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Mortgage REITs are typically known for issuing preferred shares as a way of raising capital and using it to purchase MBSs. Investors in mREITs and mREIT common shares need to understand how cost of capital works in many of these cases. It's important that investors understand that the interest rate on preferreds is basically the company's cost of capital. It's the cost of having those funds available to the company. So when the company issues preferred shares, investors in the common stock need to understand that they should only expect to see a return if there is a spread between the interest rate on preferred stock and the interest the company makes on the MBSs.

Seems pretty simple, right? So how is this information useful?

When we look at the spread between interest rates for these mREITs, it can give us a good idea of how efficient management is at leveraging their funds and getting a strong return. If we decipher which companies are making the most out of their capital, then we have an idea on which would give the strongest return on investment.

Take for example, Resource Capital (RSO), the company raised over $40 million, by issuing preferreds. The average cost of capital for these funds is 8.35%. That may seem like a hefty rate given the current environment, but the company has stated that its new loans will have leveraged yields between 13% and 18%. So the spread of 4.65%-9.65% is the return that common shareholders stand to gain.

It's also important to note what types of loans are being purchased using the proceeds from preferreds. For example, if a mREIT issues a preferred and wants to increase the return, then they can go out and purchase junk rated debt, which just means that the company has increased the amount of risk they are taking. If we take a look at Resource Capital again, they have a CMBS portfolio of more than $170 million, most of which are AAA rated and earn more than 15%. So that looks pretty good for common shareholders as Resource is able to maintain a nice spread and still purchase investment grade debt.

It is vital for mREIT investors to see if management is getting a spread and while minimizing risk. Other companies such as Annaly Capital (NLY), Armour Residential (ARR), Hatteras Financial (HTS), and Northstar Realty Finance (NRF).

Its a simple method that can help investors analyze which REITs are generating the best returns and maintaining efficiency. Armour Residential has a portfolio valued around $22 billion. During the third quarter of 2012, the annualized yield on average assets was 2.70%, and the annualized cost of funds on average liabilities was 0.89% resulting in a net interest spread of 1.82% for the quarter. Keep in mind that this is without leverage and if we factor in leverage, the ROE is actually greater than 17%.

For example, Hatteras Financial doesn't seem to be generating as strong returns as its competitors. The company reported a new spread of 1.22% and earned a ROE of 11.64%. So it seems to not be the most efficient when it comes to generating capital.

There are several items I advise mREIT investors to observe when comparing investments.

1. Finding the one with a strong net interest margin

2. Look for strong ROE

3. Make sure additional capital from sources such as preferreds have a cost of capital that is manageable

4. Strength of the current portfolio

It's important that shareholders have an idea of how efficient management is in generating returns and using their capital in the best way possible. Investors can use net interest margin and ROE to determine this. In addition to this, knowing what the company's cost of capital from sources such as preferreds can help investors are understand how much the company needs to generate in order to cover that cost.

Also just because one company generates a slightly higher return than another, its important to look at the strength of their portfolios. It is very possible that a stronger return could be due to an increase in leverage and a decrease in credit quality. I believe comparing ROE, net interest margin, and proper use of capital from preferreds can significantly help investors find the most efficient mREITs on the market.

Disclosure: I am long RSO-B. I have no positions in any other stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: mREITs, Preferreds And Cost Of Capital