Many mREITs are now trading at significant discounts to book value. This has prompted some of them to buy back some of their outstanding shares. American Capital Agency Corp. (AGNC) has stated that its latest book value is $25.27 and the stock last traded at $19.54. AGNC bought 43 million shares during 2013. REITs must pay the bulk of their earnings to shareholders to comply with tax law. The source of the funds that mREIT use to buy back shares is generally the principal payments made by the mortgage securities in their portfolio.
The question is which is better in terms of dividends per share for an mREIT to use the proceeds from principal payments to buy back shares or to buy mortgage securities?
If the book value was the same as the mREIT's market price, obviously replacing the mortgage securities lost via prepayments would have no effect on book value. If the new mortgage securities had the same yield as those lost via prepayments the dividends would also not be affected.
When shares are bought back at prices below book value the result is an increase in book value. To determine the impact of share buy backs on dividends the calculations are more complex. Consider a hypothetical mREIT that is leveraged 7 to 1 and holds mortgage securities now yielding 4%. Assume that the net borrowing costs including hedging expenses are 1%.
For simplicity sake assume that the mREIT has $200 in total assets with $25 in book value and $175 of borrowing. Assume it has 25 shares outstanding that are trading at $0.80. This would be a 20% discount to book value. This is similar to the discounts to book value that mREITs such as AGNC, Annaly Capital (NLY) ), Cypress Sharpridge (CYS) and Armour Residential Reit Inc (ARR) are trading at now.
Assume the hypothetical mREIT is experiencing a 6% CPR rate of prepayments on its portfolio of mortgage securities. Thus, it will have $12 of prepayments. The hypothetical mREIT can use the $12 to purchase new mortgage securities or it can use the $12 to purchase its own shares at the market that are trading at $0.80.
Ignoring expenses the hypothetical mREIT would be paying $.25 per share in dividends since its income from the portfolio of mortgage securities would be $8 less $1.75 interest and hedging costs = $6.25 divided by 25 shares outstanding = $.25 per share.
Replacing the prepayments with new mortgage securities paying the same yield would keep the dividend per share the same. The other choice is to buy back shares. Clearly, the hypothetical mREIT would not use the entire $12 to buy back shares as that would vastly increase leverage. Rather the share buy back would be accompanied by a paydown of debt so as to keep the degree of leverage unchanged.
In this case to keep leverage unchanged the hypothetical mREIT would be spending $1.50 on buying back outstanding shares and $10.50 to reduce borrowing. That would keep the leverage at 7 X 1. When it spent $1.50 on buying back outstanding shares at $.80 it could buy 1.875 shares. This would reduce the number of shares outstanding to 23.125.
The total assets of the hypothetical mREIT would be $188 consisting of $23.50 equity and $164.50 in debt. The income from on its portfolio of mortgage securities would now be $7.52 and the interest and hedging costs would be $1.645. Thus net income would be $5.875 and the dividend per share would be $5.875/23.125 = $0.2541. Thus, choosing to buy back shares rather than buying new mortgage securities with the proceeds from prepayments would, all other things equal would increase dividends by 41 basis points, an increase of 1.64%.
If one wanted to take advantage of the potential buy back trend in mREITs one could use ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (MORL) and Market Vectors Mortgage REIT ETF (MORT) which are baskets of 26 mREITs. As I indicated in 30% Yielding MORL, MORT And The mREITS: A Real World Application And Test Of Modern Portfolio Theory there are distinct advantages to diversifying as opposed to buying individual mREITs.