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BDC Buzz, BDC Buzz (1,522 clicks)
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This is a new series covering higher yielding Real Estate Investment Trusts ("REITs") starting with mortgage REITs ("mREITs"), hitting most of the highlights and key factors when evaluating mREITs. I am not going to get into all the nuances of these large and complex financial institutions, but rather leave the heavy lifting to the more established contributors on SA including Brad Thomas and David White, with various links to articles that provide a more in-depth analysis of the companies I review.

As an investor I prefer to maximize income and capital gains with minimal taxation. Regulated Investment Companies ("RICs") were designed to avoid double taxation, using the "conduit theory," where capital gains, dividends and interest are passed onto shareholders avoiding taxation at the corporate level but are required to distribute at least 90% of interest, dividends, and gains earned on investments. RICs are required to distribute 98% of net investment income to avoid paying a 4% excise tax.

There are three types of RICs that I follow and invest in: REITs that invest in real estate through properties or mortgages, Business Development Companies ("BDCs") invest in small and mid-sized businesses, and Master Limited Partnerships ("MLPs") invest in natural resources, real estate and commodities. Perhaps the name "BDC Buzz" is not appropriate and should be something like "RIC Buzz".

REITs were created by Congress to give smaller investors an opportunity to directly participate in the higher returns generated by real estate properties ranging from office and apartment buildings, to hospitals, shopping centers, and hotels. Currently, the top 35 dividend yielding REITs average around 9% annually plus an average annual NAV growth of approximately 15% over the last 12 months. Most of the companies that pay higher dividends are mortgage REITs that do not own actual properties but invest and own property mortgages and sometimes are considered riskier because of their increased exposure to interest rates.

Recently I covered 25 of the top BDCs in a series called "The Good, The Bad and The Maybe?" with the most recent "Prospect Capital: Is It Better Than American Capital?" comparing Prospect Capital (PSEC) to other BDCs and included a chart with various rankings. In this REIT series I plan to do something similar, taking into account specific REIT metrics. Mortgage REITs are priced differently than equity REITs and use a distinct set of metrics to evaluate profit, growth, risk, and return. I will be focusing on REITs with a market capitalization greater than $100 million and dividend yield of at least 5%. Again, this series is for the purpose of introducing REITs to dividend seeking investors and providing a fair and balanced view as a starting point for investor due diligence.

Initially I will start with some of the larger well know mREITs including:

  • American Capital Agency Corp. (AGNC) mostly invests in residential mortgages issued or guaranteed by a government agency.
  • American Capital Mortgage Investment (MTGE) invests in both agency and non-agency residential mortgages.
  • ARMOUR Residential REIT, Inc. (ARR) mostly invests in residential mortgages issued or guaranteed by a government agency.
  • AG Mortgage Investment Trust (MITT) invests in both agency and non-agency residential mortgages as well as CMBS, commercial properties, loans, and asset-backed securities.
  • Annaly Capital Management, Inc (NLY) mostly invests in residential mortgages issued or guaranteed by a government agency.
  • Two Harbors Investment Corp. (TWO) invests in both agency and non-agency residential mortgages.
  • CYS Investments (CYS) mostly invests in residential mortgages issued or guaranteed by a government agency.
  • Invesco Mortgage Capital Inc. (IVR) invests in both agency and non-agency residential mortgages as well as CMBS, commercial and residential loans.

These are the four general criteria I use to evaluate REITs:

Total Return

REITs are total return investments providing dividend yields along with long-term capital appreciation. The key is to have an overall return that is consistent, sustainable, and growing, as well as higher than average. Net asset value (NAV) growth is important with some companies such as MTGE, TWO, and IVR growing over 20% in the last 12 months while others such as NLY and CYS remained flat over the same period. Obviously dividend payout is key for investors seeking income with AGNC and MTGE currently yielding 14% or higher.

When assessing the sustainability of a company to pay its dividend I use adjusted funds from operations ("AFFO") or core earnings in the case of mREITs. AFFO adds back depreciation to net income but also deducts for capital expenditures needed to maintain the portfolio of properties. However, with mortgage REITs I use core earnings because they do not have the amount depreciation and cap ex due to the lack of actual properties. Core earnings is net income excluding both realized and unrealized gains (losses) on the sale or termination of securities, including those underlying linked transactions and derivatives. Both these measures are closer to true residual cash flow available to shareholders and a better predictor of the REITs' future capacity to pay dividends.

For projecting growth I consider a few things including historical growth, analyst projections, interest rate sensitivity (discussed later), expense ratios and available growth capital.

Risk

In general, mREITs are considered high-yielding and higher risk investments, but I will only being looking at risk relative to other REITs. Mortgage REITs get a considerable amount of their capital through secured and unsecured debt offerings. If interest rates rise, future financing will be more expensive, reducing the value of a portfolio of loans while potentially increasing borrowing costs. Some REITs are more levered than others such as AGNC, ARR and CYS with debt to equity ratios greater than 7, while others such as TWO are less than 4. There are many other factors that impact the risk profile of mREITs including: portfolio mix of agency RMBS or not, CMBS, ABS, fixed vs. floating rate assets and liabilities, duration gap, constant repayment rates (CPR), institutional and inside ownership of shares, market cap, length of operating history, down market performance, volatility ratios, average coupon vs. yield of investments, cost of funds, net interest margins, interest rate swaps, hedging, etc.

Below is an interest rate sensitivity table for MITT, showing the estimated impact of an immediate parallel shift in the yield curve up and down 25, 50, 75 and 100 basis points on the market value of the portfolio as of December 31, 2012. This takes into account many of the items listed above.

(click to enlarge)

Analyst Opinions

Analyst opinions are important as a gauge but seem to be more of a lagging indicator.

Valuation

Again, I use AFFO and core earnings instead of EPS, which is standard for the REIT industry as well as NAV indicators. When looking at forward pricing metrics I use the same approach when projecting total return as described earlier.

If there are other measurements people would like me to highlight please let me know as well as specific mREITs I should cover including:

  • Hatteras Financial Corp (HTS)
  • MFA Financial, Inc. (MFA)
  • New York Mortgage Trust Inc. (NYMT)
  • Apollo Residential Mortgage, I (AMTG)
  • Chimera Investment Corporation (CIM)
  • Resource Capital Corp. (RSO)
  • Dynex Capital Inc. (DX)
  • Capstead Mortgage Corp. (CMO)
  • Anworth Mortgage Asset Corpora (ANH)
  • PennyMac Mortgage Investment T (PMT)
  • Newcastle Investment Corp. (NCT)
  • Starwood Property Trust, Inc. (STWD)
Source: Mortgage REITs: The Good, The Bad And The Maybe?