The theme for 2022 will undoubtedly be rising interest rates and inflation. The Federal Reserve has already begun to reduce its purchases of Treasuries and mortgage backed securities, and the latest projection materials seem to predict about 3 rate hikes next year.
Since REITs are generally pretty interest rate sensitive, this change in policy will create winners and losers. While I don't like to try and predict which companies get bought (it is a tough way to make a buck even for the pros, and is a bad idea for longer-term investors) I will talk about some of the general trends in the real estate space for the upcoming year.
Image source: Getty Images.
The mortgage industry will struggle in 2022
After a great two years, mortgage bankers will have a much tougher time as the Federal Reserve starts hiking rates. Mortgage banking is a feast-or-famine business, where earnings can exhibit much higher volatility than the overall stock market.
The COVID-19 pandemic caused the Fed to cut interest rates to support the economy in the early days of the pandemic. This action triggered a massive wave of refinancing activity as borrowers with rates above 4% could suddenly get rates below 3%. The mortgage industry was not staffed for a major boom and was severely understaffed. This meant that mortgage bankers didn't need to compete with each other for business, and everyone experienced huge profit margins. Many mortgage banks took advantage of the circumstances to go public.
As rates rise, the industry will probably resume the on-again, off-again price wars, particularly between the biggest behemoths in mortgage banking: Rocket and UWM Corporation, which is known in the industry as United Wholesale. We have already seen some deals, with New Residential buying Caliber Home Loans from a private equity seller. As the pool of available loans decreases, expect to see more bankers consolidate. Mortgage banks with big portfolios of mortgage servicing rights (an esoteric asset that increases in value as rates rise) might attract interest.
Mortgage banking service providers have also been a fertile area for mergers and acquisitions activity. Intercontinental Exchange, the owner of the New York Stock Exchange purchased Ellie Mae for $11 billion, which adds to its mortgage empire that includes the Mortgage Electronic Registration System (MERS), a registry for both the owners and servicing of mortgages. Intercontinental Exchange is focused on addressing the entire value chain of mortgage banking and might be on the lookout for something in mortgage trading.
Companies that borrowed last year may use it this year
During 2020 and 2021, many REITs took advantage of the low-interest rate environment to issue debt, which gives them capital to pursue M&A activity. Last year, Realty Income bought VEREIT in a $17 billion transaction. QTS Realty Trust, a data center REIT, was bought by private REIT Blackstone Real Estate Investment Trust, which shows the appetite for faster-growing REITs. From a private equity investor's viewpoint, many publicly traded REITs have funds from operations (FFO) yields well in excess of their cost of funds.
Regardless of what happens in the stock market, we should see owners of residential properties continue to sell off assets in markets that are overheated. Apartment REITs like Equity Residential and single-family REITs like American Homes 4 Rent are sitting on properties that have been rapidly appreciating in value. At some point it makes sense to ring the register and redeploy that capital elsewhere. Overall, real estate is a good inflationary hedge, and the REIT sector should benefit from this economic backdrop. That said, many REITs, especially the higher yield REITs, will be negatively impacted by rising rates.
