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Annaly Capital Management (NYSE:NLY) reported better than expected results last week and the stock jumped a few points on the news. While I wasn't surprised about its improving business, I was surprised at the magnitude of its outperformance. I wrote an article on December 24th, 2013 about how Annaly's price seemed to be at a bottom.(Read Article) While other authors on this site were suggesting to run for the hills, I hope you heeded my advice and put at least some money to work on NLY. Investors who did have benefitted from a 13%+ return since then, including dividends paid. Whether or not Annaly can continue its positive performance is the subject of another article I am working on. But in the meantime, I think its interesting that the Annaly logo is the family crest and reads, "Prodesse Non Nocere", which means "proceed without fear". I wanted to provide some additional insight into mortgage REITs as an asset class so that investors can invest in them intelligently, without fear, and without having to read from those that try to instill fear.

Seeking Alpha is full of articles written about mortgage REITs and unfortunately, most of them are biased to one extreme or another. I too have written positively about mREITs in the past and despite their relatively poor performance in 2013, I still like them over the long run. Besides, not all mREITs performed poorly. The table below shows the returns for a list of mREITs in 2013.

Source: Morningstar

In September 2012, I wrote an article called How to Use REITs Within Your Portfolio - REIT Investing 101. In that article, I focused more on REITs in general and how they should be positioned within a broader portfolio of investments. This article will focus on some of the factors that investors should consider when investing in mREITs specifically, and should be read in conjunction with the previous article.

MREIT Performance

Over the long run, mREITs perform relatively well as shown in the table below. But that performance comes primarily from dividends sandwiched in between lots of volatility. Most investors don't have the stomach to ride the ups and downs that are typical of mREITs, but over the long-run, it may be worth it. From 1972-2013, mREITs had an average one year return of 9.06% (not annualized return), consisting of an average 1 year price decline of 3% and a dividend of 12%.

Source: NAREIT

Over the short-term, volatility can be scary and drawdowns can be significant. Since May 2013, when the Fed announced its intention to taper, mREITS took a nose-dive along with most other fixed income instruments. From May 2013 to August 2013, mREITs lost over 25%. For all of 2013, however, mREITs only lost 1.96%, helped of course by the positive returns of some of the mREITs shown in the table above. The results trailed the FTSE NAREIT All REIT index, which had a return of 3.21%, and with the S&P 500 returning over 30% for the year, investors might be asking themselves, why should I invest in REITs, and more specifically mREITs?

Why invest in mREITs?

As previously mentioned, most of the returns on mREITs are from the dividends they pay. Price appreciation, when there is any, is just icing on the cake. So it's best to invest when prices are stable or rising. But this is harder than it seems and particularly in this environment. Even though mREITs may be affected by interest rate movements in the same way bonds are, there are additional factors that are specific to the strategy being used by individual mREITs that could impact their returns as well. Both positively and negatively.

For example, in a falling interest rate environment, bonds tend to appreciate in value, since prices on fixed income securities move inverse to interest rates. But in a falling interest rate environment, mREITs may experience an increase in prepayments, as borrowers look to reduce the rates they pay on their mortgages. Initially, this drop in interest rates could increase the book value of the mortgages held on the balance sheet, but as prepayments increase, the rates at which these funds could be reinvested will be lower. Depending on the cost of borrowing, the spread between the interest earned on the mortgages and the interest rate paid for financing could change.

Conversely, in a rising rate environment, the book value of the mortgages on the books may decline, but eventually, the mREIT will be able to reinvest at higher rates. Once again, the comparison of interest received and interest paid, called net interest margin, will determine the mREITs profitability. It really depends on not just what direction rates are moving but rather, what short rates are doing relative to long rates, and how each mREIT is managing the changes through hedging, leverage, and financing options.

When to Invest in mREITs

mREITs are like banks in that they prefer a steep yield curve. A steep yield curve allows mREITs to borrow at low rates in the short-term and reinvest those proceeds at higher rates over the long-term. By leveraging this 'spread', they are able to generate a high level of core earnings and pay out a high dividend yield. Most mREITs then borrow against the assets on their balance sheet and use leverage to enhance that return.

The chart below on the left shows the yield curve on December 31st, 2012, while the one on the right shows the yield curve on December 31st, 2013. Not only is the yield curve steeper, but the steepest part of the curve is the 2Y to 7Y segment, a good situation for mREITs because they borrow for periods of less than a year and invest in securities with a duration of 7-10 years.

(click to enlarge)

Source: Stockcharts

The risk of this dependence on short-term financing, however, is that short-term rates rise, increasing the cost of borrowing and reducing the net interest margin. If this were to occur, the only way the mREIT would be able to maintain the same dividend is to increase leverage, a risky maneuver. The risk of short rates rising however, seem to be minimal, as the Fed has continued to state that they will maintain rates at low levels.

While most mREITs use some type of hedging to protect against adverse interest rate movements, the process is costly and doesn't always work to perfection. Ideally, mREITs would prefer a steep yield curve with slow changes in interest rates. (Slow changes can be properly managed) It is the quick and unexpected interest rate change that can be detrimental to mREITs. Like when interest rates shot up by 100bps in the Summer of 2013.

Which type of mREIT depends on what type of investor you are

There are many different approaches taken by mREITs in an attempt to generate profits for shareholders. Some mREITs focus exclusively on residential agency backed mortgages, which basically have an implied guarantee by the US government and may be considered, for all intents and purposes, risk-free. These are the issues backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Some of the mREITs in this category are Annaly Capital and American Capital Agency Corp. (NASDAQ:AGNC), at least until recently, when American Capital Agency began to invest in the stocks of other mREITs as well. This move was unprecedented and has been hailed as both genius and senseless.

Other REITs may prefer to invest in residential Non-agency securities, which offer a higher interest rate and are not guaranteed by the US Government. Non-agency mortgages are usually obtained by borrowers with credit scores that are too low to qualify for an agency mortgage. To invest in Non-agency mortgages however, the mREIT must have solid credit underwriting capabilities to determine the riskiness of the securities they are purchasing, along with the probability of default, and the loss given default estimates. Non-agency securities do have credit risk and it is important that mREITs in this space not experience an unexpectedly high level of losses due to defaults.

Still other mREITs may focus on the commercial side of the mortgage market, which is an area that Annaly has recently begun to explore. This sub-sector also offers higher interest rates than agency mortgages and the terms on these mortgages are usually shorter. But they are less liquid and relationships within the industry can go a long way to getting access to attractive deal flow.

Finally, I'll also mention that within each category there are mREITs that focus solely on fixed income securities while others prefer to invest in adjustable rate mortgages. Adjustable rate mortgages tend to have lower interest rates than fixed rate mortgages at the time of origination, but can adjust considerably depending on the movement of the interest rate benchmark that each security is linked to. Adjustable rate mortgages may be less sensitive to interest rate movements which could be a benefit in a rising rate environment. However, prepayment rates on adjustable rate mortgages can increase dramatically in anticipation of a rise in rates.

Most mREITs are not purely investing in just one type of mortgage security or another but diversify their approach by investing in several of the categories mentioned above. Some will adjust their strategy depending on which of the categories is offering the best opportunities.

The table below is a simple matrix ranking each category of mortgage security by certain metrics. It can be used by investors to determine which type of mortgage security they should be looking to invest in considering the their objectives and risks. For example, an investor who does not want to take credit risk, should focus on mREITs than invest in Fixed Agency mortgages. However, agency mortgages may have the longest duration and lowest interest rates so an investor should make sure they are comfortable with the risk/return profile of this sector.

For investors not willing to take duration risk, commercial mortgage backed securities may be a better option, but there may be additional credit risk involved. There are other factors to consider as well but I wanted to keep this as simple as possible. Other factors may include prepayment rates on the investment side and lets not forget that financing options for an mREIT are a critical part of its profit potential.

(Green=positive, yellow=neutral, red=negative, on a relative basis)

mREIT Allocation

For investors with a low risk tolerance and passive portfolio management style, they should probably stick to mREITs focused on the agency-backed mortgages and maintain a long-term strategic allocation to the sector. While these investments may still be volatile, at least the issue of credit risk is eliminated from the equation. On the other hand, an investor who actively manages their portfolio and has a higher risk tolerance may invest across the entire mREIT sector by tactically shifting exposure to the mREITs focused on strategies poised to do well in certain environments. Being on the wrong end of these investments can be costly, so only investors with the highest risk tolerance should even consider it.

Investors fitting other profiles may consider strategies somewhat in between the two extremes. Generally speaking, we would suggest using a core/satellite approach within your mREIT exposure, using the agency-backed REITs as core and tactically allocating to commercial and non-agency when appropriate.

mREITS compared to other asset classes

The chart below shows the performance of Annaly from 2004 through YTD 2014 and one of the things that jumps out at me is the divergence of performance between Annaly and both Diversified REIT Index and the S&P 500. In 2005, for example, Annaly was down 39%, while Diversified REITs were up 4.3% and the S&P 500 was up 4.9%. Fast forward to 2013 and Annaly had a total return of -18.3%, while both Diversified REITs and S&P500 had positive returns of 8.7% and 32.4%, respectively. So far I know I'm not making a strong case for investing in mREITs. But looking at 2004, 2006, 2007, 2008, 2010, 2011, and so far so good in 2014, mREITs outperformed one or both of the other two indices.

The point I'm trying to make here is that rather than run for the hills when it comes to mREITS, investors should accept that they should be a part of the overall portfolio.

(click to enlarge)

Source: Morningstar

Many mREITs are considered extremely volatile and I can't argue with that. Most mREITs have a standard deviation that is in line with Google (NASDAQ:GOOG), and slightly above Johnson & Johnson (NYSE:JNJ). You could argue that Google's volatility recently has been to the upside but when looking back over a longer period of time, standard deviation remained relatively stable even during phases when Google's stock wasn't on an upward trajectory.

Source: Morningstar

Valuations

Before all of the REIT experts chime in about FFO, let me first say that mortgage REITs use a metric called core earnings as the best measure of performance. FFO, or funds from operations is used by most REITs because of the high level of depreciation inherent in any company that holds a lot of real estate assets. Since mREITs don't actually invest in real estate, core earnings is used as the appropriate metric, which takes into consideration amortization of premiums on the underlying mortgage holdings.

On a core earnings basis, not very many mREITs look reasonably priced even though they had dramatic price declines last year. On a price/core earnings basis, only Annaly Capital looks interesting.

The other metric commonly used for valuation of mREITs is price to book. On a price to book basis, however, quite a few mREITs look undervalued. As we can see from the table below, most mREITs are currently trading at a discount to book value, which is very compelling.

(click to enlarge)

Source: Morningstar

The ongoing ability for mREITs to continue to pay the high level of dividends expected of them is contingent on the spread they are generating between the interest earned from investments and the interest paid on financing. As this spread tightens, the ability of the mREIT to pay the same level of dividends is threatened unless leverage is increased. Conversely, a widening spread indicates that future dividend increases may be in store for shareholders. As we mentioned in December, Annaly's net interest margin had finally stopped contracting, and last week's news that net interest margin increased by 36 bps was a huge positive surprise.

mREITS within a portfolio

As we mentioned earlier in the article, we are long-term holders of mREITs and cannot say without knowing each investor's specific situation whether it is a good investment and what type of allocation an investor should have. For investors already invested in the space, we'd like to point out a recent Barrons article suggested that investors hold on to their mREITs as tapering intentions have become better defined and transparent, allowing for better management of exposure to Fed policy by mREITs.

Within a portfolio, we would suggest categorizing mREITs along with high yield. Meaning, if mREITs are appropriate for you, you should only consider the percentage that has been allocated to high yield as a maximum, and a conservative approach would be to substitute only a portion of the high yield exposure with mREITs.

From a purely theoretical perspective, Hizmo and Van Nieuwerburgh conducted a study of the optimal portfolio including REITs and mREITs as part of the total allocation to the portfolio and determined that the optimal allocation to REITs was 20%, with 9% going to mREITs specifically.

This seems a bit high to us for an average investor but could be a good starting point and you can adjust your allocation up or down depending on individual circumstances and risk tolerances. The key is to diversify your portfolio and use mREITs as a piece of the overall pie.

Other REITs mentioned: Arlington Asset Management (NYSE:AI), Chimera Investment Corporation (NYSE:CIM), New York Mortgage Trust (NASDAQ:NYMT), Capstead Mortgage Corporation (NYSE:CMO), Resource Capital Corporation (NYSE:RSO), MFA Financial (NYSE:MFA), PennyMac Mortgage Investment Trust (NYSE:PMT), Two Harbors Investment Corp. (NYSE:TWO), Western Asset Mortgage Capital Corp. (NYSE:WMC), Invesco Mortgage Capital (NYSE:IVR), Anworth Mortgage Asset Corporation (NYSE:ANH), Hatteras Financial Corporation (NYSE:HTS), CYS Investments (NYSE:CYS), ARMOUR Residential REIT (NYSE:ARR).

Source: Mortgage REITs: Proceed Without Fear