AmREITs on Fire: Prelude or Crescendo?

Back on June 28 of this year, I suggested to readers here that they may want to look more closely at high yielding agency mortgage backed real estate investment trusts (AmREITs). I pointed out in the article that as a group, a divergence between AmREITs and the S&P 500 index ETF (SPY) had developed during the previous two weeks.

The grey vertical line just before July 9 on the chart below is the point in time when I asked the question, “Are high yielding AmREITs ready to run?” Looking back, it is now clear that this divergence was sustainable and AmREITs were indeed “ready to run.”

Source: ValueForum

Let’s look at how the six companies in the AmREIT group have done. Since the closing price on the day after the article was published (June 29), the SPY has gained 15.5 percent. The table below shows that American Capital Agency (AGNC), Annaly Capital Management (NLY), Anworth Mortgage Asset (ANH), Capstead Mortgage (CMO), Hatteras Financial (HTS), and MFA Financial (MFA) have all outperformed the SPY, some spectacularly.

The leading gainer in the group, American Capital Agency with a 34 percent total gain, followed closely by Annaly Capital Management with a 30 percent total gain. Annaly also happens to be the largest in the group by market capitalization and the most liquid.

Note: The total return with dividend reinvestment plan (DRIP) column includes actual dividend payments distributed between June 29, 2009 and September 22, 2009. Estimated annualized yield includes likely non-recurring dividend payments for AGNC.

Source: ValueForum

In fact, an even larger divergence developed between the AmREIT group and the SPY as five of the six companies hit 52-week highs yesterday. The sixth, Hatteras Financial missed a new high by 5 cents. The AmREIT group gained an average of 3.3 percent yesterday compared to the SPY which gained about 0.6 percent.

Driving these gains were several bullish dividend declarations. On Monday, Annaly Capital declared a quarterly dividend of $0.69 per share. Yesterday, Hatteras Financial announced a $1.15 per share quarterly dividend and American Capital Agency Corp. declared a $1.40 quarterly dividend payment.

The following chart shows yesterday’s closing price, performance, and share volume for each of the six companies in the group.

Source: Self Directed Investor

Dividend hungry investors will take note that the estimated annualized yields for this group of AmREITs range from 10 to 20 percent. Healthy distribution of dividends seem likely to continue as the Federal Reserve appears to be in no hurry to raise short-term rates amid a bottoming economy and forecast for a jobless recovery.

Remember, AmREITs take advantage of the spread inherent in the yield curve, borrowing short term at low-cost while investing in high-yielding, longer term mortgage securities issued by Fannie Mae, Freddie Mac and other government sponsored enterprises. The greatest risk is if the yield curve flattens as the economy recovers and the Federal Reserve decides to raise the Fed Funds rate. Funding risk, related to systemic risk, is also a possibility if the short term credit markets fail.

The question now is whether recent divergence between AmREITs and the SPY signal even higher future returns for AmREIT shareholders. As long as the Federal Reserve remains reluctant to raise the Fed Funds and Discount rates, AmREITs look like a very good bet.

But remember, even if the Federal Reserve does raise short-term rates, it may not put an end to AmREIT oversized returns. If long-term interest rates are rising along with short-term rates, a favorable spread can be preserved for the group. The key to an exit strategy in AmREITs is to keep an eye on the yield curve and its spread.

AmREITs are currently in a very favorable steep yield curve environment that could last for at least another year. Moreover, valuations are not high by historical standards. AmREITs are a great option for income investors who are willing to manage the risk of a flattening yield curve and able to tolerate unlikely “funding risk.”

I recommend—again—that readers look more closely at AmREITs to see if they might fit into your portfolio.

Full disclosure: Long AGNC, NLY, ANH, CMO.

Comments

[trekking1999:]

good article; thanks; i've owned AGNC, HTS about a year now & are among my best performers plus income; recently bought a little CMO, and am considering NLY too; i'm always a little nervous about them, though, due to mortgage connection even with agency guarantees; i'm mildly concerned about fannie & freddie; brokers etc. say the gov will never let them fail, but there will be debate about it later this year i think when some of their financing expires.

Sep 23 01:09 PM

[Tack:]

No way the government walks away from mortgage backing. Not a chance.

The risk with agency-mortgage plays is almost entirely interest rate spreads. As long as the Fed keeps holding rates, these firms will make nice margins.


On Sep 23 01:09 PM trekking1999 wrote:

> good article; thanks; i've owned AGNC, HTS about a year now &
> are among my best performers plus income; recently bought a little
> CMO, and am considering NLY too; i'm always a little nervous about
> them, though, due to mortgage connection even with agency guarantees;
> i'm mildly concerned about fannie & freddie; brokers etc. say
> the gov will never let them fail, but there will be debate about
> it later this year i think when some of their financing expires.

Sep 23 06:13 PM

[Patrick Harden:]

Continued great coverage of the agency-backed mortgage REITs! I thank you for continuing to bring these articles to SA to help investors distinguish among the various types of mortgage REITs, especially with all of the distressed debt mREIT IPOs pricing recently. It's very important to make a distinction between those mREITs bearing credit risk and the amREITs.

I guess JMP Securities has made the first call for a crescendo, downgrading both HTS and AGNC to Mkt Perform this morning. The amREITs have gotten very richly valued on a market to book basis, so it's tough to see much more forward upside performance above S&P returns.

One agency-backed name that has sort of stayed below the radar is Cypress Sharpridge Investments (CYS), which IPOed earlier this year before the rush of mREIT IPOs. CYS is trading at a modest 1.13x premium to 6/30 book value and produced $0.74/share in core earnings for Q2. I also like CYS because the company marks all its assets to fair value like RICs do, which makes for a much easier set of financials to parse.

Sep 24 10:31 AM

[Kinabalu:]

Nice to note the advantage over the S&P 500 since June, 2009 (total return for AGNC of 34%). These companies have been great bets for far longer than that however. I've been telling everyone I know about this great sector since last September, 2008, and in that time period AGNC is up about 90%, with dividends in cash not DRIP.

Sep 24 01:33 PM

[Oilbull:]

What is the biggest risk with these amreits? I have HTS and have been pleased so far with it and looking at others to add to my portfolio. I need to know the biggest danger that can happen, I can't seem to find a serious downside.

Sep 24 03:50 PM

[Patrick Harden:]

The agency-backed mREITs generally have two main risks:

1) interest-rate risk
2) counterparty risk

If short-term interest rates rise quickly and long-term rates don't move much (a flattening of the yield curve), the net interest spread available to earn disappears. See Annaly's stock price from June 2005 - December 2005 for an example of what happens in a flat or inverted yield curve environment.

Counterparty risk is sort of intertwined with fat tail or Black Swan risk. Should the liquidity associated with agency-backed MBS be threatened, the ability to finance the portfolio with cheap short-term debt may disappear. See Annaly's stock price in the last week of February 2008 (when Carlyle Capital blew up) for an example of counterparty risk.

Sep 24 05:41 PM

[User 58455:]

I hold ANH. Can anyone advise of a good blog, or web site that would give early warning of a flattening yield curve
tom

Sep 24 09:16 PM

[E Nuff Sed:]

www.smartmoney.com/inv.../

Sep 26 08:46 PM

[Taymere:]

Just monitor the Ted Spread. As far as early warning goes as long as the Fed continues to purchase ABS in general, and GSE MBS in particular I think we are safe from a rate hike. The FOMC statement has particular language about rates that has remained unchanged. I think we are safe till at least summer 2010. Even after the Fed jacks up rates a little in late 2010 the NIM's will still be good from a historic perspective. In fact the first hint of a rate raise may be a great buying opportunity for MREITS if the market overreacts.


On Sep 24 09:16 PM User 58455 wrote:

> I hold ANH. Can anyone advise of a good blog, or web site that would
> give early warning of a flattening yield curve
> tom

Sep 29 03:13 AM