Following American Capital's (AGNC) dismal quarterly performance, I have been on a hunt for a replacement for this beloved dividend paying real estate investment trust [REIT]. For my followers not familiar with a REIT, a REIT is simply any corporation, trust or association that acts as an investment agent specializing in real estate and real estate mortgages under Internal Revenue Code section 856. The rules for federal income taxation of REITs are found primarily in Part II (sections 856 through 859) of subchapter M of chapter 1 of the Internal Revenue Code. The advantage of being a REIT is that the company is entitled to deduct dividends paid to its owners, and thus a REIT may avoid incurring all or part of its liabilities for U.S. federal income tax. To meet the qualifications, REITs are required to distribute 90% of its earnings to shareholders.
Although I still like AGNC, its earnings report (links to a pdf file) was worrisome. For the first quarter, it reported comprehensive loss per common share of $1.57. This included $0.64 net income per share with a $2.21 loss per common share in other comprehensive areas (such as unrealized losses on investments). AGNC also reported a $0.78 net income spread per share (that is, the income made after cost of borrowing, expenses and interest income). The book value of the company dipped 9% to $28.93, down from $31.64 at the end of 2012.
In searching for a replacement I stumbled across a few hybrid REITs that I am considering, which I believe offer investors better diversification as well as the potential for sustained and/or increasing dividends. Briefly, a hybrid REIT is different than a standard REIT generally on how it invests. Mortgage REITs typically focus on agency strategies. Agency REITs carry limited credit risk as securities are guaranteed by government-sponsored entities. Agency REITs are subject to interest rate and refinance risk. As opposed to agency REITs, hybrid REITs invest in both agency and non-agency securities. Hybrid REIT managers have the flexibility to move between agency and non-agency securities to find the best risk/reward for shareholders. Purchased at the appropriate price, non-agency securities can offer REIT investors attractive risk adjusted returns and lower the volatility in a REIT portfolio. Non-agency mortgages trade more like equity than credit as when the economy heals, recoveries increase. As the economy heals the market drives interest rates up which hurt agency securities. My favorite hybrid REITs are as follows:
Western Asset Mortgage (WMC): WMC is currently offering 18% dividend yield on its quarterly dividend of $0.95 per share. The company has a diverse asset mix consisting of residential mortgage backed securities, asset backed securities and commercial mortgage backed securities. Additionally, since the company is classified as a hybrid mortgage REIT, it also invests in non-Agency RMBS. Therefore, I will get complete diversification within the mortgage REITs sector if I choose to buy WMC. The company reported earnings per share of $1.05, $0.18 per share ahead of what analysts were expecting. It also reported a 7 basis point increase in its asset yields during the fourth quarter. At the same time its net interest rate spread increased 5 basis points when most of its peers were reporting contractions in their spreads due to the government's aggressive bond buying. The company is set to report earnings in the coming week, and I will be watching this closely. The stock trades at $21.47 and has a low 3.9 P/E ratio. On average, 770,000 shares exchange hands daily. The stock has a 52-week range of $17.36-$24.72. (NYSE: WMC)
Discussing WMC's Funds/Income From Operations at End of Q1.
A Key metric to look for in REITs are the operating funds and income. The net income for the most recent quarter was approximately $24.8 million or $1.04 per weighted average diluted share. WMC's core earnings, which is a non-GAAP number defined as net income excluding net realized and unrealized gains and losses on investments, net unrealized gains and losses on derivative contracts and non-cash stock-based compensation expense, was approximately $25.1 million or $1.05 per diluted share. WMC's net interest income for the period was approximately $30.6 million. This number is a GAAP number and does not include the interest we received from IO securities or treated as derivatives. It also does not take into account the cost of interest rate swaps both of which are included in the gain loss on derivatives instruments line in its income statement.
On a non-GAAP basis, net interest income including the interest received from IO securities treated as derivatives and taking into account the cost of hedging was approximately $28.2 million. Included in this calculation was an approximately $55.6 million coupon interest offset by approximately 18.1 million of net premium amortization and discount accretion. The weighted average net interest spread for the quarter which takes into account the interest received from IO securities as well as the fully hedged cost of financing was 2.05%, reflecting a 2.86% gross yield on the portfolio and a 0.81% effective cost of funds.
Finally, operating expenses for the quarter were approximately $3.2 million, which include approximately 1.3 million of general and administrative expenses and approximately 1.9 million in management fees. In addition to core earnings, WMC also had approximately $12.6 million of net realized gains as a result of modest repositioning of the portfolio, which were offset by $10.9 million of realized losses on interest rate swap as we terminated some agreements early and entered into longer-dated swaps in a move to extend the duration of its liabilities.
New York Mortgage Trust (NYMT): is another hybrid mortgage REIT yielding 15.4% on its dividend payment of $0.27 per share each quarter. The stock is trading in proximity to its 52-week high. During the fourth quarter, it reported a six-fold increase in its interest income, while its profits came in at $9.4 million compared to a prior loss of $1.9 million. During the first quarter, NYMT had earnings of 15.4 million, representing basic income per common share of $0.31, as compared to net income attributable to common stockholders of $5.8 million and basic income per common share of $0.42 for the quarter ended March 31, 2012. The diversification of its investment portfolio is promising. It invests in both mortgage backed securities and distressed residential mortgage loans. It currently targets multi-family commercial MBSs, Agency residential MBSs, including Agency fixed-rate residential MBSs, Agency adjustable rate mortgages, and Agency IOs, certain commercial real estate-related debt investments and residential mortgage loans, including loans sourced from distressed markets. The stock currently trades at $7.03. It has a 6.5 P/E ratio trades on average volume of 1.4 million shares. Finally, it has a 52-week range of $5.51-$7.69.
Discussing NYMT's Funds/Income From Operations at End of Q1.
Income for NYMT's operations is strong. NYMT's interest income for the 3 months ended March 31, 2013, was $13.1 million, up approximately $6.8 million for the same period the previous year, and up approximately $1.6 million from the fourth quarter of 2012. The increase in net interest income was primarily due to an increase of $1.1 billion in average earning assets at March 31, 2013, as compared to the first quarter of 2012.
The increase in average earning assets was due to the deployment of net proceeds totaling approximately $232 million from 4 public equity offerings NYMT completed in 2012 and increases in borrowings under repurchase agreements that it used to acquire additional Agency RMBS. The company's portfolio net margin was 348 basis points during the quarter ended March 31, 2013, as compared to a net margin of 333 basis points for the quarter ended December 31, 2012. The increase in net margin in the first quarter of 2013 from the fourth quarter was attributable to investments in credit assets.
The increase in other income on the earnings includes a $5 million increase in net unrealized gains in multi-family loans and debt held in securitization trusts, an increase in unrealized gain on investment securities and related hedges of $3.3 million, which was partially offset by an increase in realized loss on investment securities and related hedges of $4.2 million that's primarily related to its IO portfolio. The increase in unrealized gains from NYMT's investment in multifamily loans and debt held in securitization trusts was due to improved credit spreads, as well as significant increase in investment in this asset class as compared to the previous periods. Credit spreads on these assets benefited from improved market conditions, as well as greater demand by investors, resulting in significant increase in valuations for investments. The increase in expenses on the earnings statement came from an increase of $0.5 million in other expenses and $0.5 million in management fees, as well as an increase of $100,000 in salaries, benefits and directors' comp and approximately $100,000 increase in professional fees. These increases in all categories are largely the result of the growth of equity of the company.
Apollo Residential Mortgage (AMTG): operates as a mortgage REIT that invests in Agency and non-Agency residential mortgage backed securities. At the end of the fourth quarter (opens a pdf) of the prior year, non-Agency mortgage backed securities were only 14% of the whole portfolio. Non-Agency paper is considered to have default risk because their principal and interest payments are not guaranteed by any government agency. Therefore, since they possess default risk, they offer high interest yields and interest income in return.
Discussing AMTG's Funds/Income From Operations at End of Q1.
This is why at the end of the fourth quarter of the prior year, the company reported a two-fold increase in its interest income compared to a year ago. However, higher operating expenses during the quarter coupled with higher cost of funds led to lower net income for the quarter. AMTG reported operating earnings of $19.1 million or $0.74 per common share, and net income eligible to common stockholders of $1.9 million or $0.07 per share. The difference in GAAP net income per common share and operating earnings per common share was due to realized gains of $0.61 per common share from the sale of certain RMBSs, offset by unrealized losses on RMBSs and some derivative instruments, which totaled $1.35 per share in the earnings pdf. At the end of the quarter, AMTG's $4.9 billion residential mortgage backed securities portfolio consisted of agency RMBSs with an estimated fair value of $4.3 billion, and on agency RMBSs with an estimated fair value of $595.8 million. AMTG's combined RMBS and securitized mortgage loan portfolio had a blended net interest spread of 2.8% and a levered asset yield of 17.7%. At March 31, 2013, the equity allocation in its portfolio was comprised of 59% agency RMBSs, 21% non-agency RMBSs, 4% securitized mortgage loans, and 16% cash. This is the beauty of the hybrid REIT structure. It enables companies to reallocate equity in a manner that management believes will maximize returns to shareholders and allows companies to take advantage of opportunities across a broad spectrum of the residential mortgage market.
The stock is currently yielding 12.5% and trades at $22.33. It has a 3.6 P/E ratio and on average trades 600,000 shares daily. Finally it has a 52-week range of $18.05-$23.59.
In summation, I am still long AGNC. I think it is a well run company and it has been very profitable for me over the years. However, the recent quarter was distressing. Perhaps it is a one-time event, but given that the economy is slowly starting to improve and rates are ticking upward, it is becoming harder and harder for these traditional REITs that invest in agency backed securities to remain profitable, or at least, expand profits. The pressure on the interest spreads is too high. Thus, I am seeking to either sell the position entirely, or more likely, sell half of the position and move it into a more diversified hybrid REIT to preserve principal and collect a dividend that may be more sustainable, if not able to grow. Currently, I am considering WMC, NYMT and AMTG.