How I Would Navigate The Troubled World Of mREITs

Includes: AGNC, NLY, REM
by: Regarded Solutions

The two largest mREITs, Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC), cannot seem to gain any traction and it is my strong opinion that this entire sector be avoided. The main reason for investors, especially those with a short term horizon or who are already retired, is the state of flux in the Federal Reserve policies on interest rates right now.

Mortgage REITs borrow short-term money to invest in mortgage-backed securities. The firms profit by earning more from the rate paid on their assets than they pay to borrow funds. Mortgage REITs employ leverage, and, as with other companies, the more leverage a REIT uses, the greater the potential for losses as well as gains. Rising rates can hit REIT payouts by increasing borrowing costs and inducing firms to cut their leverage.....Investors like mortgage REITs because they can offer high yields. But they are exposed to rate fluctuations, a relationship that can be difficult to handle.

Not a day goes by when the Fed is saying that the economy is too weak to start tapering the QE environment and either the same day, or the next, a few Fed governors say how it must begin tapering sooner than later.

There was a recent reprieve from rising rates after Fed officials surprised markets with a no-taper announcement. But analysts say the central bank is merely delaying the inevitable, injecting volatility for a few more weeks or months, and that rates will eventually head higher.

The effects that this has had on the two largest mREITs in the sector become more obvious everyday.

All One Needs To See Are The Actual Numbers

These charts tell the story in my opinion:

NLY Price to Book Value Chart

AGNC Price to Book Value Chart

The key takeaways from the numbers shown is that the declining price to book value has done absolutely nothing to spur a rush to buy "cheap" shares. Probably because the smart money knows that the shares probably will get even cheaper, especially when the likely dividend cuts are announced for the next quarter.

These charts typify catching a falling knife in my opinion, and with the state of the policies currently in place seemingly always in question, the choice is simple for investors; Invest in a high risk and wait for the Fed to get out of the way, or avoid the turbulence and put your money to work in less risky equities.

Is Yellen An All Clear Dove?

Janet Yellen will be the next Fed chief, and she stated before the Senate banking panel that the economy is too weak to begin tapering.

We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession. Unemployment is down from a peak of 10 percent, but at 7.3 percent in October, it is still too high, reflecting a labor market and economy performing far short of their potential. At the same time, inflation has been running below the Federal Reserve's goal of 2 percent and is expected to continue to do so for some time.

For these reasons, the Federal Reserve is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy.

While on the surface this appears to be favorable for the mREIT sector, the flip side of the coin is that continued lower interest rates could spur another round of refinancing which will impact profits from mortgages being paid at higher rates (pre-payments). In my opinion, it makes no difference if Yellen is a rate dove or not. Sooner or later the interest rates will rise. Either on their own, or by the Fed taking the foot off the gas pedal.

While pre-pays will place cash into the register of the mREITs for a temporary boost to book value, where will the money be redeployed for equal or better profits? Higher book values, in the past, has led to secondary stock offerings to raise funds to invest, but invest in what? The extra funds can be used to buy shares back, but how will that increase profits, or a better question would be, how will lofty dividends be paid?

This troubled world of the mREIT sector has led to the two largest companies in the sector having some rather confusing, or should I say "interesting" conference calls.

Here is Annaly's conference call, and here is American's conference call which are available right here on Seeking Alpha. I suggest that each be read and to pay particular attention to both CEOs comments.

Will Insider Buys Help?

Recently, NLY directors purchased a large number of shares on the open market (408,000). Normally I would be the first to cheer insider buying but in my opinion, this "show of force" is simply that, a show. The number of shares that these folks purchased amounts to MAYBE 2% of their annual income. Correct, ANNUAL income, not the total value of their entire net worth.

That means if someone makes $75,000 and decides to buy at the same rate as the insiders, it would be a total purchase of about $1,500-$2,000.

Wake me up when the insiders decide to plunk down 30% of their income on shares. Then I might blink. For now, this show of force means very little, as can be seen by the relative non-movement of the share price.

So What Should Investors Do?

This is the real question isn't it? I see three groups of investors of interest:

  • Current shareholders over many years or at the 52 week lows.
  • Shareholders who purchased at the extreme highs in the last 52 weeks.
  • Investors seeking income and are tempted to buy because of the price to book ratios of each company.

While I am not authorized to give any investment advice, I can tell you what I would do if I place myself in each of these groups.

  • If I have owned shares for more than 5-10 years, there is no reason to sell and I can wait for things to change. My net cost is so low that it would just not make sense unless I needed the money.
  • If I bought shares at the 52 week highs (or close to), I would begin selling the shares on days when the stock prices are up. The loss in total returns is not going to change anytime soon, and the lofty dividends are getting eaten away by the continual drop in share prices. I am also anticipating more dividend cuts.
  • If I was interested in buying shares of either NLY or AGNC, I would wait for the Fed to get out of the way completely, and let the dust settle. There are thousands of other securities with less risk that my money can be much safer in.

That is as simple as I can make it in this troubled sector. If folks choose to invest here, make sure it is money you can afford to lose and keep it at a tight minimum allocation of no greater than 1-2% of your investment portfolio.

Disclaimer: The author is not an expert in the mREIT sector and his opinions are not recommendations to either buy or sell any security. Please remember to do your own research prior to making any investment decisions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.