Mortgage REIT investors concerned about how their investments will fare under Fed QE(n) can analyze quality of earnings to gain valuable insight.
Mortgage REIT share prices depend on earnings. In the short term, irrational exuberance or panic may cause investors to bid the price of an issue higher or lower than any reasonable estimate of future earnings, but over the long term investors will pay fair value for earnings and dividends.
Mortgage REITs earn income two ways: yield spread income on leveraged shareholder capital invested in mortgage securities, and capital appreciation of securities classified as available-for-sale. The purpose of this analysis is to evaluate the financial performance of our favorite mREITs based only on yield spread income, in order to identify those funds that we believe are more likely to maintain earnings and dividends and shareholder value over the long term. Our analysis revealed sharp differences in the financial performance of the mREITs.
We reviewed mREITs that fall in three categories. Agency-only mREITs that invest only in residential mortgages issued or guaranteed by a government agency: American Capital Agency (AGNC), Armour Residential REIT (ARR), CYS Investments (CYS), Hatteras Financial Corp. (HTS), and Annaly Capital Management (NLY). Hybrid mREITs that invest in agency and non-agency residential mortgages: Apollo Residential Mortgage, Inc. (AMTG), MFA Financial Inc. (MFA), American Capital Mortgage (MTGE), and Two Harbors Investment Corp. (TWO). Diverse hybrid REITs that invest in more varied real estate assets including commercial mortgage backed securities (CMBS), commercial properties, loans, and creatively named asset backed securities (ABS) - Crexus Investments (CXS), Dynex Capital (DX), Invesco Mortgage Capital Inc. (IVR), AG Mortgage Investment Trust (MITT), Newcastle Investment Corp. (NCT), Northstar Realty Finance (NRF), and Starwood Property Trust, Inc. (STWD)
Earnings And Dividends
Net Income per share in the table is exclusive of unrealized gains or losses on securities held for sale, which is normally reported in Other Comprehensive Income (OCI). While mortgage rates steadily declined, many mREITs reported large unrealized capital gains that may have distracted investors from the fact that some of these funds earned little or no yield spread income. (See Third Quarter mREIT Review) For this analysis we will only consider yield spread income net of expenses.
Payout Ratio is the Dividend amount / Net Income per share excluding OCI. A payout ratio less than 100% means the fund paid out less in dividends than it earned in yield spread net income during the period. To maintain their tax exempt status, REITs must pay out at least 90% of income to shareholders within a twelve month period. Therefore, a fund that has excess undistributed net income is likely to take action to increase distributions to shareholders in order to maintain tax exempt status.
There is a great divergence among the funds based on this quality of earnings analysis.
Hybrid mREIT AMTG net yield spread earnings exceeded dividends for every quarter this year. In the diverse hybrid REITs, which seek opportunities for income among a broader population of real estate investments, four of seven funds consistently earned more from yield spreads than they paid out in dividends. MITT has paid out only 57% of 2012 net income. NCT has distributed only 45% of 2012 net income - merely 13% during the third quarter - portending good things to come for loyal NCT investors.
Also noteworthy is the fact that all of these top performing diverse hybrid REITs had the temerity to raise their dividends this year in direct contradiction of prophesies of doom and gloom for mREITs by some of the world's most respected financial prognosticators.
Discussion and Analysis
The Fed has provided helpful forward-looking guidance of their intention to maintain downward pressure on interest rates in general and continue relentlessly racking mortgage rates to resurrect the zombied housing sector. For at least the first half of 2013 we expect mortgage rates for qualified borrowers to continue the slow fall that allowed agency-only REITs to generate OCI to support dividends, which is convenient since none of the agency-only mREIT earned enough yield spread income in 2012 to fund dividends.
The hybrid REITs are finding rewarding investments beyond the world of guaranteed mortgage securities. Many agency-only fund managers have announced intentions to expand investments in non-agency securities, where permitted, or to open new funds with more flexible investment charters such as MTGE created by American Capital in 2011. NLY has announced its intention to acquire the portion of diverse hybrid REIT CXS that it doesn't already own.
Looking forward, we are absolutely certain that interest rates will level off and then rise. We are considerably less certain about the timing and details of these events. There is no guarantee that short-term interest rates will conveniently remain static while mortgage rates begin to rise. It is possible that short-term rates will creep up even as the Fed is relentlessly pounding on mortgage rates, so to speak. Such mischievous wickedness by the fates could inflict severe pain on investors and managers of those funds with the least flexibility.
Therefore, we suggest investors consider exposure to the diverse hybrid funds in the bottom section of our table. I find the financial performance of NCT particularly interesting; so are the colorful narratives by swashbuckling Principal and Co-Chairman Wesley Edens.