle in 2017-2019.
Annaly doesn’t have a lot of default risk. As you mentioned, its mortgages are generally government guaranteed. I’ll go ahead and put up the Annaly slide because I have that queued up. But Annaly’s portfolio is 92%, 92% of its portfolio is made up of agency-backed mortgages, Fannie Mae, Freddie Mac, conforming mortgages, government-guaranteed. Commercial loans, and mortgage servicing rights make up the rest of their portfolio. They don’t have default risk in that sense.
But, and this last bullet tells you where the risk comes from. Annaly uses a leverage ratio of 5.8-to-1 to achieve its returns. That means for every dollar of invested capital, they’re borrowing $5.80 to help buy mortgages. That’s a pretty high leverage ratio. That’s where their risk comes from, because if the interest rate they have to pay on that borrowed money goes up — and these mortgages, they’re on a fixed rate, so they keep paying the same no matter what. Their mortgages keep paying 3%.
If the cost of borrowing rises to 2% or 3%, you can see where their profit margin would evaporate very quickly. That’s why they got hit so hard during that last rate-hike cycle and they had to cut your dividend and things like that. To answer your question, they don’t have a lot of default risk, but they do have a lot of that leverage risk.
Now, Broadmark is the other story that you just mentioned, and here’s ticker symbol, B-R-M-K, someone asked that earlier. You already mentioned what they do a little bit. Broadmark specializes in hard-money loans. Think of these as short-term loans for construction projects. I think what you mentioned, a mall. You can give us an overview.
Marc Rapport: Even smaller than that. There was one was a $1.5 million spec home in Utah that a builder was building. Another one was a few townhomes in Seattle for a few million bucks. None of the ones that they were featuring on their homepage or on their webpage of projects were over a few million dollars. These were all like single-builder or maybe a little local consortia of builder type loans.
Matt Frankel: These are loans that are short-term in nature.
Marc Rapport: Yes.
Matt Frankel: I think the typical hard-money loan is anywhere from like six to 24 months in duration. As any real estate investor who’s used one can tell you, hard-money loans generally have higher interest rates. It’s not uncommon even in the current low interest rate environment to find 8%, 9%, 10% rates on hard-money loans, because they are designed for short-term needs, in situations like where you can add value to a property through a rehab project, where it might be worth paying that money. But here’s the point, and this is what Marc was alluding to as well.
Unlike most mortgage REITs, Broadmark uses no leverage at all. They do not borrow any money. If they have $1 billion in the bank, they will make $1 billion in loans. So, it doesn’t have that leverage risk when rates start going up. So, it can do this because those short-term hard-money loans have high interest rates, but it has higher default risks. These are not government-guaranteed loans. One of the reasons that hard-money loans charge higher interest rates is because they are inherently riskier. Construction projects go over budget all the time. I can bring on a contractor, for instance, who can tell you that. We have projects don’t work out for one reason or another.
A lot of times, short-term loans are based on the borrower’s ability to sell the property before the end of the term, which isn’t a guarantee. These have higher default risk, but they don’t have that leverage risk. Which is why if you saw that chart, Broadmark held up the best of those four REITs during the early days of COVID. It’s precisely for that reason: Because they didn’t have to worry about things like margin calls. As long as their borrowers kept paying their loans, they weren’t really worried about it. Now the market was obviously, when you saw that price correction. But that is Broadmark. So those are the first two I wanted to talk about it. Then I add one more that I would put in my 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 a look. So we’re trying to weed out if you are going to use these to create some yield. We’re trying to at least steer you in the right direction. The two that we’ve talked about so far are very different risk dynamics. They’re two extremes, which is neat that you have them both in your portfolio because one is like extreme default risk, but no leverage risk. One is extreme leverage risk, but no default risk. It’s a nice compliment to each other, I guess you’d say. If there was such thing as a diverse portfolio of mortgage REITs, I think you’re on the right track.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.