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Annaly Capital Management Inc. (NLY) and American Capital Agency Corp. (AGNC) are the two biggest Mortgage REITs (mREITs). REITs are often considered a safe haven and also have huge dividend yields, which make them extremely attractive to the retail investor.

REITs are structured for providing an investment opportunity in real estate the way mutual funds allow investment in equities. However, assets of mortgage REITs have grown at such a speed that it has made the Fed sit up and take notice. This article takes a look at whether the exponential growth of mREITs is something that we should be worrying about, and why.

Exponential growth and the risk

Total assets of mortgage REITs have increased four times since 2009 to $400 billion, with most of the growth being in the last couple of years. Assets of each of the two biggest mREITs, Annaly and American Capital, alone have increased to more than $100 billion in the last three years. At the same time, during this period, market capitalization of the industry has grown more than 166% - from $22.1 billion to $59 billion.

So where is the risk?

The risk is the leveraged loans appearing on the balance sheets of REITs.

Mortgage REITs are publicly traded funds that borrow money from the market and invest in real estate debt. This is different from traditional REITs that invest in physical real estate assets such as homes, rentals, malls and commercial buildings.

According to a report on WSJ.com, the Financial Stability Oversight Council, a panel of U.S. financial regulators, is expected to refer to mortgage REITs as a source of market vulnerability. Regulators are worried as they fear that past mistakes of the American economy may be repeated here. The economy is in a recovery mode and regulators see signs of bubbles forming in the financial system. Part of it is due to the easy money policy that has pushed interest rates to record lows. With banks offering pretty little on deposits, investors are forced to seek better returns elsewhere.

Mortgage REITs have been benefiting from the low-interest environment prevailing in the country where short-term wholesale debt is available at abysmally low rates. With borrowed funds they buy mortgage securities backed by agencies such as Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). These are then used as collateral for securing more short-term debt (leveraging) in order to buy more securities and get better returns.

Whereas investors are happy with the handsome returns they get by way of dividends - American Capital has a dividend yield of 15.25% and Annaly 11.49% - the regulators are worried about reliance of mREITs on leveraged and short term financing, because things could become unmanageable in times of crisis.

The total debt-to-equity ratio of three mortgage REITs, Annaly, American Capital and with Two Harbors Investment Corp. (TWO) are as follows:

For the uninitiated, debt-to-equity ratio, which represents a relative proportion of debt and shareholder equity used for creating assets of an entity, is closely related to leveraging.

Balance Sheets of the three mREITs

Annaly Capital Management

Annaly's investment policy binds it to invest at least 75% of its total assets in agency mortgage backed securities (MBS) and short term investments and as of December 2012, all MBS bought by it were backed by mortgage loans for residential homes.

As of December 2012, Annaly's total assets, all inclusive, amounted to $133.45 billion. Against this, the company owed $117.53 billion, out of which long-term debt was only $4.39 billion and short/current long term debt stood at $102.79 billion. Total tangible assets of Annaly stood at $15.86 billion.

American Capital Agency

The primary source of income of American Capital is from MBSs whose principal and interest payments are underwritten by government sponsored enterprises.

As of December 2012, American Capital had assets worth $100.45 billion against which it owed $89.57 billion out of which $13.96 billion represented long term debt and $75.03 billion as "other" liabilities. Net tangible assets of the company stood at $10.90 billion.

Two Harbors Investment

The focus of Two Harbors is on residential MBS including agency as well as non-agency. This is a much smaller REIT with total assets worth $16.81 billion against liabilities of $13.63 billion. Net tangible assets of the company amounted to $3.45 billion.

The high amount of leverage is evident from the figures given above. The net result is the same for all three: these mREITs have tangible assets between $3 billion to $16 billion. Whatever assets they own beyond these have been funded by short/long term debt.

My take on mREITs

I would like to draw attention to the following chart I prepared.

(click to enlarge)

All three REITs have very handsome operating and profit margins. Even the return on equity is pretty attractive. However, what I am concerned about is return on assets - a vast majority (refer debt/equity chart above) of which has been created with borrowed funds. I shudder at the thought of what would happen in the event of funds drying up due to financial crisis or economic downturn or whatever. How long can the Fed keep propping up the financial sector and the economy artificially?

Chairman and CEO of Annaly, Wellington J. Denahan, puts the entire situation in a correct perspective. He is quoted as saying that mortgage REITs have grown bigger by virtue of "increased capital base" and the risks associated with the low-interest rate environment is something that every investor should be aware of and should be "prudent about managing."

No doubt the asset base of mREITs has increased but so has the risk on account of leveraged loans. Personally, I think that every investor who is already invested or thinking of investing in REITs should be aware of it.

Source: End Of The mREIT Honeymoon?