Is ARMOR Residential REIT in Trouble?
Mortgage Real Estate Investment Trusts (mREITs) are in an interesting place right now. Record high refinancing rates and the demand for new loans due to an environment with low mortgage rates have helped drive revenue for mREITs across the board over the past year. At the same time, 2.6 million Americans are indulgent, 5.02% of all residential mortgage loans are criminals, and millions of Americans are still unemployed. As the forbearance protection expires at the end of June 2021, this means that mortgage REITs, especially residential MREITs, such as ARMOR Residential REIT Inc. (NYSE: ARR), could be in trouble.
The ARMOR business model
Unlike other mREITs, ARMOR Residential does not issue mortgage loans. Instead, the company invests in mortgage-backed securities (MBS) through its broker BUCKLER Securities. The MBS are issued and / or guaranteed by US government agencies such as Fannie Mae, Freddie Mac or Ginnie Mae, which allows the company not only to earn money with the interest accumulated on the loans, but also to participate in loan swaps. Credit swaps, also known as interest rate swaps, are an important part of ARMOR’s business model and account for around 19% of income in the first quarter of 2021.
Credit default swaps (CDS) are a common practice in the financial markets and help large banks, lenders and mREITs hedge against fluctuating market rates and potential defaults for borrowers, while now providing liquidity to sellers. ARMOR buys and sells pools of government-backed loans in the repo market and achieves a spread between the floating rate versus the rate associated with the company’s debt obligations. Credit swaps generated revenues of $ 182.4 million in the first quarter of 2021 and held a nominal value of $ 6.0 billion in May 2021.
Early repayment of loans also hurts the bottom line of mREITs, especially in a low interest rate environment as we see it today. Fortunately, the ARMOR portfolio protects itself against this:
- 25% of the loans have prepayment penalties.
- 8% of the loans are in geographic areas that are subject to additional taxes for refinancing.
Prepayments for the company decreased in the first quarter of the year.
Is ARMOR in trouble?
mREITs are known for their volatility and risk. While this investment model has great upside potential, it still has significant market exposure even in the event of a financial or economic crisis. Rising loan defaults are putting more pressure on companies like ARMOR, especially given their primary investment strategy, which is government-insured loans like Fannie Mae and Freddie Mac, on which some of most borrowers are currently lenient. As of March 2021, an estimated 1.69 million loans from FHA, VA, Fannie Mae, and Freddie Mac were in forbearance, according to a Black Knight report. One percent of the loans in the ARMOR portfolio have a loan-to-value ratio of over 95%, and FICO scores less than 700 points, which is a strength. Low credit scores and high loan-to-value ratios mean less equity and higher risk for the debtor in the event of default.
The uncertainty in financial markets also results in less trading in the repo market and an increased likelihood that swap buyers may become unable to meet their debt obligations in the event of a loan default. Given the volume of ARMOR’s trading in the repo market, the current environment, especially when forbearance expires, means that the company is reasonably exposed to a decline in revenue and volatility in the repo market. However, given the level of government intervention the repo market has received over the past year, it is unlikely that the government will allow too much volatility or risk its collapse.
Core earnings per share were $ 0.23 for the first quarter of 2021. This means that the company’s current payout ratio is 130%. This is high for equity REITs, but not uncommon in the mREIT world. As of the first quarter of 2021, the company’s leverage ratio was 7.1x with a leverage ratio of 4.1x. The company has $ 687 million in cash, insufficient to meet its current total debt of $ 4.5 billion. However, because mREITs operate on debt leverage, the amount of debt the company currently holds is not uncommon.
At the moment the company seems to be doing well. However, should the market suddenly turn or if government intervention in the repo or financial markets abates, ARMOR Residential could be in a difficult position and unable to maintain its dividend payout ratios. Investors in mREITs are often drawn to the higher returns, which are currently around 10%. However, there is great risk and volatility in these markets. Investors need to understand that ARMOR Residential may not have any issues right now, but a quick move in the market and that could very well be.