During pandemic-driven market dislocations in March 2020, Real Estate Investment Trusts (REITs) were hit hard, with the S&P U.S. REIT Index falling 44% from its peak a month earlier. As the real estate market absorbed new realities of how people live and work, the REIT market was slower to bounce back than the broader market. 

Necessity drove multiple REITs to hoard cash by shedding interest rate swap hedges and replacing them with lower-margin Treasury futures. These events shined a spotlight on REIT hedge efficiency that persisted even after the market’s return to relative normalcy, spurring analysts to pay increased attention to margin minimization as a differentiator for maximizing Earnings for Distribution.

Three recent events in the swap futures world caught our attention, prompting us to contemplate how much capital the top mortgage REITs could free up by replacing their interest rate swaps with Eris SOFR Swap futures (Eris SOFR).

First, Minnesota-based REIT Two Harbors Investment Corp. (TWO) published their 10-Q and Q1 investor presentation in April, both of which disclose hedging activity using 10-year Eris SOFR. The initial position size is modest, but it caught our attention because it’s the first time we’ve seen Eris SOFR mentioned in TWO’s filings.

So we called TWO and they confirmed our finding, saying, “We’re always looking for ways to manage capital more efficiently and hedging with swap futures combines the risk exposure of SOFR swaps with the margin efficiency of futures.”

Second, Eris SOFR swap futures got several shout-outs in the May 20 and June 25 editions of the BTIG Mortgage Finance Roundup, which covers this sector. The May 20 edition (available by request here) calls out the “value in mortgage originators and REITs migrating away from bilateral swaps into lower-margin products like Treasury and swap futures…” (emphasis ours) and highlights multiple REITs whose transition to futures could allow “even more room for valuation improvement.” 

The June 25 version (available by request here) highlights “low-margin Eris swap futures” and estimates that large REITs AGNC and Annaly could each obtain “$300+ million of potential margin savings… [by] migrating from bilateral swaps to futures.”

Last, the Eris SOFR markets have recently absorbed significant directional trading activity, including $3 billion notional of trades on April 22, $2 billion on June 13, and another $2 billion June 14. This activity was in the 5-year and 10-year tenors, and the market data and subsequent jump in open interest suggest it was an influx of end user activity. The primary broker responsible for the first round of flow was quoted publicly saying the markets stayed solid despite this influx of nearly $2 million in dollar duration, or DV01, terms. 

We’ve observed Eris SOFR markets grow tighter and deeper since CME Group enabled portfolio margining with interest rate swaps in March 2023, but to see the markets withstand this level of outright risk transfer on multiple recent occasions has been eye-opening. 

Taken together, these events suggest the potential for the REIT industry to contemplate a structural shift in hedging efficiency just as the Eris SOFR markets are demonstrating readiness for more widespread use. The BTIG analysis, in particular, prompted us to contemplate exactly how much money can REITs save by using swap futures. 

With CME Group’s launch of Eris SOFR Swap futures in 2020, REITs now have a viable alternative for hedging SOFR-indexed risk with low-margin futures.

Whether they plan to use the excess cash for reinvestment, improving liquidity ratios or distributing it to investors, REITs are likely to find margin savings from improving hedge efficiency as an attractive alternative compared with liquidating assets or raising capital. And at some point rates will go down and prepayment speeds will increase, requiring REITs to have cash to fund the timing mismatch between the publication of factors, (which reduces the notional value of their collateral), and the receipt of prepayment cash, which occurs a week or more later. 

After all, REITs use interest rate swaps for hedging bulk duration, while ensuring they comply with REIT tax, accounting and distribution requirements. This use case doesn’t require highly-customized swaps. They should, therefore, look to take advantage of the low margins and liquidity efficiencies of standardized derivatives, rather than forgoing these advantages, as is often required when using more bespoke structures.